There is a general view that executive compensation in corporate America is inefficient and corrupted. Discontent with executive pay is not a recent trend; rather, “scrutinizing, criticizing, and regulating high levels of executive pay has been an American pastime for nearly a century.” Since the early 2000s, however, this trend has found a systematic theoretical framework in the “managerial power theory” of executive compensation, espoused most prominently by Harvard law professors Lucian A. Bebchuk and Jesse M. Fried. In a recently published article, we challenge this view from both a theoretical and empirical perspective.
Managerial power theory views the typical CEO pay package as a reflection of managerial moral hazard. Managerial moral hazard is the risk that managers may fail to exert sufficient effort and abuse their corporate power for personal gains. In response to this risk, corporate law grants ultimate control over corporate affairs to the board of directors, as the institution charged with monitoring management decisions in the interest of shareholders. Managerial power scholars, however, argue that structural flaws in corporate governance, such as board insulation from shareholder discipline through the use of defensive measures, make boards largely beholden to managers. As a result, among other inefficiencies, managers can extract excessive pay or pay that is not tied to performance—that is, “inefficient rents.”
Managerial power theory has now become the dominant view in the law and economics literature. It has also led to major regulatory changes promoting shareholder empowerment, which managerial power scholars defend as the most effective remedy to address excessive executive pay.
Notwithstanding the far-reaching success of managerial power theory, our article argues that this theory fails to convincingly answer crucial questions about executive compensation. First, managerial power scholars fail to explain how one should reconcile their view with what we refer to as the “managerial talent theory” of executive compensation. The latter theory is the prevailing economic paradigm of executive compensation, pursuant to which CEO pay reflects compensation for scarce managerial talent in competitive markets. Managerial talent theory thus challenges the view that the executive-compensation process is isolated from competitive pressure, as managerial power scholars seem to assume.
Second, managerial power theory is premised on a static, one-period model of executive compensation, where the manager initially makes decisions, and then investments are liquidated, gains or losses are realized, and the manager gets paid by the end of the single period. In the real corporate world, however, the relationships between managers, boards, and shareholders tend to be dynamic, as investments typically play out along multi-period horizons and top executives hold their positions for several years. Consequently, we raise the question of how moving from a static to a dynamic setting affects the positive or normative conclusions of managerial power theory.
Third, recent empirical work on the value impact of defensive measures documents that temporary board protection from shareholder interference, such as the protection granted by a staggered board, is associated with increased firm value. But if board protection can serve a positive governance function, how can it also be the main culprit for inefficient executive pay, as claimed by managerial power scholars?
In investigating these and other questions, our article makes four main contributions. First, it shows that the data do not support the managerial power claim that defensive measures are a source of distortions in CEO pay, as the adoption of such measures is not associated with significant changes in CEO pay levels or structure. Second, the article documents that greater competition in the market for managerial talent is associated with statistically and economically significant increases in CEO pay, consistent with the predictions of managerial talent theory. Third, it documents that higher CEO pay is associated with higher firm value, and this effect is stronger when a corporation has a staggered board. Fourth, it provides plausible causal evidence that firms were overusing option-based pay—that is, high-powered incentives—in the early 2000s.
Overall, these results indicate that competition for talented managers is a critical source of increased CEO pay and that corporate governance provisions do not affect either CEO pay or its structure. Most important, they suggest that, in general, high executive pay is not excessive in the sense described by scholars of managerial power (that is, in the sense that it dissipates shareholder value). Rather, high executive pay seems to ensure that the most talented CEOs are indeed allocated to the most valuable firms to the benefit of these firms’ shareholders. Lastly, these results suggest that protecting boards from short-term market and shareholder interference may promote a more positive relationship between CEO pay and firm value, making it less likely that market forces may promote an excessive use of high-powered incentives that inefficiently emphasize short- over long-term performance.
Still, it could be argued that the results of our value analysis are subject to endogeneity concerns—the ever-present risk that correlation might be mistaken for causation. For example, it could be that enhanced CEO effectiveness or expectations of future positive performance result in higher CEO pay, rather than higher pay causing better performance. To mitigate such concerns, our article considers an event study that focuses on the 2005 introduction of Financial Accounting Standard (FAS) regulation 123(R). FAS123(R) mandated that all public firms expense stock options, eliminating the prior privileged accounting treatment of options relative to restricted stock. As the product of regulatory intervention, this event can be regarded as independent from firm-specific circumstances and, therefore, as plausibly inducing exogenous changes in both the levels and structure of CEO pay (that is, changes that are outside a firm’s direct control). It follows that examining the subsequent performance of firms that were and were not affected by the introduction of FAS123(R) can plausibly provide causal evidence about the impact of modifications in CEO pay levels and structure on firm value. In particular, as FAS123(R) leveled the playing field between the use of options and restricted stock from an accounting perspective, we expect such an event study to provide us with additional insights into the relative efficiency of more versus less powerful incentives.
We show that FAS123(R) led to a significant reduction in the option component of executive pay for the affected firms that had outstanding options. More importantly, we also show that the more firms reduced option grants in favor of restricted stock grants in the two years after the rule change, the greater the increase in firm value. Combined with our finding that greater market and shareholder pressures are associated with a larger use of option grants, these results confirm the above interpretation of our value analysis that market forces might introduce distortions in optimal incentive design, such as an excessive use of high-powered incentives that overemphasize short-term performance at the expense of long-term firm value.
From a normative perspective, our analysis provides important insights for the social welfare implications of the executive compensation debate. Our central results are that high executive pay is generally efficient in attracting talented managers. Based on these results, we defend the traditional deference paid by Delaware courts to board decision-making in executive- compensation matters as normatively desirable. With the same spirit, we argue that policymakers would do well to reconsider the case for enhanced shareholder power in the executive-pay process, as this case emerges as both theoretically and empirically wanting.
 Kevin J. Murphy, Executive Compensation: Where We Are, and How We Got There, in 2A Handbook of the Economics of Finance 211, 213 (George M. Constantinides et al. eds., 2013).
 See generally Lucian Arye Bebchuk & Jesse M. Fried, Executive Compensation as an Agency Problem, J. Econ. Persp., Summer 2003, at 71.
 See Simone M. Sepe, Making Sense of Executive Compensation, 36 Del. J. Corp. L. 189, 212–13 (2011). As a positive matter, the analysis developed in our article expands Sepe’s earlier analysis, incorporating a competitive-market framework
 See K.J. Martijn Cremers & Simone M. Sepe, The Shareholder Value of Empowered Boards, 68 Stan. L. Rev. 67, 109-117 (2016) and K. J. Martijn Cremers, Lubomir P. Litov & Simone M. Sepe, Staggered Boards and Long- Term Firm Value, Revisited, 126 J. Fin. Econ. 422 (2017).
This post comes to us from Professor Simone M. Sepe at the University of Arizona’s James E. Rogers College of Law. It is based on a recent article by him, Martijn Cremers, and Saura Masconale, “CEO Pay Redux” available here.