Pay Without Performance: The Unfulfilled Promise of Executive Compensation.

• Author: Core, John E.
• Position: Book Review - Brief Review

PAY WITHOUT PERFORMANCE: THE UNFULFILLED PROMISE OF EXECUTIVE COMPENSATION. By Lucian Bebchuk and Jesse Fried. Cambridge: Harvard University Press. 2004. Pp. 304. Cloth, $24.95.

INTRODUCTION

In Pay Without Performance, Professors Lucian Bebchuk (1) and Jesse Fried (2) develop and summarize the leading critiques of current executive compensation practices in the United States. This book, and their highly influential earlier article, Managerial Power and Rent Extraction in the Design of Executive Compensation, with David Walker (3) offer a negative, if mainstream, assessment of the state of U.S. executive compensation: U.S. executive compensation practices are failing in a widespread manner, and much systemic reform is needed. The purpose of our Review is to summarize the book and to offer some counterarguments to try to balance what is becoming an increasingly one-sided debate.

The book's thesis is that executive compensation practices in the U.S. benefit corporate executives at the expense of shareholders through implicit and explicit corruption of the pay-setting process. It argues that CEO employment contracts are bad for shareholders (not "optimal") because they are the product of managerial power. Managerial power arises, the authors claim, because boards of directors at public companies are beholden to the firm's top executives, largely due to management's control over the director nomination process. Weak compensation committees thus do little to protect the firm in its pay negotiations with the CEO, leading to levels of executive pay that are both inappropriately high and have inappropriately low levels of incentives. The only constraint on this process is "outrage," either among the firm's shareholders or the general public. This outrage constraint, however, only polices extreme cases of executive overcompensation.

In support of this claim, the authors offer a four-part analysis of CEO pay. In Part I, they begin with a short description and critique of optimal contracting theory, which posits that executive compensation arrangements are designed to benefit shareholders. (4) After developing their arguments against the optimal contracting thesis, they go on in Part II to explain their version of managerial power theory, in part through an in-depth analysis of current executive compensation practices. Having claimed to establish the superiority of managerial power theory to optimal contracting, in Part III the authors provide a more detailed critique of the relationship between CEO pay and firm performance. They assert that the managerial power theory provides a superior explanation of current practices to the optimal-contracting perspective. They also draw the strong implication that if such power exists, it means that something is wrong with the contracting process. They conclude in Part IV with their policy recommendations to address what they perceive to be the failings of executive pay practices.

While we agree with some of the analysis offered in Pay Without Performance, (5) we think it is important to put its arguments into perspective. In a nutshell, the key issue is whether the problems Bebchuk and Fried discuss are examples of a few bad apples or are evidence that the whole barrel is rotten. (6) The essence of their claim that the entire barrel is bad rests on the following assumption: If contracts are optimal, they do not reflect managerial power, and if contracts reflect managerial power, they are suboptimal. The authors view evidence of managerial power as evidence that the system is failing and that reform is needed.

We agree that it is useful to consider the effect of managerial power on compensation, but disagree with their interpretation of the consequences of such power. It is true that contract structures reflect CEO power, and that CEOs with more power get more pay, but this does not necessarily lead to the conclusion that CEO pay is not optimized for shareholders, nor does it imply that CEO pay needs reform.

More generally, our Review points out that Bebchuk and Fried have missed some important aspects of executive pay and incentives. As a result, they have not shown that there are systematic failures with U.S. CEO compensation, and therefore have not shown that reform is needed.

We try to accomplish this task in the following manner. We begin in Part I by summarizing what we see as the main themes of the book in some detail. This overview sets the stage for us in Part II to define carefully what we understand to be the optimal contract perspective and managerial power perspective. We then show that in many settings where managerial power exists, observed contracts anticipate and try to minimize the costs of this power, and therefore may in fact be written optimally. (7) As a result, the two perspectives are complementary, not competing, explanations.

In Part III, we examine Bebchuk and Fried's claim that U.S. CEO compensation is inefficient "pay without performance." We note that their analysis focuses primarily on whether CEO annual pay varies with firm performance, and that this perspective ignores the lion's share of CEOs' incentives: the large holdings of stock and options that provide powerful performance incentives and ensure that the wealth of most CEOs varies strongly with their firm's stock price. Thus, we believe that the authors' claim that CEO pay is "pay without performance" is based on a mischaracterization of the structure of U.S. CEO compensation and incentives.

Finally, we conclude by briefly examining some of Bebchuk and Fried's policy recommendations and summarizing our main points.

1. OVERVIEW OF THE BOOK

   In Pay Without Performance, Professors Lucian Bebchuk and Jesse Fried assert that American executives are vastly overpaid by their overly friendly boards of directors. Bebchuk and Fried argue that current executive pay practices are a sign of widespread corporate governance failures, a view that they believe to be supported by scholarly research on executive compensation.

   The departure point for their project is the large increases in U.S. CEO pay between 1992 and 2000. (8) Bebchuk and Fried maintain that current pay arrangements are inefficient and excessive, and are the result of managerial power and a lack of arm's-length bargaining. On the other hand, some financial economists are hesitant to conclude that current pay practices reflect a poorly functioning market for executive labor and question the generalizability of the managerial power perspective. (9)

   Bebchuk and Fried argue that the negotiations that take place between boards and CEOs over pay are distinctly one-sided in favor of the executive. Boards do not, and cannot, act as effective monitors of management because their members, even supposedly independent ones, are beholden to CEOs for a host of financial, social, and psychological reasons. Other players in the corporate governance field are either too weak, too unaware of the facts, or too interested in preserving the status quo, to do anything about it. In short, the thesis of the book is that the U.S. executive compensation system is broken and that serious corporate governance reform is needed to fix it.

   PART I. THE ARM'S-LENGTH BARGAINING MODEL

   Bebchuk and Fried begin with a description of the "official," or "arm's-length bargaining" model, which they claim informs most financial economists' research. This model rests on the widely accepted agency-cost model of the American corporation: diffuse ownership of large corporations leaves substantial discretion in professional managers' hands as to how to run the company, and managers can use this discretion in ways that do not maximize shareholder value. The resulting agency costs can be reduced through a variety of methods, including the use of a monitoring board of directors. Such a board will leave much discretion in the hands of managers, but oversee executives' actions in an attempt to minimize, but not eliminate, the agency costs resulting from the separation of ownership and control.

   As part of the effort to minimize agency costs, executive compensation is designed to provide incentives that reward managers for acting in ways that benefit shareholders. Theory predicts that boards will use schemes that pay each executive their reservation wage, which is the value of the next-best opportunity available to the manager, plus a premium for bearing the risk that comes with incentives that tie the manager's wealth to changes in shareholder value. These incentives induce the executive to exercise his discretion to create more shareholder value. When the firm's success depends heavily upon the decisions and effort level of its executives, then compensation contracts should be highly incentivized. As the amount of incentives is increased, however, so is the risk premium that executives demand, resulting in higher pay. An effective incentive contract maximizes the benefits of increasing shareholder value through incentives net the costs of paying for these higher incentives.

   Bebchuk and Fried argue that this model assumes that executive compensation arrangements are the product of "arm's-length bargaining between the executive and a board seeking to maximize shareholder value" (p. 18). They then ask the question of whether this assumption comports with the reality in the marketplace. Here, they contend the answer is a resounding no.

   Directors, in Bebchuk and Fried's view, are heavily biased against engaging in arm's-length negotiations for CEO pay. They offer a long list of reasons for this, including: CEOs control, or at least strongly influence, who sits on the board, and board members want to be reelected to continue to enjoy the many benefits of board membership; CEOs can award benefits to directors, directly or indirectly, by hiring their firms, or contributing to their favorite charities; CEOs have significant influence over director compensation, with higher CEO pay being...