Managerial Power and Rent Extraction in the Design of Executive Compensation

Abstract

This paper develops an account of the role and significance of managerial power and rent extraction in executive compensation. Under the optimal contracting approach to executive compensation, which has dominated academic re-search on the subject, pay arrangements are set by a board of directors that aims to maximize shareholder value. In contrast, the managerial power approach suggests that boards do not operate at arm's length in devising executive compensation arrangements; rather, executives have power to influence their own pay, and they use that power to extract rents.Furthermore, the desire to camouflage rent extraction might lead to the use of inefficient pay arrangements that provide suboptimal incentives and thereby hurt shareholder value. The authors show that the processes that produce compensation arrangements, and the various market forces and constraints that act on these processes, leave managers with considerable power to shape their own pay arrangements.Examining the large body of empirical work on executive compensation, the authors show that managerial power and the desire to camouflage rents can explain significant features of the executive compensation landscape, including ones that have long been viewed as puzzling or problematic from the optimal contracting perspective. The authors conclude that the role managerial power plays in the design of executive compensation is significant and should be taken into account in any examination of executive pay arrangements or of corporate governance generally.

The economic psychology of incentives: An international study of top managers

“…In other words, we argue that part of the explanation for the inflation in executive compensation is a consequence of the form in which compensation is provided. This is not the same as the managerial power or "board capture" hypothesis (Bebchuk & Fried, 2004;Bebchuk, Fried, & Walker, 2002) which proposes that executives exercise undue influence over boards, thereby encouraging non-executive directors to allow executive compensation to be inflated over and above the market clearing wage. Our argument is more subtle.…”

The remuneration of independent directors in the UK and Italy: An empirical analysis based on agency theory

“…High levels of INEDs' remuneration could reflect the time commitment (Adams & Ferreira, 2008) and reputational risk that accompanies the INEDs role (e.g., Linck, Netter & Yang, 2009;Aguir, Burns, Mansi & Wald, 2014). On the other hand, INEDs' remuneration might also reveal INEDs' ineffectiveness because of the potential reciprocity between INEDs and corporate insiders where ineffective monitoring makes corporate insiders more inclined towards INEDs' remuneration increases (Bebchuk, Fried & Walker, 2002). From this perspective, INEDs' remuneration could represent a "reward" for ineffective monitoring actions resulting from the collusion between INEDs and corporate insiders.…”

Public Opinion and Executive Compensation

“…Nevertheless, it is still unclear whether public opinion has influence over the setting of executive compensation. The existence of a public outrage constraint that could limit the level of CEO pay has been assumed in the managerial power view of executive compensation proposed by Bebchuk, Fried, & Walker (2002) and Bebchuk & Fried (2004). Also, Weisbach (2007) argues that firms may camouflage executive compensation by having it take forms that are typically not discussed in the press, so as not to attract public attention.…”