The manager's share.

• Author: Walker, David I.

THE MANAGER'S SHARE TABLE OF CONTENTS INTRODUCTION I. THE FIXED APPROPRIATION VIEW AND APPROPRIATION DEFINED A. The Fixed Appropriation Argument Deployed B. Appropriation Defined II. THE EXTERNAL MARKET FORCES LIMITATION AND FIXED APPROPRIATION A. The External Market Forces Limitation Argument 1. Managerial Labor Market (Reputation) 2. The Market for Corporate Control 3. Capital and Products Markets B. Objections to the Market Forces Limitation Argument 1. Imperfect Markets Result in Significant Slack 2. Efficiency Differences Affect Appropriation (But Only in an Evolutionary Sense) 3. Opaque Appropriation Undermines Market Discipline III. EFFECT OF ADDITIONAL AVENUES OF APPROPRIATION WITHIN THE OPTIMAL CONTRACTING FRAMEWORK A. The Optimal Contracting Model of Managerial Compensation B. Optimal Compensation Exceeds Lower Bound on the Manager's Share C. Upper Bound on the Manager's Share D. Effect of an Additional Channel of Appropriation on the Optimal Contract E. Factors Affecting the Magnitude of Managerial Appropriation Under the Optimal Contracting Model 1. Difficulty of Direct Monitoring 2. Intensity of Private Benefits 3. Ability of Directors to "Just Say No" IV. EFFECT OF ADDITIONAL AVENUES OF APPROPRIATION UNDER THE MANAGERIAL POWER MODEL A. Description of the Managerial Power Model B. Avenues of Value Appropriation Under the Managerial Power Model 1. Opaque Value Transfer 2. Plausible Justifications for Additional Transfers 3. Both Opaque and Plausibly Justified C. Other Factors Affecting Managerial Appropriation Under the Managerial Power Model V. EMPIRICAL EVIDENCE A. The Empirical Evidence Suggests that Unconventional Compensation Increases Total Compensation 1. Stock Options 2. Deal Bonuses 3. Corporate Aircraft 4. Executive Loans 5. Insider Trading B. The Empirical Evidence Suggests At Least Some Incremental Appropriation 1. Deal Bonuses 2. Stock Options 3. Perks 4. Executive Loans C. The Empirical Evidence Is Generally Inconsistent with the Optimal Contracting Model (and Consistent with the Managerial Power Model) 1. Deal Bonuses 2. Stock Options 3. Perks and Loans 4. Insider Trading VI. IMPLICATIONS A. Channels Matter B. Disclosure Matters C. Legal Rules Matter CONCLUSION ABSTRACT

It is sometimes argued in the corporate governance literature that the total share of corporate value that can be extracted by a manager is fixed and independent of the avenues through which value is extracted. Shareholders need not worry about an activity such as insider trading, the story goes, because any profits achieved by a manager through insider trading will simply offset conventional compensation. This Article challenges that idea and argues that whether one views the manager's share as being capped by external market forces, set by an optimal principal/agent contract, or limited by saliency and outrage in accordance with the managerial power view of corporate governance, the total value that can and will be appropriated by managers will be a function of the number and type of avenues through which value can be appropriated.

Although analysis of each of the corporate governance mechanisms results in the same directional prediction, the magnitude of the impact of expanding channels of appropriation depends on which mechanism dominates. For example, potential avenues of appropriation that are easily monitored and under the unilateral control of the directors, such as bonuses or perks, should have little effect on incremental appropriation under the optimal contracting model, but could have significant impact under the managerial power model. A review of the relevant empirical literature suggests that additional avenues of appropriation do indeed lead to greater overall appropriation. The evidence, moreover, is largely inconsistent with the optimal contracting view. This analysis highlights a largely overlooked cost of compensation complexity: In all likelihood, the increasing complexity and opacity of executive compensation over the last two decades has contributed to the overall increase in managerial appropriation.

INTRODUCTION

Corporate governance scholars sometimes argue that the total share of corporate value that a manager can extract is independent of the avenues through which value is extracted. Easterbrook and Fischel put it this way:

Managers with the power to pay themselves can take their profits once only. They can't take it in salary, and a second time in options, and a third time in trading profits, and a fourth time in perks. Grant that managers can wring so much from investors; then they will take it, and the division between trading profits and skyboxes to football games matters only if the form of compensation has efficiency properties. (1) This Article challenges the idea that the manager's share is fixed. Whether one views managerial appropriation as being capped by external market forces, set by an optimal principal/agent contract, or limited by saliency and outrage in accordance with the managerial power view of corporate governance, the total value that can and will be appropriated by managers of diffusely held public companies (2) will be a function of the number and type of avenues through which value can be appropriated. To be sure, some avenues of appropriation are less problematic under one model of corporate governance than another, but the bottom line conclusion is the same--channels of appropriation matter.

Resistance to the fixed slack argument is not novel. Many commentators have approached various corporate governance arrangements under the assumption that total appropriation increases as channels of appropriation increase. (3) A primary contribution of this Article, however, is to provide a rigorous analysis of and rebuttal to the fixed appropriation view.

The mechanism that controls the manager's share of corporate wealth is not perfectly understood. The optimal contracting model of the managerial agency relationship posits that the principal (the board of directors on behalf of the shareholders) can only imperfectly observe the effort, focus, and effectiveness of its agent (the manager) and negotiates a contract that minimizes the resulting agency costs, that is, the costs of (1) contracting with the manager, (2) monitoring the manager's performance, (3) bonding by the manager to maximize shareholder value, and (4) the residual slack or divergence that remains between the actions selected by the manager and those that would optimally benefit the shareholders. (4)

Recently, two colleagues and I have set forth a managerial power theory of managerial slack that can be seen as supplementing the optimal contracting theory. (5) Under the managerial power theory, appropriation by strong managers is limited by the outrage that excessive appropriation causes among financial analysts, institutional investors, and other corporate governance watchdogs. (6) Outside directors are sensitive to this outrage, and limit managerial compensation accordingly. (7) As a result, managers have an incentive to camouflage compensation in order to limit outrage. (8)

Under both of the aforementioned theories there is an overriding cap on managerial value extraction that is determined by external market forces--markets for corporate control, capital, products, and even the managerial labor market. External market forces, however, are generally thought to permit considerable slack, leaving one to question the extent to which such forces actually limit appropriation. (9)

Given the controversy concerning which mechanism actually limits managerial appropriation, this Article considers the impact of additional avenues of value appropriation under each theory. I first analyze the external market forces that are viewed as placing an upper bound on managerial appropriation and rendering channels of appropriation irrelevant. If managerial labor and takeover markets limited appropriation, and if these markets were perfectly transparent and competitive, avenues of appropriation would not affect a manager's overall share. Rational managers would themselves select the most efficient compensation arrangement in order to appropriate as much firm value as possible without triggering market discipline. Managers would reject inefficient compensation and would be forced to trade off equally efficient forms dollar for dollar. (10)

In reality, of course, markets are imperfect, and far from transparent. But the fact that there is market slack only means that managers are able to appropriate more under this model; it does not mean that channels matter. Presumably, managers operating under a slack market forces limitation would still maximize their share and trade off one form of efficient compensation for another dollar for dollar, albeit at a higher overall level. However, additional opaque avenues of appropriation do affect total appropriation under this model because each new opaque channel undermines the effectiveness of these external market forces. Legalizing insider trading, for example, would weaken managerial labor market discipline and permit increased managerial appropriation because private monitoring of insider trading would be difficult and costly. (11)

Next, I consider the effect of additional appropriation channels under the optimal contracting model. Stickiness in external market forces suggests that there often will be a significant gap between the minimum amount of compensation required to attract and retain a manager--the reservation wage--and the external market forces limitation on appropriation. Shareholders, or boards of directors acting for them, may be able to hold appropriation and agency costs to a level below the external market forces limitation through aggressive monitoring and the use of incentive compensation. The optimal contracting model posits that shareholders will minimize agency costs through this internal labor "market." (12)

A simple thought experiment demonstrates why...