0AY 7ITHOUT 0ERFORMANCE /VERVIEW OF THE )SSUES

BY ,UCIAN ! "EBCHUK (ARVARD ,AW 3CHOOL AND *ESSE - &RIED 5NIVERSITY OF #ALIFORNIA AT "ERKELEY

)N JUDGING WHETHER #ORPORATE !MERICA IS SERIOUS ABOUT REFORMING ITSELF

#%/ PAY REMAINS THE ACID TEST 4O DATE THE RESULTS ARENT ENCOURAGING
7ARREN "UFFETT LETTER TO SHAREHOLDERS OF "ERKSHIRE (ATHAWAY )NC &EBRUARY 

N OUR RECENT BOOK 0AY 7ITHOUT 0ERFORMANCE

AND IN SEVERAL ACCOMPANYING AND SUBSEQUENT
PAPERS WE SEEK TO PROVIDE A FULL ACCOUNT OF HOW
MANAGERIAL POWER AND INmUENCE HAVE SHAPED
EXECUTIVE COMPENSATION IN PUBLICLY TRADED 53 COMPANIES
&INANCIAL ECONOMISTS STUDYING EXECUTIVE COMPENSATION
HAVE TYPICALLY ASSUMED THAT PAY ARRANGEMENTS ARE PRODUCED
BY ARMS LENGTH CONTRACTING
CONTRACTINGCONTRACTING BETWEEN EXECU
TIVES ATTEMPTING TO GET THE BEST POSSIBLE DEAL FOR THEMSELVES
AND BOARDS TRYING TO GET THE BEST DEAL FOR SHAREHOLDERS 4HIS
ASSUMPTION HAS ALSO BEEN THE BASIS FOR THE CORPORATE LAW
RULES GOVERNING THE SUBJECT 7E AIM TO SHOW HOWEVER THAT
THE PAY SETTING PROCESS IN 53 PUBLIC COMPANIES HAS STRAYED
FAR FROM THE ARMS LENGTH MODEL
/UR ANALYSIS INDICATES THAT MANAGERIAL POWER HAS PLAYED
A KEY ROLE IN SHAPING EXECUTIVE PAY 4HE PERVASIVE ROLE OF
MANAGERIAL POWER CAN EXPLAIN MUCH OF THE CONTEMPORARY
LANDSCAPE OF EXECUTIVE COMPENSATION INCLUDING PRACTICES
AND PATTERNS THAT HAVE LONG PUZZLED lNANCIAL ECONOMISTS
7E ALSO SHOW THAT MANAGERIAL INmUENCE OVER THE DESIGN OF
PAY ARRANGEMENTS HAS PRODUCED CONSIDERABLE DISTORTIONS IN
THESE ARRANGEMENTS RESULTING IN COSTS TO INVESTORS AND THE
ECONOMY 4HIS INmUENCE HAS LED TO COMPENSATION SCHEMES
THAT WEAKEN MANAGERS INCENTIVES TO INCREASE lRM VALUE AND
EVEN CREATE INCENTIVES TO TAKE ACTIONS THAT REDUCE LONG TERM
lRM VALUE

4HE DRAMATIC RISE IN #%/ PAY DURING THE LAST TWO

DECADES HAS BEEN THE SUBJECT OF MUCH PUBLIC CRITICISM WHICH
INTENSIlED FOLLOWING THE CORPORATE GOVERNANCE SCANDALS THAT
BEGAN ERUPTING IN LATE  4HE WAVE OF CORPORATE SCANDALS
SHOOK CONlDENCE IN THE PERFORMANCE OF PUBLIC COMPANY
BOARDS AND DREW ATTENTION TO POSSIBLE mAWS IN THEIR EXECUTIVE
COMPENSATION PRACTICES !S A RESULT THERE IS NOW WIDESPREAD
RECOGNITION THAT MANY BOARDS HAVE EMPLOYED COMPENSATION
ARRANGEMENTS THAT DO NOT SERVE SHAREHOLDERS INTERESTS "UT
THERE IS STILL SUBSTANTIAL DISAGREEMENT ABOUT THE SCOPE AND
SOURCE OF SUCH PROBLEMS AND NOT SURPRISINGLY ABOUT HOW TO
ADDRESS THEM
-ANY TAKE THE VIEW THAT CONCERNS ABOUT EXECUTIVE
COMPENSATION HAVE BEEN EXAGGERATED 3OME MAINTAIN THAT
mAWED COMPENSATION ARRANGEMENTS HAVE BEEN LIMITED TO
A RELATIVELY SMALL NUMBER OF lRMS AND THAT MOST BOARDS
HAVE EFFECTIVELY CARRIED OUT THEIR ROLE OF SETTING EXECUTIVE
PAY /THERS CONCEDE THAT mAWS IN COMPENSATION ARRANGE
MENTS HAVE BEEN WIDESPREAD BUT MAINTAIN THAT THESE mAWS
HAVE RESULTED FROM HONEST MISTAKES AND MISPERCEPTIONS ON
THE PART OF BOARDS SEEKING TO SERVE SHAREHOLDERS !CCORDING
TO THIS VIEW NOW THAT THE PROBLEMS HAVE BEEN RECOGNIZED
CORPORATE BOARDS CAN BE EXPECTED TO lX THEM ON THEIR OWN
3TILL OTHERS ARGUE THAT EVEN THOUGH REGULATORY INTERVEN
TION WAS NECESSARY RECENT REFORMS THAT STRENGTHEN DIRECTOR
INDEPENDENCE WILL FULLY ADDRESS PAST PROBLEMS ONCE THESE

4HIS PAPER IS A REVISION OF AN ARTICLE PREPARED FOR THE SUMMER  ISSUE OF THE
*OURNAL OF #ORPORATION ,AW &OR lNANCIAL SUPPORT WE WOULD LIKE TO THANK THE *OHN - /LIN
#ENTER FOR ,AW %CONOMICS AND "USINESS AND THE 'UGGENHEIM ,ENS AND .ATHAN #UM
MINS &OUNDATIONS "EBCHUK  AND THE "OALT (ALL &UND AND THE 5# "ERKELEY #OMMITTEE ON
2ESEARCH &RIED 
 ,UCIAN ! "EBCHUK AND *ESSE - &RIED 0AY 7ITHOUT 0ERFORMANCE 4HE 5NFULlLLED
0ROMISE OF %XECUTIVE #OMPENSATION #AMBRIDGE -! (ARVARD 5NIVERSITY 0RESS  
%ARLIER ARTICLES BY US ON WHICH THE BOOK DRAWS INCLUDE ,UCIAN ! "EBCHUK *ESSE - &RIED
AND $AVID ) 7ALKER h-ANAGERIAL 0OWER AND 2ENT %XTRACTION IN THE $ESIGN OF %XECUTIVE
#OMPENSATIONv 5NIVERSITY OF #HICAGO ,AW 2EVIEW 6OL    PP   AND
,UCIAN ! "EBCHUK AND *ESSE - &RIED h%XECUTIVE #OMPENSATION AS AN !GENCY 0ROBLEMv

*OURNAL OF %CONOMIC 0ERSPECTIVES 6OL    PP  

 4HESE STUDIES INCLUDE ,UCIAN ! "EBCHUK AND *ESSE - &RIED h3TEALTH #OMPENSA
TION VIA 2ETIREMENT "ENElTSv "ERKELEY "USINESS ,AW *OURNAL 6OL    PP  
,UCIAN ! "EBCHUK AND *ESSE - &RIED h%XECUTIVE #OMPENSATION AT &ANNIE -AE ! #ASE
3TUDY OF 0ERVERSE )NCENTIVES .ONPERFORMANCE 0AY AND #AMOUmAGEv FORTHCOMING IN
*OURNAL OF #ORPORATION ,AW   ,UCIAN ! "EBCHUK AND 9ANIV 'RINSTEIN h4HE 'ROWTH OF
%XECUTIVE 0AYv /XFORD 2EVIEW OF %CONOMIC 0OLICY 6OL    PP   ,UCIAN !
"EBCHUK AND 2OBERT *ACKSON *R h0UTTING %XECUTIVE 0ENSIONS ON THE 2ADAR 3CREENv (AR
VARD /LIN 0APER .O  FORTHCOMING IN *OURNAL OF #ORPORATION ,AW   AND ,UCIAN
! "EBCHUK AND 9ANIV 'RINSTEIN h&IRM %XPANSION AND #%/ 0AYv 7ORKING 0APER (ARVARD
,AW 3CHOOL AND ."%2  

*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

! -ORGAN 3TANLEY 0UBLICATION s &ALL 

REFORMS ARE IMPLEMENTED BOARDS CAN BE EXPECTED TO ADOPT

SHAREHOLDER SERVING PAY POLICIES
/UR WORK SEEKS TO PERSUADE READERS THAT SUCH COMPLA
CENCY IS UNWARRANTED 4O BEGIN WITH mAWED COMPENSATION
ARRANGEMENTS HAVE NOT BEEN LIMITED TO A SMALL NUMBER OF
hBAD APPLESv THEY HAVE BEEN WIDESPREAD PERSISTENT AND
SYSTEMIC &URTHERMORE THE PROBLEMS HAVE NOT RESULTED
FROM TEMPORARY MISTAKES OR LAPSES OF JUDGMENT THAT BOARDS
CAN BE EXPECTED TO CORRECT ON THEIR OWN RATHER THEY HAVE
STEMMED FROM STRUCTURAL DEFECTS IN THE UNDERLYING GOVER
NANCE STRUCTURE THAT ENABLE EXECUTIVES TO EXERT CONSIDERABLE
INmUENCE OVER THEIR BOARDS 4HE ABSENCE OF EFFECTIVE ARMS
LENGTH DEALING UNDER TODAYS SYSTEM OF CORPORATE GOVERNANCE
HAS BEEN THE PRIMARY SOURCE OF PROBLEMATIC COMPENSATION
ARRANGEMENTS &INALLY WHILE RECENT REFORMS THAT SEEK TO
INCREASE BOARD INDEPENDENCE WILL LIKELY IMPROVE MATTERS
THEY WILL NOT BE SUFlCIENT TO MAKE BOARDS ADEQUATELY
ACCOUNTABLE MUCH MORE NEEDS TO BE DONE
!NOTHER BROADER AIM OF OUR WORK HAS BEEN TO CONTRIB
UTE TO A BETTER UNDERSTANDING OF SOME BASIC PROBLEMS
WITH THE 53 CORPORATE GOVERNANCE SYSTEM 4HE STUDY OF
EXECUTIVE COMPENSATION OPENS A WINDOW THROUGH WHICH
WE CAN EXAMINE OUR CURRENT RELIANCE ON BOARDS TO ACT AS
GUARDIANS OF SHAREHOLDERS INTERESTS /UR CORPORATE GOVER
NANCE SYSTEM GIVES BOARDS SUBSTANTIAL POWER AND COUNTS
ON THEM TO MONITOR AND SUPERVISE COMPANY MANAGERS !S
LONG AS CORPORATE DIRECTORS ARE BELIEVED TO CARRY OUT THEIR
TASKS FOR THE BENElT OF SHAREHOLDERS CURRENT GOVERNANCE
ARRANGEMENTSWHICH INSULATE BOARDS FROM INTERVENTION BY
SHAREHOLDERSAPPEAR ACCEPTABLE /UR ANALYSIS OF THE EXECU
TIVE PAY LANDSCAPE CASTS DOUBT ON THE VALIDITY OF THIS BELIEF
AND ON THE WISDOM OF INSULATING BOARDS FROM SHAREHOLDERS
! FULL UNDERSTANDING OF THE mAWS IN CURRENT COMPEN
SATION ARRANGEMENTS AND IN THE GOVERNANCE PROCESSES THAT
HAVE PRODUCED THEM IS NECESSARY TO ADDRESS THESE PROBLEMS
!FTER PROVIDING A FULL ACCOUNT OF THE EXISTING PROBLEMS OUR
WORK ALSO PUTS FORWARD A SET OF PROPOSALS FOR IMPROVING BOTH
EXECUTIVE PAY AND CORPORATE GOVERNANCE 7E PROVIDE DETAILED
SUGGESTIONS FOR MAKING BOTH THE AMOUNT OF PAY AND ITS
PERFORMANCE SENSITIVITY MORE TRANSPARENT 3UCH TRANSPARENCY
WILL PROVIDE A BETTER CHECK ON MANAGERS POWER TO INmUENCE
THEIR OWN PAY )T WILL ALSO ELIMINATE EXISTING INCENTIVES TO
CHOOSE COMPENSATION ARRANGEMENTS THAT ARE LESS EFlCIENT BUT
MORE EFFECTIVE IN CAMOUmAGING EITHER THE AMOUNT OF PAY OR
ITS INSENSITIVITY TO MANAGERS OWN PERFORMANCE
&URTHERMORE OUR ANALYSIS OF THE MANY WAYS IN WHICH
PAY SCHEMES WEAKEN OR DISTORT MANAGERIAL INCENTIVES PROVIDES
A BASIS FOR RECOMMENDING HOW CORPORATE BOARDS COULD
STRENGTHEN THE LINK BETWEEN PAY AND PERFORMANCE AND THEREBY
IMPROVE INCENTIVES &INALLY WE PROPOSE A NUMBER OF REFORMS
THAT WOULD MAKE DIRECTORS NOT ONLY MORE INDEPENDENT OF
INSIDERS BUT ALSO MORE DEPENDENT ON SHAREHOLDERS THUS
IMPROVING BOARD ACCOUNTABILITY TO SHAREHOLDERS 3UCH REFORMS
*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

MAY WELL OFFER THE MOST PROMISING ROUTE FOR IMPROVING EXECU
TIVE COMPENSATION AND CORPORATE GOVERNANCE MORE GENERALLY
)N THIS PAPER WE OUTLINE SOME OF THE MAIN ELEMENTS OF
OUR CRITIQUE OF CONTEMPORARY EXECUTIVE COMPENSATION AND
CORPORATE GOVERNANCE ARRANGEMENTS AS WELL AS OUR PROPOSALS
AND SUGGESTED REFORMS 7E START BY DESCRIBING THE LIMITATIONS
OF THE OFlCIAL ARMS LENGTH MODEL OF EXECUTIVE COMPENSA
TION 7E THEN TURN TO THE MANAGERIAL POWER PERSPECTIVE 7E
SHOW THAT MANAGERIAL INmUENCE CAN EXPLAIN MANY FEATURES
OF THE COMPENSATION LANDSCAPE AND EXPLAIN HOW THIS INmU
ENCE HAS LED TO OPAQUE AND DISTORTED PAY ARRANGEMENTS 7E
CONCLUDE WITH A DISCUSSION OF OUR PROPOSALS FOR MAKING PAY
MORE TRANSPARENT IMPROVING THE DESIGN OF PAY ARRANGE
MENTS AND INCREASING BOARD ACCOUNTABILITY
"EFORE PROCEEDING WE WANT TO EMPHASIZE THAT OUR
CRITIQUE OF EXISTING PAY ARRANGEMENTS AND PAY SETTING
PROCESSES DOES NOT IMPLY THAT MOST DIRECTORS AND EXECUTIVES
HAVE ACTED LESS ETHICALLY THAN OTHERS WOULD HAVE IN THEIR
PLACE /UR PROBLEM IS NOT WITH THE MORAL CALIBER OF DIRECTORS
AND EXECUTIVES BUT RATHER WITH THE SYSTEM OF ARRANGEMENTS
AND INCENTIVES WITHIN WHICH DIRECTORS AND EXECUTIVES
OPERATE !S CURRENTLY STRUCTURED OUR CORPORATE GOVERNANCE
SYSTEM UNAVOIDABLY CREATES INCENTIVES AND PSYCHOLOGICAL
AND SOCIAL FORCES THAT DISTORT PAY CHOICES 3UCH INCENTIVES
AND FORCES CAN BE EXPECTED TO LEAD MOST PEOPLE TO GO ALONG
WITH ARRANGEMENTS THAT FAVOR THEIR COLLEAGUES OR INDIVIDUALS
WHO CAN IN TURN FAVOR THEM AS LONG AS THESE ARRANGEMENTS
ARE CONSISTENT WITH PREVAILING PRACTICES AND CONVENTIONS
AND THUS NOT DIFlCULT TO JUSTIFY TO THEMSELVES AND TO OTHERS
)F WE WERE TO MAINTAIN THE BASIC STRUCTURE OF THE SYSTEM
AND MERELY REPLACE CURRENT DIRECTORS AND EXECUTIVES WITH A
DIFFERENT SET OF INDIVIDUALS THE NEW DIRECTORS AND EXECUTIVES
WOULD BE EXPOSED TO THE SAME INCENTIVES AND FORCES AS THEIR
PREDECESSORS AND BY AND LARGE WE WOULD NOT EXPECT THEM
TO ACT ANY DIFFERENTLY 4O ADDRESS THE mAWS IN THE PAY SETTING
PROCESS WE NEED TO CHANGE THE GOVERNANCE ARRANGEMENTS
THAT PRODUCE THESE DISTORTIONS
4HE 3TAKES
7HAT IS AT STAKE IN THE DEBATE OVER EXECUTIVE PAY 3OME
MIGHT QUESTION WHETHER EXECUTIVE COMPENSATION HAS A
SIGNIlCANT ECONOMIC IMPACT ON SHAREHOLDERS AND THE ECON
OMY 4HE PROBLEMS WITH EXECUTIVE COMPENSATION IT MIGHT
BE ARGUED DO NOT MUCH AFFECT SHAREHOLDERS BOTTOM LINE
BUT INSTEAD ARE MAINLY SYMBOLIC (OWEVER THE QUESTION OF
WHETHER AND TO WHAT EXTENT PAY ARRANGEMENTS ARE mAWED
IS IMPORTANT FOR SHAREHOLDERS AND POLICYMAKERS BECAUSE
DEFECTS IN THESE ARRANGEMENTS CAN IMPOSE SUBSTANTIAL COSTS
ON SHAREHOLDERS
,ETS START WITH THE EXCESS PAY THAT MANAGERS RECEIVE AS A
RESULT OF THEIR POWERTHAT IS THE DIFFERENCE BETWEEN WHAT
MANAGERS INmUENCE ENABLES THEM TO OBTAIN AND WHAT THEY
WOULD GET UNDER ARMS LENGTH CONTRACTING !S A RECENT STUDY
! -ORGAN 3TANLEY 0UBLICATION s &ALL 

4ABLE 

!GGREGATE 4OP &IVE #OMPENSATION   IN BILLIONS OF  DOLLARS

&ULL PERIOD
&IRST lVE YEARS
,AST lVE YEARS

0ERIOD

!LL %XECU#OMP
&IRMS

.ON %XECU#OMP
&IRMS

!LL &IRMS

 
 
 













.OTES 4HE TABLE SHOWS AGGREGATE COMPENSATION PAID BY A LARGE SET OF PUBLIC lRMS TO THEIR TOP lVE EXECUTIVES 4HE SAMPLE INCLUDES ALL %XECU#OMP lRMS AND #OMPUSTAT lRMS WITH
MARKET CAP LARGER THAN  MILLION EXCEPT FOR 2%)4S MUTUAL FUNDS OTHER INVESTMENT FUNDS 3)# CODES XX  AND lRMS WITH MISSING #OMPUSTAT DATA 4HE COMPENSATION PAID TO EXECU
TIVES OF NON %XECU#OMP lRMS IS ESTIMATED USING THE COEFlCIENTS FROM ANNUAL REGRESSIONS OF COMPENSATION ON lRM CHARACTERISTICS IN %XECU#OMP lRMS
3OURCE "EBCHUK AND 'RINSTEIN h4HE 'ROWTH OF %XECUTIVE 0AYv

4ABLE 

#OMPENSATION AND #ORPORATE %ARNINGS

0ERIOD

!GGREGATE 4OP &IVE

#OMPENSATION
TO !GGREGATE %ARNINGS

4HREE YEAR PERIODS

 
 
 
 
 
 
 
 
 











&IVE YEAR PERIODS

 
 




&ULL PERIOD

 



.OTES 4HE TABLE SHOWS FOR A LARGE SET OF PUBLIC lRMS THE RATIO OF THE AGGREGATE COMPENSATION OF THESE lRMS TOP lVE EXECUTIVES TO THE AGGREGATE EARNINGS NET INCOME OF THESE
lRMS 4HE SET OF lRMS INCLUDES ALL %XECU#OMP lRMS AND #OMPUSTAT lRMS WITH MARKET CAP LARGER THAN  MILLION EXCEPT FOR 2%)4S MUTUAL FUNDS OTHER INVESTMENT FUNDS AND lRMS WITH
MISSING #OMPUSTAT DATA )NCOME INFORMATION IS FROM #OMPUSTAT AND THE ESTIMATES OF AGGREGATE TOP lVE COMPENSATION ARE CALCULATED IN THE SAME WAY AS IN 4ABLE 
3OURCE "EBCHUK AND 'RINSTEIN h4HE 'ROWTH OF %XECUTIVE 0AYv

BY 9ANIV 'RINSTEIN AND ONE OF US DOCUMENTS IN DETAIL THE

AMOUNTS INVOLVED ARE HARDLY POCKET CHANGE FOR SHAREHOLD
ERS !MONG OTHER THINGS THIS STUDY PROVIDES lGURES FOR THE
AGGREGATE COMPENSATION OF THE TOP lVE EXECUTIVES OF PUBLICLY
TRADED 53 lRMS !CCORDING TO THE STUDYS ESTIMATES WHICH
ARE SHOWN IN 4ABLE  THESE COMPANIES PAID THEIR TOP lVE
EXECUTIVES A TOTAL OF  BILLION DURING THE ELEVEN YEAR
PERIOD   WITH ABOUT  BILLION PAID DURING
THE lVE YEAR PERIOD   .OTE THAT THE AGGREGATE
COMPENSATION lGURES REPORTED BY THE STUDY REmECT ONLY THOSE
AMOUNTS REPORTED IN EACH lRMS ANNUAL SUMMARY COMPEN
SATION TABLE !S WILL BE DISCUSSED LATER STANDARD EXECUTIVE
COMPENSATION DATASETS LIKE THE %XECU#OMP DATASET USED
IN THE STUDY OMIT MANY SIGNIlCANT FORMS OF COMPENSA
TION SUCH AS THE SUBSTANTIAL AMOUNTS OF RETIREMENT BENElTS
RECEIVED BY EXECUTIVES 4HUS THE AGGREGATE COMPENSATION

lGURES MAY SIGNIlCANTLY UNDERSTATE THE ACTUAL COMPENSA

TION RECEIVED BY TOP EXECUTIVES DURING THIS PERIOD
4ABLE  DISPLAYS THE RATIO OF AGGREGATE TOP lVE COMPEN
SATION TO AGGREGATE CORPORATE EARNINGS FOR PUBLICLY TRADED
53 lRMS 3UCH AGGREGATE COMPENSATION ACCOUNTED FOR
 OF THE AGGREGATE EARNINGS NET INCOME OF PUBLICLY
TRADED 53 lRMS DURING THE PERIOD   -OREOVER
DURING THE MOST RECENT THREE YEAR PERIOD EXAMINED BY
THE STUDY    AGGREGATE TOP lVE COMPENSATION
JUMPED TO  OF AGGREGATE EARNINGS UP FROM  DURING
THE PERIOD  
4HESE lGURES INDICATE THAT IF COMPENSATION LEVELS COULD
BE CUT WITHOUT WEAKENING MANAGERIAL INCENTIVES THE GAIN
TO INVESTORS WOULD NOT BE MERELY SYMBOLIC IT WOULD HAVE
A DISCERNIBLE EFFECT ON CORPORATE EARNINGS "UT EXCESS PAY
IS UNLIKELY TO BE THE ONLY OR EVEN THE MAIN COST OF CURRENT

 "EBCHUK AND 'RINSTEIN h4HE 'ROWTH OF %XECUTIVE 0AYv CITED EARLIER



*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

! -ORGAN 3TANLEY 0UBLICATION s &ALL 

COMPENSATION PRACTICES -ANAGERS INmUENCE OVER THEIR

COMPENSATION ARRANGEMENTS CAN RESULT IN THE WEAKENING AND
DISTORTION OF MANAGERIAL INCENTIVES )N OUR VIEW THE DILUTION
AND DISTORTION OF INCENTIVES COULD WELL IMPOSE A LARGER COST
ON SHAREHOLDERS THAN EXCESSIVE COMPENSATION PER SE
%XISTING PAY ARRANGEMENTS HAVE BEEN PRODUCING
TWO TYPES OF INCENTIVE PROBLEMS &IRST COMPENSATION
ARRANGEMENTS HAVE PROVIDED WEAKER INCENTIVES TO INCREASE
SHAREHOLDER VALUE THAN WOULD HAVE BEEN PROVIDED UNDER
ARMS LENGTH CONTRACTING "OTH THE NON EQUITY AND EQUITY
COMPONENTS OF MANAGERIAL COMPENSATION HAVE BEEN MORE
SHARPLY DECOUPLED FROM MANAGERS CONTRIBUTION TO COMPANY
PERFORMANCE THAN APPEARANCES MIGHT SUGGEST -AKING PAY
MORE SENSITIVE TO PERFORMANCE COULD THEREFORE HAVE SUBSTAN
TIAL BENElTS FOR SHAREHOLDERS
3ECOND PREVAILING PRACTICES NOT ONLY FAIL TO PROVIDE COST
EFFECTIVE INCENTIVES TO INCREASE VALUE BUT ALSO CREATE PERVERSE
INCENTIVES &OR EXAMPLE MANAGERS BROAD FREEDOM TO UNLOAD
COMPANY OPTIONS AND STOCK CAN LEAD THEM TO ACT IN WAYS
THAT REDUCE SHAREHOLDER VALUE %XECUTIVES WHO EXPECT TO
UNLOAD SHARES HAVE INCENTIVES TO REPORT MISLEADING RESULTS
SUPPRESS BAD NEWS AND CHOOSE PROJECTS AND STRATEGIES THAT ARE
LESS TRANSPARENT TO THE MARKET 4HE EFlCIENCY COSTS OF SUCH
DISTORTIONS MAY WELL EXCEEDPOSSIBLY BY A LARGE MARGIN
WHATEVER LIQUIDITY OR RISK BEARING BENElTS EXECUTIVES OBTAIN
FROM BEING ABLE TO UNLOAD THEIR OPTIONS AND SHARES AT WILL
3IMILARLY BECAUSE EXISTING PAY PRACTICES OFTEN REWARD MANAG
ERS FOR INCREASING lRM SIZE THEY PROVIDE EXECUTIVES WITH
INCENTIVES TO PURSUE EXPANSION THROUGH ACQUISITIONS OR OTHER
MEANS EVEN WHEN THAT STRATEGY IS VALUE REDUCING
4HE !RMS ,ENGTH #ONTRACTING 6IEW
!CCORDING TO THE hOFlCIALv VIEW OF EXECUTIVE COMPENSATION
CORPORATE BOARDS SETTING PAY ARRANGEMENTS ARE GUIDED SOLELY
BY SHAREHOLDER INTERESTS AND OPERATE AT ARMS LENGTH FROM
THE EXECUTIVES WHOSE PAY THEY SET 4HE PREMISE THAT BOARDS
CONTRACT AT ARMS LENGTH WITH EXECUTIVES HAS LONG BEEN AND
REMAINS A CENTRAL TENET IN THE CORPORATE WORLD AND IN MOST
RESEARCH ON EXECUTIVE COMPENSATION BY lNANCIAL ECONO
MISTS )N THE CORPORATE WORLD THE OFlCIAL VIEW SERVES AS THE
PRACTICAL BASIS FOR LEGAL RULES AND PUBLIC POLICY )T IS USED
TO JUSTIFY DIRECTORS COMPENSATION DECISIONS TO SHAREHOLDERS
POLICYMAKERS AND COURTS 4HESE DECISIONS ARE PORTRAYED AS
BEING MADE LARGELY WITH SHAREHOLDERS INTERESTS AT HEART AND
THEREFORE DESERVING OF DEFERENCE
 4HE LINK BETWEEN ARMS LENGTH CONTRACTING AND EFlCIENT ARRANGEMENTS HAS LED US TO
LABEL ARMS LENGTH CONTRACTING AS hEFlCIENT CONTRACTINGv OR hOPTIMAL CONTRACTINGv IN SOME
OF OUR EARLIER WORK 3EE "EBCHUK &RIED AND 7ALKER   CITED EARLIER "EBCHUK AND
&RIED   CITED EARLIER
 3EE EG /LIVIER *EAN "LANCHARD &LORENCIO ,OPEZ DE 3ILANES AND !NDREI 3HLEIFER
h7HAT $O &IRMS $O WITH #ASH 7INDFALLSv *OURNAL OF &INANCIAL %CONOMICS 6OL   
PP   $AVID 9ERMACK h'OOD 4IMING #%/ 3TOCK /PTION !WARDS AND #OMPANY
.EWS !NNOUNCEMENTSv *OURNAL OF &INANCE 6OL    PP   AND -ARIANNE
"ERTRAND AND 3 -ULLAINATHAN h!RE #%/S 2EWARDED FOR ,UCK 4HE /NES WITHOUT 0RINCIPALS

*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

4HE PREMISE OF ARMS LENGTH CONTRACTING HAS ALSO BEEN

SHARED BY MOST OF THE RESEARCH ON EXECUTIVE COMPENSATION
-ANAGERS INmUENCE OVER DIRECTORS HAS BEEN RECOGNIZED BY
THOSE WRITING ON THE SUBJECT FROM LEGAL ORGANIZATIONAL AND
SOCIOLOGICAL PERSPECTIVES AS WELL AS BY MEDIA COMMENTARY
ON EXECUTIVE PAY "UT THE VAST MAJORITY OF RESEARCH ON EXECU
TIVE PAY HAS BEEN DONE BY lNANCIAL ECONOMISTS AND MOST OF
THEIR WORK ASSUMES THAT CORPORATE BOARDS ADOPT PAY ARRANGE
MENTS THAT SERVE SHAREHOLDERS BY PROVIDING MANAGERS WITH
COST EFFECTIVE INCENTIVES TO MAXIMIZE VALUE "ECAUSE BOARDS
AND EXECUTIVES OPERATING AT ARMS LENGTH HAVE INCENTIVES TO
AVOID INEFlCIENT PROVISIONS THE ARMS LENGTH CONTRACTING
VIEW HAS LED RESEARCHERS TO ASSUME THAT EXECUTIVE COMPEN
SATION ARRANGEMENTS WILL TEND TO INCREASE VALUE 3OME
lNANCIAL ECONOMISTS WHOSE STUDIES WE DISCUSS AT LENGTH IN
OUR BOOK HAVE REPORTED lNDINGS THEY VIEWED AS INCONSISTENT
WITH THE ARMS LENGTH MODEL (OWEVER MOST WORK IN THE
lELD HAS STARTED FROM THE PREMISE OF ARMS LENGTH CONTRACT
ING BETWEEN BOARDS AND EXECUTIVES
&INANCIAL ECONOMISTS BOTH THEORISTS AND EMPIRICISTS
HAVE LARGELY WORKED WITHIN THE ARMS LENGTH MODEL IN
ATTEMPTING TO EXPLAIN COMMON COMPENSATION ARRANGEMENTS
AS WELL AS DIFFERENCES IN COMPENSATION PRACTICES AMONG
COMPANIES )N FACT UPON DISCOVERING PRACTICES THAT APPEAR
INCONSISTENT WITH THE COST EFFECTIVE PROVISION OF INCEN
TIVES lNANCIAL ECONOMISTS HAVE LABORED TO COME UP WITH
CLEVER EXPLANATIONS FOR HOW SUCH PRACTICES MIGHT BE CONSIS
TENT WITH ARMS LENGTH CONTRACTING AFTER ALL 0RACTICES FOR
WHICH NO EXPLANATION HAS BEEN FOUND HAVE BEEN DESCRIBED
AS hANOMALIESv OR hPUZZLESv THAT WILL ULTIMATELY EITHER BE
EXPLAINED WITHIN THE PARADIGM OR DISAPPEAR
)N OUR BOOK WE IDENTIlED MANY COMPENSATION PRACTICES
THAT ARE DIFlCULT TO UNDERSTAND UNDER THE ARMS LENGTH
CONTRACTING VIEW BUT CAN READILY BE EXPLAINED BY MANAGE
RIAL INmUENCE OVER THE PAY SETTING PROCESS )N RESPONSE
CRITICS SUGGESTED REASONS WHY SOME OF THESE PRACTICES COULD
STILL HAVE AN EXPLANATION WITHIN AN ARMS LENGTH CONTRACTING
FRAMEWORK AND ARGUED THAT WE HAVE THEREFORE NOT SUCCEEDED
IN RULING OUT COMPLETELY THE POSSIBILITY OF ARMS LENGTH
DEALING &OR EXAMPLE IN RESPONSE TO OUR ACCOUNT OF THE
SIGNIlCANT EXTENT TO WHICH PAY IS DECOUPLED FROM PERFOR
MANCE *OHN #ORE 7AYNE 'UAY AND 2ANDALL 4HOMAS
ARGUE THAT THERE ARE CIRCUMSTANCES IN WHICH LARGE AMOUNTS
OF NON PERFORMANCE PAY MIGHT BE DESIRABLE 3IMILARLY IN
RESPONSE TO OUR CRITICISM OF THE WIDESPREAD FAILURE OF lRMS
!REv 1UARTERLY *OURNAL OF %CONOMICS 6OL    PP  
 &OR SURVEYS FROM THIS PERSPECTIVE IN THE lNANCE AND ECONOMICS LITERATURE SEE FOR
EXAMPLE *OHN - !BOWD AND $AVID 3 +APLAN h%XECUTIVE #OMPENSATION 3IX 1UESTIONS
4HAT .EED !NSWERINGv *OURNAL OF %CONOMIC 0ERSPECTIVES 6OL    PP  
AND *OHN % #ORE 7AYNE 'UAY AND $AVID & ,ARCKER h%XECUTIVE %QUITY #OMPENSATION AND
)NCENTIVES ! 3URVEYv %CONOMIC 0OLICY 2EVIEW 6OL    PP  
 3EE EG *OHN % #ORE 7AYNE 2 'UAY AND 2ANDALL 3 4HOMAS h)S 53 #%/ #OM
PENSATION )NEFlCIENTv -ICHIGAN ,AW 2EVIEW 6OL    PP  

! -ORGAN 3TANLEY 0UBLICATION s &ALL 



TO ADOPT OPTION PLANS THAT lLTER OUT WINDFALLS BOTH *EFF

'ORDON AND "ENGT (OLMSTROM ARGUE THAT OUR ANALYSIS HAS
NOT COMPLETELY RULED OUT THE POSSIBILITY OF EXPLAINING SUCH
FAILURE WITHIN THE ARMS LENGTH CONTRACTING MODEL
4HESE ARGUMENTS REmECT AN IMPLICIT PRESUMPTION IN
FAVOR OF ARMS LENGTH CONTRACTING PAY ARRANGEMENTS ARE
ASSUMED TO BE THE PRODUCT OF ARMS LENGTH CONTRACTING
UNLESS ONE CAN PROVE OTHERWISE 4HE PRESUMPTION OF ARMS
LENGTH CONTRACTING HOWEVER DOES NOT SEEM WARRANTED !S
WE DISCUSS BELOW AN EXAMINATION OF THE PAY SETTING PROCESS
SUGGESTS THAT MANAGERIAL INmUENCE SEEMS LIKELY TO PLAY A KEY
ROLE 4HUS GIVEN THE A PRIORI LIKELIHOOD OF MANAGERIAL INmU
ENCE THE BURDEN OF PROOF SHOULD BE ON THOSE ARGUING THAT
EXECUTIVE PAY ARRANGEMENTS ARE NOT SIGNIlCANTLY SHAPED BY
SUCH INmUENCE )N ANY EVENT THE FACT THAT lNANCIAL ECONO
MISTS CONTINUE IMPLICITLY OR EXPLICITLY TO USE ARMS LENGTH
CONTRACTING AS THEIR BASELINE PRESUMPTION INDICATES THE
DOMINANCE AND POWER OF THIS LONG HELD VIEW
,IMITS OF THE !RMS ,ENGTH 6IEW
4HE OFlCIAL ARMS LENGTH STORY IS NEAT TRACTABLE AND REAS
SURING "UT IT FAILS TO ACCOUNT FOR THE REALITIES OF EXECUTIVE
COMPENSATION
4HE ARMS LENGTH CONTRACTING VIEW RECOGNIZES THAT
MANAGERS ARE SUBJECT TO AN AGENCY PROBLEM AND DO NOT
AUTOMATICALLY SEEK TO MAXIMIZE SHAREHOLDER VALUE 4HE
POTENTIAL DIVERGENCE BETWEEN MANAGERS AND SHAREHOLD
ERS INTERESTS MAKES IT IMPORTANT TO PROVIDE MANAGERS WITH
ADEQUATE INCENTIVES 5NDER THE ARMS LENGTH VIEW THE BOARD
ATTEMPTS TO PROVIDE SUCH INCENTIVES COST EFFECTIVELY THROUGH
MANAGERS COMPENSATION PACKAGES "UT JUST AS THERE IS
NO REASON TO ASSUME THAT MANAGERS AUTOMATICALLY SEEK TO
MAXIMIZE SHAREHOLDER VALUE THERE IS NO REASON TO EXPECT
THAT DIRECTORS WILL EITHER )NDEED AN ANALYSIS OF DIRECTORS
INCENTIVES AND CIRCUMSTANCES SUGGESTS THAT DIRECTOR BEHAV
IOR IS ALSO SUBJECT TO AN AGENCY PROBLEM
$IRECTORS HAVE HAD AND CONTINUE TO HAVE VARIOUS
ECONOMIC INCENTIVES TO SUPPORT OR AT LEAST GO ALONG WITH
ARRANGEMENTS THAT FAVOR THE COMPANYS TOP EXECUTIVES
! VARIETY OF SOCIAL AND PSYCHOLOGICAL FACTORSCOLLEGIAL
ITY TEAM SPIRIT A NATURAL DESIRE TO AVOID CONmICT WITHIN
THE BOARD FRIENDSHIP AND LOYALTY AND COGNITIVE DISSO
NANCEEXERT ADDITIONAL PULL IN THAT DIRECTION !LTHOUGH
MANY DIRECTORS OWN SOME STOCK IN THEIR COMPANIES THEIR
OWNERSHIP POSITIONS ARE TOO SMALL TO GIVE THEM A lNANCIAL
INCENTIVE TO TAKE THE PERSONALLY COSTLY OR AT THE VERY LEAST
UNPLEASANT ROUTE OF RESISTING COMPENSATION ARRANGEMENTS
SOUGHT BY EXECUTIVES )N ADDITION LIMITATIONS ON TIME AND
RESOURCES HAVE MADE IT DIFlCULT FOR EVEN WELL INTENTIONED
 3EE "ENGT (OLMSTROM h#OMMENTS ON "EBCHUK AND &RIEDS BOOK @0AY 7ITHOUT 0ER
FORMANCE 4HE 5NFULlLLED 0ROMISE OF %XECUTIVE #OMPENSATIONv FORTHCOMING IN *OURNAL OF
#ORPORATION ,AW   *EFFREY 'ORDON h%XECUTIVE #OMPENSATION )F 4HERES A 0ROBLEM
7HATS THE 2EMEDY 4HE #ASE FOR @#OMPENSATION $ISCLOSURE AND !NALYSISv *OURNAL OF



*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

DIRECTORS TO DO THEIR PAY SETTING JOB PROPERLY &INALLY THE

MARKET CONSTRAINTS WITHIN WHICH DIRECTORS OPERATE ARE FAR
FROM TIGHT AND DO NOT PREVENT DEVIATIONS FROM ARMS LENGTH
CONTRACTING OUTCOMES IN FAVOR OF EXECUTIVES "ELOW WE
BRIEmY DISCUSS EACH OF THESE FACTORS
)NCENTIVES TO BE 2E %LECTED

"ESIDES AN ATTRACTIVE SALARY A DIRECTORSHIP IS ALSO LIKELY TO

PROVIDE PRESTIGE AND VALUABLE BUSINESS AND SOCIAL CONNEC
TIONS 4HE lNANCIAL AND NONlNANCIAL BENElTS OF HOLDING
A BOARD SEAT NATURALLY GIVE DIRECTORS AN INTEREST IN KEEPING
THEIR POSITIONS
)N A WORLD WHERE SHAREHOLDERS SELECT INDIVIDUAL DIREC
TORS BOARD MEMBERS MIGHT HAVE AN INCENTIVE TO DEVELOP
REPUTATIONS AS SHAREHOLDER SERVING 4YPICALLY HOWEVER THE
DIRECTOR SLATE PROPOSED BY MANAGEMENT IS THE ONLY ONE
OFFERED 4HE KEY TO RETAINING A BOARD POSITION IS THUS BEING
PLACED ON THE COMPANYS SLATE !ND BECAUSE THE #%/ HAS
HAD SIGNIlCANT INmUENCE OVER THE NOMINATION PROCESS
DISPLEASING THE #%/ HAS BEEN LIKELY TO HURT ONES CHANCES
OF BEING PUT ON THE COMPANY SLATE $IRECTORS HAVE THUS HAD
AN INCENTIVE TO GO ALONG WITH THE #%/S PAY ARRANGEMENT AS
LONG AS THE COMPENSATION PACKAGE REMAINS WITHIN THE RANGE
OF WHAT CAN PLAUSIBLY BE DEFENDED AND JUSTIlED )N ADDITION
DEVELOPING A REPUTATION AS A DIRECTOR WHO BLOCKS COMPEN
SATION ARRANGEMENTS SOUGHT BY EXECUTIVES CAN ONLY HURT A
DIRECTORS CHANCES OF BEING INVITED TO JOIN OTHER BOARDS
4HE NEW STOCK EXCHANGE LISTING REQUIREMENTS WHICH
ATTEMPT TO GIVE INDEPENDENT DIRECTORS A GREATER ROLE IN DIREC
TOR NOMINATIONS WEAKEN BUT DO NOT ELIMINATE EXECUTIVES
INmUENCE OVER DIRECTOR NOMINATIONS 4HE #%/S WISHES CAN
BE EXPECTED TO CONTINUE TO INmUENCE THE DECISIONS OF THE
NOMINATING COMMITTEE AFTER ALL THE DIRECTORS APPOINTED TO
THE BOARD ARE EXPECTED TO WORK CLOSELY WITH THE #%/ !S A
PRACTICAL MATTER DIRECTOR CANDIDATES WHO ARE OPPOSED BY THE
#%/ ARE NOT EXPECTED TO BE OFFERED BOARD NOMINATION AND
WOULD LIKELY DECLINE THE NOMINATION IF IT WERE OFFERED %VEN IF
THE #%/ HAD NO INmUENCE OVER NOMINATIONS MEMBERS OF THE
NOMINATING COMMITTEE WOULD BE UNLIKELY TO LOOK FAVORABLY ON
AN INDIVIDUAL WHO HAS TAKEN A TOUGH POSITION ON THE #%/S
PAY 4HEY MIGHT WISH TO AVOID THE FRICTION AND UNPLEASANTNESS
ACCOMPANYING DISPUTES OVER THE #%/S PAY OR MIGHT SIMPLY
SIDE WITH THE #%/ FOR OTHER REASONS DISCUSSED BELOW
#%/S 0OWER TO "ENElT $IRECTORS

4HERE ARE A VARIETY OF WAYS IN WHICH #%/S CAN BENElT

INDIVIDUAL DIRECTORS OR BOARD MEMBERS AS A GROUP &OR ONE
THING #%/S HAVE INmUENCE OVER DIRECTOR COMPENSATION !S
THE COMPANY LEADER USUALLY AS A BOARD MEMBER AND OFTEN AS
!PPLIED #ORPORATE &INANCE THIS ISSUE 
 $ANIEL .ASAW h/PENING THE "OARD 4HE &IGHT )S /N TO $ETERMINE 7HO 7ILL 'UIDE THE
3ELECTION OF $IRECTORS IN THE &UTUREv 7ALL 3TREET *OURNAL /CTOBER    P 2

! -ORGAN 3TANLEY 0UBLICATION s &ALL 

BOARD CHAIRMAN THE #%/ CAN CHOOSE EITHER TO DISCOURAGE

OR ENCOURAGE INCREASES IN DIRECTOR PAY )NDEPENDENT DIREC
TORS WHO ARE GENEROUS TOWARD THE #%/ MIGHT REASONABLY
EXPECT THE #%/ TO USE HIS OR HER BULLY PULPIT TO SUPPORT
HIGHER DIRECTOR COMPENSATION !T A MINIMUM GENEROUS
TREATMENT OF THE #%/ CONTRIBUTES TO AN ATMOSPHERE THAT IS
CONDUCIVE TO GENEROUS TREATMENT OF DIRECTORS !ND IN FACT A
STUDY lNDS THAT COMPANIES WITH HIGHER #%/ COMPENSATION
HAVE HIGHER DIRECTOR COMPENSATION AS WELLAND THAT SUCH
HIGH PAY LEVELS APPEAR TO REmECT INSIDER hCOOPERATIONv RATHER
THAN SUPERIOR CORPORATE PERFORMANCE
#%/S ALSO HAVE OFTEN USED THEIR POWER OVER CORPORATE
RESOURCES TO REWARD INDIVIDUAL DIRECTORS WHO WERE PARTICU
LARLY COOPERATIVE 4HE NEW STOCK EXCHANGE LISTING STANDARDS
PLACE SOME LIMITS ON #%/S ABILITY TO REWARD INDEPENDENT
DIRECTORS BUT THEY DO LEAVE #%/S WITH SUBSTANTIAL POWER
IN THIS AREA &OR EXAMPLE THESE REQUIREMENTS ALLOW THE
COMPANY TO PAY  IN ADDITIONAL COMPENSATION TO
AN INDEPENDENT DIRECTOR !ND THERE IS NO LIMIT TO HOW MUCH
THE lRM CAN PAY AN INDEPENDENT DIRECTORS IMMEDIATE FAMILY
MEMBERS AS LONG AS THEY ARE NON EXECUTIVE EMPLOYEES
3IMILARLY THE REQUIREMENTS LIMIT BUT DO NOT PROHIBIT
BUSINESS DEALINGS BETWEEN A COMPANY AND AN INDEPENDENT
DIRECTORS lRM AND THEY PLACE NO LIMIT ON THE COMPANYS
DEALINGS WITH THE DIRECTORS lRM BEFORE OR AFTER THE DIRECTOR
QUALIlES FOR INDEPENDENT DIRECTOR STATUS 4HE STANDARDS ALSO
PERMIT UNLIMITED CONTRIBUTIONS TO CHARITABLE ORGANIZATIONS
THAT INDEPENDENT DIRECTORS RUN ARE AFlLIATED WITH OR SIMPLY
FAVOR )N SUM EXECUTIVES CONTROL OVER CORPORATE RESOURCES
CONTINUES TO ENABLE THEM TO PROVIDE MANY DIRECTORS WITH
REWARDSREWARDS THAT GENERALLY OUTWEIGH THE SMALL DIRECT
PERSONAL COST TO MOST DIRECTORS OF APPROVING PAY ARRANGE
MENTS THAT FAIL TO SERVE SHAREHOLDER INTERESTS
&RIENDSHIP AND ,OYALTY

-ANY INDEPENDENT DIRECTORS HAVE SOME PRIOR SOCIAL CONNECTION

TO THE COMPANYS #%/ OR OTHER SENIOR EXECUTIVES %VEN DIREC
TORS WHO DID NOT KNOW THE #%/ BEFORE THEIR APPOINTMENT MAY
WELL HAVE BEGUN THEIR SERVICE WITH A SENSE OF OBLIGATION AND
LOYALTY TO THE #%/ 4HE #%/ OFTEN WILL HAVE BEEN INVOLVED
IN RECRUITING THE DIRECTOR TO THE BOARD !S A RESULT DIRECTORS
OFTEN START SERVING WITH A RESERVOIR OF GOOD WILL TOWARD THE
#%/ WHICH WILL CONTRIBUTE TO A TENDENCY TO FAVOR THE #%/
ON COMPENSATION MATTERS 4HIS KIND OF RECIPROCITY IS EXPECTED
AND OBSERVED IN MANY SOCIAL AND PROFESSIONAL CONTEXTS .OT
SURPRISINGLY STUDIES lND THAT COMPENSATION COMMITTEES
WHOSE CHAIRS HAVE BEEN APPOINTED AFTER THE #%/ TAKES OFlCE
HAVE TENDED TO AWARD HIGHER #%/ COMPENSATION
 )VAN % "RICK /DED 0ALMON AND *OHN + 7ALD h#%/ #OMPENSATION $IRECTOR
#OMPENSATION AND &IRM 0ERFORMANCE %VIDENCE OF #RONYISMv FORTHCOMING IN *OURNAL OF
#ORPORATE &INANCE  
 "RIAN ' - -AIN #HARLES ! /2EILLY ))) AND *AMES 7ADE h4HE #%/ THE "OARD
OF $IRECTORS AND %XECUTIVE #OMPENSATION %CONOMIC AND 0SYCHOLOGICAL 0ERSPECTIVESv

*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

#OLLEGIALITY AND !UTHORITY

)N ADDITION TO FRIENDSHIP AND LOYALTY CONSIDERATIONS THERE

ARE OTHER SOCIAL AND PSYCHOLOGICAL FORCES THAT MAKE IT DIFl
CULT FOR DIRECTORS TO RESIST EXECUTIVE SERVING COMPENSATION
ARRANGEMENTS 4HE #%/ IS THE DIRECTORS COLLEAGUE AND
DIRECTORS ARE GENERALLY EXPECTED TO TREAT THEIR FELLOW DIREC
TORS COLLEGIALLY 4HE #%/ IS ALSO THE COMPANYS LEADER THE
PERSON WHOSE DECISIONS AND VISIONS HAVE THE MOST INmU
ENCE ON THE lRMS FUTURE DIRECTION )N MOST CIRCUMSTANCES
DIRECTORS TREAT THE #%/ WITH RESPECT AND SUBSTANTIAL DEFER
ENCE 3WITCHING HATS TO CONTRACT AT ARMS LENGTH WITH ONES
COLLEAGUE AND LEADER IS NATURALLY DIFlCULT
#OGNITIVE $ISSONANCE AND 3OLIDARITY

-ANY MEMBERS OF COMPENSATION COMMITTEES ARE CURRENT

AND FORMER EXECUTIVES OF OTHER COMPANIES "ECAUSE INDI
VIDUALS HAVE A TENDENCY TO DEVELOP VIEWS THAT ARE CONSISTENT
WITH THEIR SELF INTEREST EXECUTIVES AND FORMER EXECUTIVES ARE
LIKELY TO HAVE FORMED BELIEFS THAT SUPPORT THE TYPE OF PAY
ARRANGEMENTS FROM WHICH THEY THEMSELVES HAVE BENElTED
!N EXECUTIVE WHO HAS BENElTED FROM A CONVENTIONAL OPTION
PLAN FOR EXAMPLE IS MORE LIKELY TO RESIST THE VIEW THAT SUCH
PLANS PROVIDE EXECUTIVES WITH EXCESSIVE WINDFALLS
&URTHER REINFORCING SUCH COGNITIVE DISSONANCE AN
EXECUTIVE WHO SERVES AS A DIRECTOR IN ANOTHER lRM MIGHT
IDENTIFY AND FEEL SOME SOLIDARITY OR SYMPATHY WITH THAT
lRMS EXECUTIVES AND NATURALLY WOULD BE INCLINED TO TREAT
THESE EXECUTIVES THE SAME WAY HE OR SHE WOULD LIKE TO BE
TREATED .OT SURPRISINGLY THERE IS EVIDENCE THAT #%/ PAY IS
CORRELATED WITH THE PAY LEVELS OF THE OUTSIDE DIRECTORS SERVING
ON THE COMPENSATION COMMITTEE
4HE 3MALL #OST OF &AVORING %XECUTIVES

$IRECTORS TYPICALLY OWN ONLY A SMALL FRACTION OF THE lRMS

SHARES !S A RESULT THE DIRECT PERSONAL COST TO BOARD MEMBERS
OF APPROVING COMPENSATION ARRANGEMENTS THAT ARE TOO
FAVORABLE TO EXECUTIVESTHE REDUCTION IN THE VALUE OF THEIR
SHAREHOLDINGSIS SMALL 4HIS COST IS THEREFORE UNLIKELY TO
OUTWEIGH THE ECONOMIC INCENTIVES AND SOCIAL AND PSYCHO
LOGICAL FACTORS THAT INDUCE DIRECTORS TO GO ALONG WITH PAY
SCHEMES THAT FAVOR EXECUTIVES
2ATCHETING

)T IS NOW WIDELY RECOGNIZED THAT THE RISE IN EXECUTIVE

COMPENSATION HAS IN PART BEEN DRIVEN BY MANY BOARDS SEEK
ING TO PAY THEIR #%/ MORE THAN THE INDUSTRY AVERAGE THIS
WIDESPREAD PRACTICE HAS LED TO AN EVER INCREASING AVERAGE
AND A CONTINUOUS ESCALATION OF EXECUTIVE PAY ! REVIEW
)NDUSTRIAL AND #ORPORATE #HANGE 6OL    PP  
 -AIN /2EILLY ))) AND 7ADE   CITED EARLIER
 +EVIN * -URPHY h%XECUTIVE #OMPENSATIONv IN (ANDBOOK OF ,ABOR %CONOMICS
EDITED BY /RLEY !SHENFELTER AND $AVID #ARD .EW 9ORK %LSEVIER  

! -ORGAN 3TANLEY 0UBLICATION s &ALL 



OF REPORTS OF COMPENSATION COMMITTEES IN LARGE COMPANIES

INDICATES THAT A LARGE MAJORITY OF THEM USED PEER GROUPS IN
DETERMINING PAY AND SET COMPENSATION AT OR ABOVE THE TH
PERCENTILE OF THE PEER GROUP 3UCH RATCHETING IS CONSISTENT
WITH A PICTURE OF BOARDS THAT DO NOT SEEK TO GET THE BEST DEAL
FOR THEIR SHAREHOLDERS BUT ARE HAPPY TO GO ALONG WITH WHAT
EVER CAN BE JUSTIlED AS CONSISTENT WITH PREVAILING PRACTICES
,IMITS OF -ARKET &ORCES

3OME WRITERS HAVE ARGUED THAT EVEN IF DIRECTORS ARE UNDER THE
CONSIDERABLE INmUENCE OF CORPORATE EXECUTIVES MARKET FORCES
WILL FORCE BOARDS AND EXECUTIVES TO ADOPT THE COMPENSATION
ARRANGEMENTS THAT ARMS LENGTH CONTRACTING WOULD PRODUCE
/UR ANALYSIS HOWEVER lNDS THAT MARKET FORCES ARE NEITHER
SUFlCIENTLY lNE TUNED NOR SUFlCIENTLY POWERFUL TO COMPEL
SUCH OUTCOMES 4HE MARKETS FOR CAPITAL CORPORATE CONTROL
AND MANAGERIAL LABOR DO IMPOSE SOME CONSTRAINTS ON EXECU
TIVE COMPENSATION "UT THESE CONSTRAINTS ARE BY NO MEANS
STRINGENT AND THEY PERMIT SUBSTANTIAL DEVIATIONS FROM ARMS
LENGTH CONTRACTING
#ONSIDER FOR EXAMPLE THE MARKET FOR CORPORATE
CONTROLTHE THREAT OF A TAKEOVER -OST COMPANIES HAVE
SUBSTANTIAL DEFENSES AGAINST TAKEOVERS &OR EXAMPLE A MAJOR
ITY OF COMPANIES HAVE A STAGGERED BOARD WHICH PREVENTS
A HOSTILE ACQUIRER FROM GAINING CONTROL BEFORE TWO ANNUAL
ELECTIONS ARE HELD AND OFTEN ENABLES INCUMBENT MANAGERS
TO BLOCK HOSTILE BIDS THAT ARE ATTRACTIVE TO SHAREHOLDERS 4O
OVERCOME INCUMBENT OPPOSITION A HOSTILE BIDDER MUST BE
PREPARED TO PAY A SUBSTANTIAL PREMIUM 4HE DISCIPLIN
ARY FORCE OF THE MARKET FOR CORPORATE CONTROL IS FURTHER
WEAKENED BY THE PREVALENCE OF GOLDEN PARACHUTE PROVISIONS
AS WELL AS BY PAYOFFS MADE BY ACQUIRERS TO TARGET MANAG
ERS TO FACILITATE THE ACQUISITION 4HE MARKET FOR CORPORATE
CONTROL THUS EXERTS LITTLE DISCIPLINING FORCE ON MANAGERS AND
BOARDS LEAVING THEM WITH CONSIDERABLE SLACK AND THE ABILITY
TO NEGOTIATE MANAGER FAVORING PAY ARRANGEMENTS
.EW #%/S

3OME CRITICS OF OUR WORK HAVE ASSUMED THAT OUR ANALYSIS

OF MANAGERIAL INmUENCE DOES NOT APPLY WHEN BOARDS NEGO
TIATE PAY WITH A #%/ CANDIDATE FROM OUTSIDE THE lRM
(OWEVER WHILE SUCH NEGOTIATIONS MIGHT BE CLOSER TO THE
ARMS LENGTH MODEL THAN NEGOTIATIONS WITH AN INCUMBENT
#%/ THEY STILL FALL QUITE SHORT OF THIS BENCHMARK
!MONG OTHER THINGS DIRECTORS NEGOTIATING WITH AN
OUTSIDE #%/ CANDIDATE KNOW THAT AFTER THE CANDIDATE
BECOMES #%/ HE OR SHE WILL HAVE INmUENCE OVER THEIR RE
NOMINATION TO THE BOARD AND OVER THEIR COMPENSATION AND
 *OHN - "IZJAK -ICHAEL , ,EMMON AND ,ALITHA .AVEEN h(AS THE 5SE OF 0EER
'ROUPS #ONTRIBUTED TO (IGHER ,EVELS OF %XECUTIVE #OMPENSATIONv 7ORKING PAPER
 
 ,UCIAN "EBCHUK *OHN #OATES )6 AND 'UHAN 3UBRAMANIAN h4HE 0OWERFUL !NTITA
KEOVER &ORCE OF 3TAGGERED "OARDS 4HEORY %VIDENCE AND 0OLICYv 3TANFORD ,AW 2EVIEW
6OL   



*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

PERKS 4HE DIRECTORS WILL ALSO WISH TO HAVE GOOD PERSONAL

AND WORKING RELATIONSHIPS WITH THE INDIVIDUAL WHO IS
EXPECTED TO BECOME THE lRMS LEADER AND A FELLOW BOARD
MEMBER !ND WHILE AGREEING TO A PAY PACKAGE THAT FAVORS
THE OUTSIDE #%/ IMPOSES LITTLE lNANCIAL COST ON DIRECTORS
A BREAKDOWN IN THE NEGOTIATIONS WHICH MIGHT EMBARRASS
THE DIRECTORS AND FORCE THEM TO RE OPEN THE #%/ SELECTION
PROCESS WOULD BE PERSONALLY COSTLY TO THEM &INALLY DIREC
TORS LIMITED TIME FORCES THEM TO RELY ON INFORMATION SHAPED
AND PRESENTED BY THE COMPANYS HUMAN RESOURCES STAFF AND
COMPENSATION CONSULTANTS ALL OF WHOM HAVE INCENTIVES TO
PLEASE THE INCOMING #%/
&IRING OF %XECUTIVES

3OME HAVE SUGGESTED THAT THE INCREASED WILLINGNESS OF DIREC

TORS TO FORCE OUT #%/S OVER THE PAST DECADE ESPECIALLY IN
RECENT YEARS PROVIDES EVIDENCE THAT BOARDS DO IN FACT DEAL
WITH #%/S AT ARMS LENGTH (OWEVER lRINGS OR RESIGNA
TIONS UNDER lRE ARE STILL LIMITED TO UNUSUAL SITUATIONS IN
WHICH THE #%/ IS ACCUSED OF LEGAL OR ETHICAL VIOLATIONS SUCH
AS &ANNIE -AE !)' "OEING AND -ARSH OR IS VIEWED BY
REVOLTING SHAREHOLDERS AS HAVING A RECORD OF TERRIBLE PERFOR
MANCE SUCH AS -ORGAN 3TANLEY AND (0  7ITHOUT STRONG
OUTSIDE PRESSURE TO lRE THE #%/ MERE MEDIOCRITY IS FAR
FROM ENOUGH TO GET A #%/ PUSHED OUT &URTHERMORE IN
THE RARE CASES IN WHICH BOARDS lRE EXECUTIVES BOARDS OFTEN
PROVIDE THE DEPARTING EXECUTIVES WITH BENElTS BEYOND THOSE
REQUIRED BY THE CONTRACT TO SWEETEN THE #%/S DEPARTURE
AND ALLEVIATE THE DIRECTORS GUILT AND DISCOMFORT !LL IN ALL
BOARDS RECORD OF DEALING WITH FAILED EXECUTIVES DOES NOT
SUPPORT THE VIEW THAT BOARDS TREAT #%/S AT ARMS LENGTH
)N SUM A REALISTIC PICTURE OF THE INCENTIVES AND CIRCUM
STANCES OF BOARD MEMBERS REVEALS MANY INCENTIVES AND
TENDENCIES THAT LEAD DIRECTORS TO BEHAVE VERY DIFFERENTLY THAN
BOARDS CONTRACTING AT ARMS LENGTH WITH THEIR EXECUTIVES OVER
PAY 2ECENT REFORMS SUCH AS THE NEW STOCK EXCHANGE LISTING
REQUIREMENTS MAY WEAKEN SOME OF THESE FACTORS BUT WILL
NOT ELIMINATE THEM 7ITHOUT ADDITIONAL REFORMS THE PAY
SETTING PROCESS WILL CONTINUE TO DEVIATE SUBSTANTIALLY FROM
ARMS LENGTH CONTRACTING
0OWER AND 0AY
4HE SAME FACTORS THAT LIMIT THE USEFULNESS OF THE ARMS
LENGTH MODEL IN EXPLAINING EXECUTIVE COMPENSATION SUGGEST
THAT EXECUTIVES HAVE HAD SUBSTANTIAL INmUENCE OVER THEIR
OWN PAY #OMPENSATION ARRANGEMENTS HAVE OFTEN DEVI
ATED FROM ARMS LENGTH CONTRACTING BECAUSE DIRECTORS HAVE
BEEN INmUENCED BY MANAGEMENT INSUFlCIENTLY MOTIVATED
 +EVIN * -URPHY h%XPLAINING %XECUTIVE #OMPENSATION -ANAGERIAL 0OWER VS THE
0ERCEIVED #OST OF 3TOCK /PTIONSv 5NIVERSITY OF #HICAGO ,AW 2EVIEW 6OL    PP
 
 3EE EG (OLMAN 7 *ENKINS h/UTRAGEOUS #%/ 0AY 2EVISITEDv 7ALL 3TREET *OURNAL
/CTOBER    P !

! -ORGAN 3TANLEY 0UBLICATION s &ALL 

TO INSIST ON SHAREHOLDER SERVING COMPENSATION OR SIMPLY

INEFFECTUAL %XECUTIVES INmUENCE OVER DIRECTORS HAS ENABLED
THEM TO OBTAIN hRENTSvBENElTS GREATER THAN THOSE OBTAIN
ABLE UNDER TRUE ARMS LENGTH CONTRACTING
)N OUR WORK WE lND THAT THE ROLE OF MANAGERIAL POWER
CAN EXPLAIN MANY ASPECTS OF THE EXECUTIVE COMPENSATION
LANDSCAPE )T IS WORTH EMPHASIZING THAT OUR CONCLUSION
IS NOT BASED ON THE AMOUNT OF COMPENSATION RECEIVED BY
EXECUTIVES )N OUR VIEW HIGH ABSOLUTE LEVELS OF PAY DO NOT BY
THEMSELVES IMPLY THAT COMPENSATION ARRANGEMENTS DEVIATE
FROM ARMS LENGTH CONTRACTING /UR lNDING THAT SUCH DEVIA
TIONS HAVE BEEN COMMON IS BASED PRIMARILY ON AN ANALYSIS
OF THE PROCESS BY WHICH PAY IS SET AND AN EXAMINATION OF
THE INEFlCIENT DISTORTED AND NONTRANSPARENT STRUCTURE OF
PAY ARRANGEMENTS THAT EMERGE FROM THIS PROCESS &OR US
THE hSMOKING GUNv OF MANAGERIAL INmUENCE OVER PAY IS NOT
HIGH LEVELS OF PAY BUT RATHER SUCH THINGS AS THE CORRELATION
BETWEEN POWER AND PAY THE SYSTEMATIC USE OF COMPENSATION
PRACTICES THAT OBSCURE THE AMOUNT AND PERFORMANCE INSEN
SITIVITY OF PAY AND THE SHOWERING OF GRATUITOUS BENElTS ON
DEPARTING EXECUTIVES
!LTHOUGH TOP EXECUTIVES GENERALLY HAVE SOME DEGREE OF INmU
ENCE OVER THEIR BOARDS THE EXTENT OF THEIR INmUENCE DEPENDS
ON VARIOUS FEATURES OF THE COMPANYS GOVERNANCE STRUCTURE
4HE MANAGERIAL POWER APPROACH PREDICTS THAT EXECUTIVES
WHO HAVE MORE POWER SHOULD RECEIVE HIGHER PAYOR PAY
THAT IS LESS SENSITIVE TO PERFORMANCETHAN THEIR LESS POWER
FUL COUNTERPARTS ! SUBSTANTIAL BODY OF EVIDENCE DOES INDEED
INDICATE THAT PAY IS HIGHER AND LESS SENSITIVE TO PERFORMANCE
WHEN EXECUTIVES HAVE MORE POWER
&IRST THERE IS EVIDENCE THAT EXECUTIVE COMPENSATION IS
HIGHER WHEN THE BOARD IS RELATIVELY WEAK OR INEFFECTUAL VIS
VIS THE #%/ )N PARTICULAR #%/ COMPENSATION IS HIGHER
WHEN THE BOARD IS LARGE WHICH MAKES IT MORE DIFlCULT FOR
DIRECTORS TO ORGANIZE IN OPPOSITION TO THE #%/ WHEN MORE
OF THE OUTSIDE DIRECTORS HAVE BEEN APPOINTED BY THE #%/
WHICH COULD CAUSE THEM TO FEEL GRATITUDE OR OBLIGATION TO
THE #%/ AND WHEN OUTSIDE DIRECTORS SERVE ON THREE OR MORE
BOARDS AND THUS ARE MORE LIKELY TO BE DISTRACTED !LSO
#%/ PAY IS  TO  HIGHER IF THE #%/ IS THE CHAIRMAN
OF THE BOARD AND IT IS NEGATIVELY CORRELATED WITH THE STOCK
OWNERSHIP OF COMPENSATION COMMITTEE MEMBERS
3ECOND STUDIES lND A NEGATIVE CORRELATION BETWEEN THE
PRESENCE OF A LARGE OUTSIDE SHAREHOLDER AND PAY ARRANGEMENTS

THAT FAVOR EXECUTIVES ! LARGE OUTSIDE SHAREHOLDER MIGHT

ENGAGE IN CLOSER MONITORING AND THEREBY REDUCE MANAG
ERS INmUENCE OVER THEIR COMPENSATION /NE STUDY lNDS A
NEGATIVE CORRELATION BETWEEN THE EQUITY OWNERSHIP OF THE
LARGEST SHAREHOLDER AND THE AMOUNT OF #%/ COMPENSA
TION MORE SPECIlCALLY DOUBLING THE PERCENTAGE OWNERSHIP
OF A LARGE OUTSIDE SHAREHOLDER IS ASSOCIATED WITH A  TO
 REDUCTION IN A #%/S NON SALARY COMPENSATION
!NOTHER STUDY lNDS THAT #%/S IN COMPANIES WITHOUT A 
OR LARGER OUTSIDE SHAREHOLDER TEND TO RECEIVE MORE hLUCK
BASEDv PAYTHAT IS PAY ASSOCIATED WITH PROlT INCREASES THAT
ARE GENERATED ENTIRELY BY EXTERNAL FACTORS SUCH AS CHANGES IN
OIL PRICES AND EXCHANGE RATES RATHER THAN BY MANAGERS OWN
EFFORTS 4HIS STUDY ALSO lNDS THAT IN COMPANIES LACKING
LARGE OUTSIDE SHAREHOLDERS BOARDS MAKE SMALLER REDUCTIONS
IN CASH COMPENSATION WHEN THEY INCREASE #%/S OPTION
BASED COMPENSATION
4HIRD THERE IS EVIDENCE LINKING EXECUTIVE PAY TO THE
CONCENTRATION OF INSTITUTIONAL SHAREHOLDERS WHICH ARE MORE
LIKELY TO MONITOR THE #%/ AND THE BOARD /NE STUDY
lNDS THAT MORE CONCENTRATED INSTITUTIONAL OWNERSHIP
LEADS TO LOWER AND MORE PERFORMANCE SENSITIVE COMPENSA
TION !NOTHER STUDY lNDS THAT THE EFFECT OF INSTITUTIONAL
SHAREHOLDERS ON #%/ PAY DEPENDS ON THE NATURE OF THEIR
RELATIONSHIPS WITH THE lRM 4HIS STUDY REPORTS THAT #%/
PAY IS NEGATIVELY CORRELATED WITH THE PRESENCE OF hPRESSURE
RESISTANTv INSTITUTIONSINSTITUTIONS THAT HAVE NO OTHER
BUSINESS RELATIONSHIP WITH THE lRM AND THUS PRESUMABLY
ARE CONCERNED ONLY WITH THE lRMS SHARE VALUE "UT #%/
PAY IS POSITIVELY CORRELATED WITH THE PRESENCE OF hPRESSURE
SENSITIVEv INSTITUTIONSTHOSE HAVING BUSINESS RELATIONSHIPS
WITH THE lRM SUCH AS MANAGING ITS PENSION FUNDS AND THUS
MORE VULNERABLE TO MANAGEMENT PRESSURE
&INALLY STUDIES lND A CONNECTION BETWEEN PAY AND ANTI
TAKEOVER PROVISIONS ARRANGEMENTS THAT MAKE #%/S AND THEIR
BOARDS LESS VULNERABLE TO A HOSTILE TAKEOVER /NE STUDY lNDS
THAT #%/S OF COMPANIES ADOPTING ANTI TAKEOVER PROVI
SIONS ENJOY ABOVE MARKET COMPENSATION BEFORE ADOPTION
OF THE PROVISIONS AND THAT ADOPTION IS FOLLOWED BY FURTHER
SIGNIlCANT INCREASES IN PAY 4HIS PATTERN IS NOT READILY
EXPLAINABLE BY ARMS LENGTH CONTRACTING INDEED IF RISK
AVERSE MANAGERS JOBS ARE MORE SECURE SHAREHOLDERS SHOULD
BE ABLE TO PAY THE MANAGERS LESS !NOTHER STUDY lNDS THAT
#%/S OF COMPANIES THAT BECAME PROTECTED BY STATE ANTI
TAKEOVER LEGISLATION ENACTED DURING THE PERIOD OF  
REDUCED THEIR HOLDINGS OF SHARES WHICH BECAME LESS IMPOR

 *OHN #ORE 2OBERT (OLTHAUSEN AND $AVID ,ARCKER h#ORPORATE 'OVERNANCE #HIEF
%XECUTIVE #OMPENSATION AND &IRM 0ERFORMANCEv *OURNAL OF &INANCIAL %CONOMICS 6OL 
  PP  
 #ORE (OLTHAUSEN AND ,ARCKER   CITED EARLIER 2ICHARD #YERT 3OK (YON +ANG
AND 0RAVEEN +UMAR h#ORPORATE 'OVERNANCE 4AKEOVERS AND 4OP -ANAGEMENT #OMPEN
SATION 4HEORY AND %VIDENCEv -ANAGEMENT 3CIENCE 6OL    PP  
 #YERT +ANG AND +UMAR   CITED EARLIER
 -ARIANNE "ERTRAND AND 3ENDHIL -ULLAINATHAN h!GENTS 7ITH AND 7ITHOUT 0RINCIPALSv

!MERICAN %CONOMIC 2EVIEW 6OL    PP  

 *AY # (ARTZELL AND ,AURA 4 3TARKS h)NSTITUTIONAL )NVESTORS AND %XECUTIVE #OMPEN
SATIONv *OURNAL OF &INANCE 6OL    PP  
 $AVID 0ARTHIBAN 2AHUL +OCHAR AND %DWARD ,EVITAS h4HE %FFECT OF )NSTITUTIONAL
)NVESTORS ON THE ,EVEL AND -IX OF #%/ #OMPENSATIONv !CADEMY OF -ANAGEMENT *OURNAL
6OL    PP  
 +ENNETH ! "OROKHOVICH +ELLY 2 "RUNARSKI AND 2OBERT 0ARRINO h#%/ #ONTRACTING
AND !NTI 4AKEOVER !MENDMENTSv *OURNAL OF &INANCE 6OL    PP  

0OWER 0AY 2ELATIONSHIPS

*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

! -ORGAN 3TANLEY 0UBLICATION s &ALL 



TANT FOR THE PURPOSE OF MAINTAINING CONTROL BY AN AVERAGE OF

 !RMS LENGTH CONTRACTING BY CONTRAST MIGHT PREDICT
THAT #%/S PROTECTED BY ANTI TAKEOVER LEGISLATION WOULD BE
REQUIRED BY THEIR BOARDS TO INCREASE THEIR SHAREHOLDINGS TO
RESTORE THEIR INCENTIVE TO GENERATE SHAREHOLDER VALUE
,IMITS OF -ANAGERIAL )NmUENCE

4HERE ARE OF COURSE LIMITS TO THE ARRANGEMENTS THAT DIREC

TORS WILL APPROVE AND EXECUTIVES WILL SEEK !LTHOUGH MARKET
FORCES ARE NOT SUFlCIENTLY POWERFUL TO PREVENT SIGNIlCANT
DEVIATIONS FROM ARMS LENGTH OUTCOMES THEY DO IMPOSE
SOME CONSTRAINTS ON EXECUTIVE COMPENSATION )F A BOARD
WERE TO APPROVE A PAY ARRANGEMENT VIEWED AS EGREGIOUS
FOR EXAMPLE SHAREHOLDERS WOULD BE LESS WILLING TO SUPPORT
INCUMBENTS IN A HOSTILE TAKEOVER OR A PROXY lGHT
)N ADDITION DIRECTORS AND EXECUTIVES ADOPTING SUCH
AN ARRANGEMENT MIGHT BEAR SOCIAL COSTS $IRECTORS APPROV
ING A CLEARLY INmATED AND DISTORTED PAY PACKAGE MIGHT BE
SUBJECT TO RIDICULE OR SCORN IN THE MEDIA OR IN THEIR SOCIAL AND
BUSINESS CIRCLES -OST DIRECTORS WOULD WISH TO AVOID SUCH
TREATMENT EVEN IF THEIR BOARD POSITIONS WERE NOT AT RISK AND
THESE POTENTIAL SOCIAL COSTS REINFORCE THE CONSTRAINTS IMPOSED
BY MARKET FORCES ,IKE MARKET FORCES THESE POTENTIAL COSTS
CANNOT PRECLUDE SIGNIlCANT DEVIATIONS FROM SHAREHOLDER
SERVING ARRANGEMENTS BUT THEY MAY DISCOURAGE THE ADOPTION
OF ARRANGEMENTS THAT ARE PATENTLY ABUSIVE AND INDEFENSIBLE
/NE IMPORTANT BUILDING BLOCK OF THE MANAGERIAL POWER
APPROACH IS THEREFORE hOUTRAGEv COSTS 7HEN A BOARD APPROVES
A COMPENSATION ARRANGEMENT FAVORABLE TO MANAGERS THE
EXTENT TO WHICH DIRECTORS AND EXECUTIVES BEAR ECONOMIC COSTS
SUCH AS HEIGHTENED RISK OF TAKEOVER AND SOCIAL COSTS SUCH
AS EMBARRASSMENT WILL DEPEND ON HOW THE ARRANGEMENT IS
PERCEIVED BY OUTSIDERS WHOSE VIEWS MATTER TO THE DIRECTORS
AND EXECUTIVES 4HE MORE OUTRAGE A COMPENSATION ARRANGE
MENT IS EXPECTED TO GENERATE THE LARGER WILL BE THE POTENTIAL
ECONOMIC AND SOCIAL COSTS AND THUS THE MORE RELUCTANT
DIRECTORS WILL BE TO APPROVE IT AND THE MORE HESITANT MANAG
ERS WILL BE TO PROPOSE IT IN THE lRST PLACE
4HERE IS EVIDENCE THAT THE DESIGN OF COMPENSATION
ARRANGEMENTS IS INDEED INmUENCED BY HOW OUTSIDERS PERCEIVE
THEM /NE STUDY lNDS THAT DURING THE S #%/S WHO
WERE THE TARGET OF SHAREHOLDER RESOLUTIONS CRITICIZING EXECU
TIVE PAY HAD THEIR ANNUAL INDUSTRY ADJUSTED COMPENSATION
REDUCED OVER THE FOLLOWING TWO YEARS
#AMOUmAGE AND 3TEALTH #OMPENSATION

4HE CRITICAL ROLE OF OUTSIDERS PERCEPTION OF EXECUTIVES

COMPENSATION AND THE SIGNIlCANCE OF OUTRAGE COSTS EXPLAIN
THE IMPORTANCE OF YET ANOTHER COMPONENT OF THE MANAGE
 3HIJUN #HENG 6ENKY .AGAR AND -ADHAR 6 2AJAN h)DENTIFYING #ONTROL -OTIVES IN
-ANAGERIAL /WNERSHIP %VIDENCE FROM !NTITAKEOVER ,EGISLATIONv 2EVIEW OF &INANCIAL 3TUD
IES 6OL    PP  
 2ANDALL 3 4HOMAS AND +ENNETH * -ARTIN h4HE %FFECT OF 3HAREHOLDER 0ROPOSALS



*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

RIAL POWER APPROACH hCAMOUmAGEv 4HE DESIRE TO MINIMIZE

OUTRAGE GIVES DESIGNERS OF COMPENSATION ARRANGEMENTS A
STRONG INCENTIVE TO TRY TO LEGITIMIZE JUSTIFY OR OBSCUREOR
MORE GENERALLY TO CAMOUmAGETHE AMOUNT AND PERFOR
MANCE INSENSITIVITY OF EXECUTIVE COMPENSATION
4HE DESIRE TO CAMOUmAGE HAS AN IMPORTANT EFFECT ON PAY
STRUCTURES 7E SHOW THAT COMPENSATION DESIGNERS ATTEMPTS
TO OBSCURE THE AMOUNT AND PERFORMANCE INSENSITIVITY OF
COMPENSATION HAVE LED TO ARRANGEMENTS THAT UNDERMINE
AND DISTORT MANAGERIAL INCENTIVES THEREBY WEAKENING lRM
PERFORMANCE /VERALL THE CAMOUmAGE MOTIVE TURNS OUT
TO BE QUITE USEFUL IN EXPLAINING MANY OTHERWISE PUZZLING
FEATURES OF THE EXECUTIVE COMPENSATION LANDSCAPE
!MONG THE ARRANGEMENTS THAT DISGUISE OR DOWNPLAY
THE AMOUNT AND PERFORMANCE INSENSITIVITY OF COMPENSA
TION ARE EXECUTIVE PENSION PLANS DEFERRED COMPENSATION
ARRANGEMENTS AND POST RETIREMENT PERKS -OST EXECUTIVE
PENSIONS AND DEFERRED COMPENSATION ARRANGEMENTS DO NOT
ENJOY THE LARGE TAX SUBSIDY GRANTED TO THE STANDARD RETIRE
MENT ARRANGEMENTS PROVIDED TO OTHER EMPLOYEES )N THE CASE
OF EXECUTIVES SUCH ARRANGEMENTS MERELY SHIFT TAX LIABILITY
FROM THE EXECUTIVE TO THE lRM 4HE EFlCIENCY GROUNDS FOR
PROVIDING COMPENSATION THROUGH IN KIND RETIREMENT PERKS
ARE ALSO FAR FROM CLEAR
!LL OF THESE ARRANGEMENTS HOWEVER MAKE EXECUTIVES
COMPENSATION LESS VISIBLE TO INVESTORS REGULATORS AND THE
GENERAL PUBLIC !MONG OTHER THINGS EXISTING DISCLOSURE
RULES DO NOT REQUIRE COMPANIES TO PLACE A DOLLAR VALUE
ONOR INCLUDE IN THEIR PUBLICLY lLED SUMMARY COMPEN
SATION TABLESTHE AMOUNTS PROVIDED TO EXECUTIVES AFTER
THEY RETIRE !LTHOUGH THE EXISTENCE AND TERMS OF EXECUTIVES
RETIREMENT ARRANGEMENTS MUST BE DISCLOSED IN VARIOUS PLACES
THROUGHOUT THE lRMS PUBLIC lLINGS THIS DISCLOSURE IS LESS
VISIBLE BECAUSE OUTSIDERS INCLUDING COMPENSATION RESEARCH
ERS AND THE MEDIA FOCUS ON THE DOLLAR AMOUNTS REPORTED IN
THE COMPENSATION TABLES
)N A RECENT EMPIRICAL STUDY 2OBERT *ACKSON AND ONE
OF US USED INFORMATION PROVIDED IN PROXY STATEMENTS TO
ESTIMATE THE VALUE OF THE EXECUTIVE PENSION PLANS OF 30
 #%/S !BOUT TWO THIRDS OF #%/S HAVE SUCH PLANS
AND THE STUDY ESTIMATED THE VALUE OF THESE PLANS FOR ALL THE
#%/S WHO RECENTLY LEFT THEIR lRMS OR ARE CLOSE TO RETIRE
MENT AGE &OR THE MEDIAN #%/ IN THE STUDYS SAMPLE THE
ACTUARIAL VALUE OF THE #%/S PENSION WAS  MILLION WHICH
MADE UP ABOUT ONE THIRD OF THE TOTAL COMPENSATION BOTH
EQUITY BASED AND NON EQUITY THEY HAD RECEIVED DURING
THEIR SERVICE AS #%/S
&URTHERMORE THE STUDY INDICATES THAT WHEN PENSION
VALUE IS INCLUDED IN CALCULATING EXECUTIVE PAY COMPENSA
ON %XECUTIVE #OMPENSATIONv 5NIVERSITY OF #INCINNATI ,AW 2EVIEW 6OL    PP
 
 3EE "EBCHUK AND *ACKSON   CITED EARLIER

! -ORGAN 3TANLEY 0UBLICATION s &ALL 

TION IS MUCH LESS LINKED TO PERFORMANCE THAN COMMONLY

PERCEIVED !FTER PENSION VALUE IS INCLUDED THE PERCENT
AGE OF A #%/S TOTAL COMPENSATION THAT IS hSALARY LIKEv
IE THE PORTION THAT CONSISTS OF lXED ANNUAL PAYMENTS
SUCH AS BASIC SALARY DURING THE #%/S SERVICE AND PENSION
PAYMENTS AFTERWARDS  INCREASES FROM  TO  4HE
STUDY DOCUMENTS THAT THE CURRENT OMISSION OF RETIREMENT
BENElTS FROM STANDARD COMPENSATION DATASETS HAS DISTORTED
INVESTORS PICTURE OF PAY ARRANGEMENTS )N PARTICULAR THIS
OMISSION HAS LED TO  SIGNIlCANT UNDERESTIMATIONS OF THE
TOTAL AMOUNT OF PAY  CONSIDERABLE DISTORTIONS IN COMPAR
ISONS AMONG EXECUTIVE PAY PACKAGES AND  SUBSTANTIAL
OVERESTIMATIONS OF THE EXTENT TO WHICH EXECUTIVE PAY IS
LINKED TO PERFORMANCE
7HILE COMPANIES DO NOT MAKE THE VALUE OF EXECUTIVE
PENSIONS TRANSPARENT THEY ARE REQUIRED TO DISCLOSE ENOUGH
INFORMATION TO ENABLE DILIGENT RESEARCHERS TO ESTIMATE
THE VALUE OF THESE PENSIONS )N CONTRAST THE INFORMATION
PROVIDED ABOUT DEFERRED COMPENSATION ARRANGEMENTS DOES
NOT ALLOW EVEN THE MOST CAREFUL ANALYST TO ESTIMATE WITH ANY
PRECISION THE VALUE CONFERRED ON EXECUTIVES THROUGH THESE
ARRANGEMENTS 4HUS THIS FORM OF COMPENSATION IS ESPECIALLY
EFFECTIVE IN CAMOUmAGING POTENTIALLY LARGE AMOUNTS OF NON
PERFORMANCE PAY
'RATUITOUS 'OODBYE 0AYMENTS

)N MANY CASES BOARDS GIVE DEPARTING #%/S PAYMENTS

AND BENElTS THAT ARE NOT REQUIRED UNDER THE TERMS OF A
#%/S COMPENSATION CONTRACT 3UCH GRATUITOUS hGOOD
BYE PAYMENTSv ARE COMMON EVEN WHEN #%/S PERFORM SO
POORLY THAT THEIR BOARDS FEEL COMPELLED TO REPLACE THEM &OR
EXAMPLE WHEN -ATTEL #%/ *ILL "ARAD RESIGNED UNDER lRE
THE BOARD FORGAVE A  MILLION LOAN GAVE HER AN ADDI
TIONAL  MILLION IN CASH TO COVER THE TAXES FOR FORGIVENESS
OF ANOTHER LOAN AND ALLOWED HER UNVESTED OPTIONS TO VEST
PREMATURELY 4HESE GRATUITOUS BENElTS WERE OFFERED IN ADDI
TION TO THE CONSIDERABLE BENElTS THAT SHE RECEIVED UNDER
HER EMPLOYMENT AGREEMENT WHICH INCLUDED A TERMINATION
PAYMENT OF  MILLION AND A STREAM OF RETIREMENT BENE
lTS EXCEEDING  PER YEAR
)T IS NOT EASY TO RECONCILE SUCH GRATUITOUS PAYMENTS
WITH THE ARMS LENGTH CONTRACTING MODEL 4HE BOARD HAS
THE AUTHORITY TO lRE THE #%/ AND PAY NO MORE THAN THE
#%/S CONTRACTUAL SEVERANCE BENElTS 4HERE SHOULD BE NO
NEED TO hBRIBEv A POORLY PERFORMING #%/ TO STEP DOWN )N
ADDITION THE SIGNAL SENT BY THE GRATUITOUS GOODBYE PAYMENT
WILL IF ANYTHING ONLY WEAKEN THE INCENTIVE OF THE NEXT
#%/ TO PERFORM
4HE MAKING OF SUCH GRATUITOUS PAYMENTS HOWEVER IS
QUITE CONSISTENT WITH THE EXISTENCE OF MANAGERIAL INmUENCE
 -ICHAEL # *ENSEN AND +EVIN * -URPHY h0ERFORMANCE 0AY AND 4OP -ANAGEMENT
)NCENTIVESv *OURNAL OF 0OLITICAL %CONOMY 6OL    PP   AND -ICHAEL #
*ENSEN AND +EVIN * -URPHY h#%/ )NCENTIVES )TS .OT (OW -UCH 9OU 0AY BUT (OWv (AR

*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

OVER THE BOARD "ECAUSE OF THEIR RELATIONSHIP WITH THE #%/

SOME DIRECTORS MIGHT BE UNWILLING TO REPLACE THE EXISTING
#%/ UNLESS HE OR SHE IS VERY GENEROUSLY TREATED /THER
DIRECTORS MIGHT BE WILLING TO REPLACE THE #%/ EVEN WITHOUT
A GRATUITOUS GOODBYE PAYMENT BUT PREFER TO GIVE IT EITHER TO
REDUCE THEIR PERSONAL DISCOMFORT IN FORCING OUT THE #%/
OR TO MAKE THE SEPARATION PROCESS LESS PERSONALLY UNPLEAS
ANT )N ALL OF THESE CASES DIRECTORS WILLINGNESS TO MAKE SUCH
PAYMENTS STEMS FROM THEIR RELATIONSHIPS WITH THE #%/
/F COURSE TAKING MANAGERIAL POWER AS GIVEN PROVIDING
GRATUITOUS PAYMENTS TO lRED #%/S COULD BE BENElCIAL TO
SHAREHOLDERS IN SOME INSTANCES )F MANY DIRECTORS ARE LOYAL
TO THE #%/ SUCH PAYMENTS MIGHT BE NECESSARY TO ASSEMBLE
A BOARD MAJORITY IN FAVOR OF REPLACING THE EXECUTIVE )N THIS
CASE THE PRACTICE HELPS SHAREHOLDERS WHEN THE #%/S DEPAR
TURE YIELDS A BENElT LARGER THAN THE COST OF THE GOODBYE
PAYMENT &OR OUR PURPOSES HOWEVER WHAT IS IMPORTANT
IS THAT THESE GRATUITOUS PAYMENTS WHETHER OR NOT THEY ARE
BENElCIAL TO SHAREHOLDERS GIVEN MANAGERS POWER  REmECT
THE EXISTENCE AND SIGNIlCANCE OF MANAGERIAL INmUENCE
4HE $ECOUPLING OF 0AY FROM 0ERFORMANCE
)N THE EARLY S PROMINENT lNANCIAL ECONOMISTS SUCH AS
-ICHAEL *ENSEN AND +EVIN -URPHY URGED SHAREHOLDERS TO
BE MORE ACCEPTING OF LARGE PAY PACKAGES THAT WOULD PROVIDE
HIGH POWERED INCENTIVES 3HAREHOLDERS IT WAS ARGUED
SHOULD CARE MUCH MORE ABOUT PROVIDING MANAGERS WITH
SUFlCIENTLY STRONG INCENTIVES THAN ABOUT THE AMOUNTS SPENT
ON EXECUTIVE PAY $EFENDERS OF CURRENT PAY ARRANGEMENTS
VIEW THE RISE IN PAY OVER THE PAST  YEARS AS THE NECESSARY
PRICEAND ONE WELL WORTH PAYINGFOR IMPROVING EXECU
TIVES INCENTIVES
4HE PROBLEM HOWEVER IS THAT EXECUTIVES LARGE COMPEN
SATION PACKAGES HAVE BEEN MUCH LESS SENSITIVE TO THEIR OWN
PERFORMANCE THAN HAS BEEN COMMONLY RECOGNIZED 3HAREHOLD
ERS HAVE NOT RECEIVED THE MOST BANG FOR THEIR BUCK #OMPANIES
COULD HAVE GENERATED THE SAME INCREASE IN INCENTIVES AT A MUCH
LOWER COST TO THEIR SHAREHOLDERS OR THEY COULD HAVE USED THE
AMOUNT SPENT TO OBTAIN MORE POWERFUL INCENTIVES
.ON %QUITY #OMPENSATION

!LTHOUGH THE EQUITY BASED FRACTION OF MANAGERS COMPENSA

TION HAS INCREASED CONSIDERABLY DURING THE PAST DECADE AND HAS
THEREFORE RECEIVED MORE ATTENTION NON EQUITY COMPENSATION
CONTINUES TO BE SUBSTANTIAL )N  NON EQUITY COMPENSA
TION REPRESENTED ON AVERAGE ABOUT HALF THE TOTAL COMPENSATION
OF BOTH THE #%/ AND THE TOP lVE EXECUTIVES OF 30 
COMPANIES NOT CLASSIlED AS NEW ECONOMY lRMS
!LTHOUGH SIGNIlCANT NON EQUITY COMPENSATION COMES
IN THE FORM OF BASE SALARY AND SIGN UP hGOLDEN HELLOv
VARD "USINESS 2EVIEW 6OL    PP  
 "EBCHUK AND 'RINSTEIN h4HE 'ROWTH OF %XECUTIVE 0AYv CITED EARLIER

! -ORGAN 3TANLEY 0UBLICATION s &ALL 



PAYMENTS THAT DO NOT PURPORT TO BE PERFORMANCE RELATED

MUCH NON EQUITY COMPENSATION COMES IN THE FORM OF BONUS
COMPENSATION THAT DOES PURPORT TO BE PERFORMANCE BASED
.ONETHELESS EMPIRICAL STUDIES HAVE FAILED TO lND ANY SIGNIF
ICANT CORRELATION BETWEEN NON EQUITY COMPENSATION AND
MANAGERS OWN PERFORMANCE DURING THE S
! CLOSE EXAMINATION OF COMPENSATION PRACTICES SUGGESTS
WHY NON EQUITY COMPENSATION IS NOT TIGHTLY CONNECTED TO
MANAGERS OWN PERFORMANCE &IRST OF ALL MANY COMPA
NIES USE SUBJECTIVE CRITERIA FOR AT LEAST SOME OF THEIR BONUS
PAYMENTS 3UCH CRITERIA COULD PLAY A USEFUL ROLE IN THE HANDS
OF BOARDS GUIDED SOLELY BY SHAREHOLDER INTERESTS (OWEVER
BOARDS FAVORING THEIR TOP EXECUTIVES CAN USE THE DISCRETION
PROVIDED BY THESE PLANS TO ENSURE THAT EXECUTIVES ARE WELL
PAID EVEN WHEN THEIR PERFORMANCE IS SUBSTANDARD
&URTHERMORE WHEN COMPANIES DO USE OBJECTIVE CRITE
RIA THESE CRITERIA AND THEIR IMPLEMENTATION ARE USUALLY NOT
DESIGNED TO REWARD MANAGERS FOR THEIR OWN CONTRIBUTION TO
THE lRMS PERFORMANCE "ONUSES ARE TYPICALLY BASED NOT ON
HOW THE lRMS OPERATING PERFORMANCE OR EARNINGS INCREASED
RELATIVE TO ITS PEERS BUT RATHER ON OTHER METRICS !ND WHEN
COMPANIES FAIL TO MEET THE ESTABLISHED TARGETS THE BOARD
CAN RESET THE TARGET AS HAPPENED AT #OCA #OLA IN  AND
AT !44 7IRELESS IN  OR COMPENSATE THE EXECUTIVES
BY SETTING EVEN LOWER lGURES GOING FORWARD
&INALLY MANY BOARDS AWARD BONUSES TO MANAGERS SIMPLY
FOR BUYING OTHER COMPANIES )N ABOUT  OF LARGE ACQUI
SITIONS DURING THE PERIOD   THE ACQUIRING lRM
#%/ RECEIVED A MULTI MILLION DOLLAR BONUS FOR COMPLET
ING THE DEAL "UT MAKING ACQUISITIONS HARDLY APPEARS TO
BE SOMETHING FOR WHICH MANAGERS SHOULD RECEIVE A SPECIAL
REWARDTHAT IS A PAYMENT ABOVE AND BEYOND WHATEVER
BENElT THEY GET FROM THE EFFECT OF THE ACQUISITION ON THE
VALUE OF THE MANAGERS OPTIONS SHARES AND EARNINGS BASED
BONUSES %XECUTIVES DO NOT LACK INCENTIVES TO MAKE VALUE
INCREASING ACQUISITIONS )F ANYTHING INVESTORS CONCERN IS
THAT EXECUTIVES MAY ENGAGE IN EMPIRE BUILDING AND MAKE
TOO MANY ACQUISITIONS 4HUS ALTHOUGH THE MAKING OF A
LARGE ACQUISITION MIGHT PROVIDE A CONVENIENT EXCUSE FOR A
LARGE BONUS ACQUISITION BONUSES ARE NOT CALLED FOR BY INCEN
TIVE CONSIDERATIONS
7INDFALLS IN %QUITY "ASED #OMPENSATION

)N LIGHT OF THE HISTORICALLY WEAK LINK BETWEEN NON EQUITY

COMPENSATION AND MANAGERIAL PERFORMANCE SHAREHOLD
ERS AND REGULATORS WISHING TO MAKE PAY MORE SENSITIVE TO
PERFORMANCE HAVE INCREASINGLY ENCOURAGED THE USE OF EQUITY
BASED COMPENSATION OFTEN IN THE FORM OF STOCK OPTIONS
7E STRONGLY SUPPORT EQUITY BASED COMPENSATION WHICH IN
 3EE -URPHY   CITED EARLIER
 9ANIV 'RINSTEIN AND 0AUL (RIBAR h#%/ #OMPENSATION AND )NCENTIVES %VIDENCE FROM
-! "ONUSESv *OURNAL OF &INANCIAL %CONOMICS 6OL    PP  
 $ANIEL "ERGSTRESSER AND 4HOMAS 0HILIPPON h#%/ )NCENTIVES AND %ARNINGS -ANAGE



*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

PRINCIPLE CAN PROVIDE MANAGERS WITH DESIRABLE INCENTIVES )N

PRACTICE HOWEVER THE DESIGN OF EXECUTIVES STOCK OPTIONS HAS
ENABLED EXECUTIVES TO REAP SUBSTANTIAL REWARDS EVEN WHEN
THEIR OWN PERFORMANCE WAS MERELY PASSABLE OR EVEN POOR

2EWARDS FOR -ARKET 7IDE AND )NDUSTRY 7IDE

-OVEMENTS #ONVENTIONAL STOCK OPTIONS ENABLE EXECUTIVES

TO GAIN FROM ANY INCREASE IN THE NOMINAL STOCK PRICE ABOVE

THE GRANT DATE MARKET VALUE 4HIS IN TURN MEANS THAT EXECU
TIVES CAN PROlT EVEN WHEN THEIR COMPANIES PERFORMANCE
SIGNIlCANTLY LAGS THAT OF THEIR PEERS AS LONG AS MARKET WIDE
AND INDUSTRY WIDE MOVEMENTS PROVIDE SUFlCIENT LIFT FOR THE
STOCK PRICE ! SUBSTANTIAL FRACTION OF STOCK PRICE INCREASES IS
DUE TO SUCH MOVEMENTS RATHER THAN TO lRM SPECIlC FACTORS
THAT MIGHT REmECT THE MANAGERS OWN PERFORMANCE
!LTHOUGH THERE IS A VARIETY OF WAYS IN WHICH MARKET
AND INDUSTRY DRIVEN WINDFALLS COULD BE lLTERED OUT VERY
FEW COMPANIES HAVE ADOPTED EQUITY BASED PLANS THAT EVEN
ATTEMPT TO lLTER OUT SUCH WINDFALLS 5NFORTUNATELY MOST OF
THE BOARDS NOW CHANGING THEIR EQUITY BASED COMPENSATION
PLANS IN RESPONSE TO OUTSIDE PRESSURE ARE STILL CHOOSING TO
AVOID PLANS THAT WOULD EFFECTIVELY ELIMINATE SUCH WINDFALLS
)NSTEAD THEY ARE MOVING TO PLANS BASED ON RESTRICTED STOCK
THAT FAIL TO ELIMINATE AND SOMETIMES EVEN INCREASE THESE
WINDFALLS
2EWARDS FOR 3HORT 4ERM 3PIKES /PTION PLANS HAVE BEEN
DESIGNED AND LARGELY CONTINUE TO BE DESIGNED IN WAYS THAT
ENABLE EXECUTIVES TO MAKE CONSIDERABLE GAINS FROM TEMPORARY
SPIKES IN THE COMPANYS STOCK PRICE EVEN WHEN LONG TERM
STOCK PERFORMANCE IS POOR #OMPANIES HAVE GIVEN EXECUTIVES
BROAD FREEDOM TO UNWIND EQUITY INCENTIVES A PRACTICE THAT
HAS BEEN BENElCIAL TO EXECUTIVES BUT COSTLY TO SHAREHOLDERS
)N ADDITION TO BEING GRANTED THE FREEDOM TO EXERCISE THEIR
OPTIONS AS SOON AS THEY VEST AND SELL THE UNDERLYING STOCK
EXECUTIVES OFTEN HAVE CONSIDERABLE CONTROL OVER THE TIMING OF
SALES ENABLING THEM TO BENElT FROM THEIR INSIDE INFORMATION
#OMPOUNDING THE PROBLEM MANY lRMS HAVE ADOPTED RELOAD
PLANS THAT MAKE IT EASIER FOR EXECUTIVES TO LOCK IN PROlTS FROM
SHORT TERM SPIKES 4HE FEATURES OF OPTION PLANS THAT REWARD
MANAGERS FOR SHORT TERM SPIKES NOT ONLY DECOUPLE PAY FROM
MANAGERS OWN PERFORMANCE BUT ALSO PROVIDE INCENTIVES TO
MANIPULATE EARNINGS 4HERE IS IN FACT SIGNIlCANT EVIDENCE
LINKING EXECUTIVES FREEDOM TO UNLOAD OPTIONS WITH EARNINGS
MANIPULATION AND lNANCIAL MISREPORTING
#OMPENSATION !T AND !FTER $EPARTURE

!S ALREADY NOTED THE DOLLAR VALUE OF A SUBSTANTIAL PORTION OF

EXECUTIVE COMPENSATION IS NOT REPORTED IN lRMS PUBLICLY lLED
SUMMARY COMPENSATION TABLES AND IS THEREFORE NOT INCLUDED
IN STANDARD COMPENSATION DATASETS 4HIS hSTEALTH COMPEN
MENT %VIDENCE FROM THE Sv FORTHCOMING IN *OURNAL OF &INANCIAL %CONOMICS  
3COTT , 3UMMERS AND *OHN 4 3WEENEY h&RAUDULENTLY -ISSTATED &INANCIAL 3TATEMENTS AND
)NSIDER 4RADING !N %MPIRICAL !NALYSISv !CCOUNTING 2EVIEW 6OL    PP  

! -ORGAN 3TANLEY 0UBLICATION s &ALL 

SATIONv INCLUDES EXECUTIVE PENSIONS DEFERRED COMPENSATION

ARRANGEMENTS AND POST RETIREMENT CONSULTING CONTRACTS AND
PERKS 4HESE LESS VISIBLE FORMS OF COMPENSATION HAVE TENDED
TO BE INSENSITIVE TO MANAGERIAL PERFORMANCE THUS FURTHER
CONTRIBUTING TO A DECOUPLING OF PAY FROM PERFORMANCE
4AKE FOR EXAMPLE &RANKLIN 2AINES WHO WAS FORCED
TO RETIRE AS &ANNIE -AES #%/ IN LATE  5PON DEPAR
TURE &ANNIE OWED HIM AND HIS SURVIVING SPOUSE AFTER HIS
DEATH AN ANNUAL PENSION OF APPROXIMATELY  MILLION AN
AMOUNT SPECIlED WITHOUT ANY CONNECTION TO THE lRMS STOCK
PERFORMANCE UNDER 2AINES )N A CASE STUDY OF HIS COMPEN
SATION WE ESTIMATED THE VALUE OF THIS NON PERFORMANCE
ELEMENT OF PAY AT ABOUT  MILLION
&URTHER DECOUPLING PAY FROM PERFORMANCE ARE SEVERANCE
PAYMENTS GIVEN TO DEPARTING EXECUTIVES %XECUTIVES PUSHED
OUT BY THEIR BOARDS ARE TYPICALLY PAID A SEVERANCE AMOUNT
ING TO TWO OR THREE YEARS WORTH OF ANNUAL COMPENSATION
4HESE PAYMENTS ARE NOT REDUCED EVEN WHEN THE EXECU
TIVES PERFORMANCE HAS BEEN CLEARLY AND OBJECTIVELY DISMAL
&URTHERMORE STANDARD SEVERANCE PROVISIONS DO NOT REDUCE
THE SEVERANCE PAYMENT EVEN IF THE EXECUTIVE QUICKLY lNDS
OTHER EMPLOYMENT
)T IS DOUBTFUL THAT THESE SEVERANCE ARRANGEMENTS REmECT
EFlCIENT ARMS LENGTH CONTRACTING .ON EXECUTIVE EMPLOY
EES ARE BOTH MORE LIKELY TO BE TERMINATED THAN EXECUTIVES
AND LESS lNANCIALLY CAPABLE OF BEARING THIS RISK "UT THEY ARE
NOT PROTECTED FROM HAVING TO BEAR A SUBSTANTIAL MONETARY
LOSS IN THE EVENT OF TERMINATION )F EXECUTIVE SEVERANCE
PROVISIONS WERE DRIVEN BY RISK BEARING CONSIDERATIONS ONE
WOULD EXPECT NON EXECUTIVE EMPLOYEES TO HAVE SUCH PROVI
SIONS AS WELL
-ORE IMPORTANTLY IF EXECUTIVES HIGH PAY IS JUSTIlED
BY THE IMPORTANCE OF PROVIDING THEM WITH INCENTIVES ONE
WOULD EXPECT THEIR COMPENSATION ARRANGEMENTS TO BE MORE
SENSITIVE TO PERFORMANCE THAN NON EXECUTIVE PAY AND TO
PROVIDE LESS PROTECTION IN THE EVENT OF DISMAL FAILURE #URRENT
CORPORATE SEVERANCE PRACTICES NOT ONLY FAIL TO STRENGTHEN THE
LINK BETWEEN PAY AND PERFORMANCE THEY UNDERMINE IT BY
DIMINISHING THE DIFFERENCE BETWEEN PAYOFFS FOR GOOD AND
BAD PERFORMANCE
)MPROVING 4RANSPARENCY
7E NOW TURN TO OUR PROPOSALS FOR IMPROVING PAY ARRANGE
MENTS AND THE GOVERNANCE PROCESSES THAT PRODUCE THOSE
ARRANGEMENTS 7E START WITH A REFORM THAT WE VIEW AS A
hNO BRAINERv ONE FOR WHICH WE SEE NO REASONABLE BASIS FOR
OPPOSITION )N PARTICULAR THE 3%# SHOULD REQUIRE PUBLIC
COMPANIES TO MAKE THE AMOUNT AND STRUCTURE OF THEIR EXEC
UTIVE PAY PACKAGES MORE TRANSPARENT
&INANCIAL ECONOMISTS HAVE PAID LITTLE ATTENTION TO
TRANSPARENCY 4HEY TEND TO FOCUS ON STOCK PRICE BEHAVIOR

AND ASSUME THAT ANY PUBLICLY AVAILABLE INFORMATION EVEN

IF UNDERSTOOD BY ONLY A SMALL NUMBER OF PROFESSIONALS
BECOMES INCORPORATED INTO STOCK PRICES 4HUS ECONOMISTS
ARE TYPICALLY INTERESTED IN WHETHER CERTAIN INFORMATION
IS PUBLICLY AVAILABLE NOT HOW IT IS DISCLOSED !S WE HAVE
DISCUSSED 3%# REGULATIONS ALREADY REQUIRE DETAILED DISCLOSURE
OF THE COMPENSATION OF A COMPANYS #%/ AND ITS FOUR OTHER
MOST HIGHLY PAID EXECUTIVES 4HUS FROM ECONOMISTS STOCK
PRICING PERSPECTIVE THERE IS ALREADY A SIGNIlCANT AMOUNT OF
INFORMATION AVAILABLE ABOUT EXECUTIVE COMPENSATION
)N OUR VIEW HOWEVER IS IT CRITICAL TO RECOGNIZE THE IMPOR
TANCE OF MAKING SUCH DISCLOSURES TRANSPARENT 4HE PURPOSE
OF EXECUTIVE COMPENSATION DISCLOSURE IS NOT MERELY TO ENABLE
ACCURATE PRICING OF CORPORATE SECURITIES BUT TO PROVIDE SOME
CHECK ON ARRANGEMENTS THAT ARE TOO FAVORABLE TO EXECUTIVES
4HIS GOAL IS NOT WELL SERVED BY DISSEMINATING INFORMATION IN
A WAY THAT MAKES THE INFORMATION UNDERSTANDABLE TO A SMALL
NUMBER OF MARKET PROFESSIONALS BUT OPAQUE TO OTHERS
0UBLIC OFlCIALS GOVERNANCE REFORMERS AND INVESTORS
SHOULD WORK TO ENSURE THAT COMPENSATION ARRANGEMENTS ARE
AND REMAIN TRANSPARENT 4RANSPARENCY WOULD PROVIDE SHARE
HOLDERS WITH A MORE ACCURATE PICTURE OF TOTAL PAY AND ITS
RELATIONSHIP TO PERFORMANCE AND THEREBY PROVIDE SOME CHECK
ON DEPARTURES FROM ARRANGEMENTS THAT SERVE SHAREHOLDER
INTERESTS &URTHERMORE TRANSPARENCY WOULD ELIMINATE THE
DISTORTIONS THAT CURRENTLY ARISE WHEN PAY DESIGNERS CHOOSE
PARTICULAR FORMS OF COMPENSATION FOR THEIR CAMOUmAGE VALUE
RATHER THAN FOR THEIR EFlCIENCY &INALLY TRANSPARENCY WOULD
IMPOSE LITTLE COST ON COMPANIES BECAUSE IT WOULD SIMPLY
REQUIRE THEM TO DISCLOSE CLEARLY INFORMATION THEY HAVE OR
CAN OBTAIN AT NEGLIGIBLE COST
!LTHOUGH WE SUPPORT IMPROVED MANDATORY DISCLOSURE
REQUIREMENTS NOTHING PREVENTS COMPANIES IN THE MEANTIME
FROM VOLUNTARILY MAKING PAY MORE TRANSPARENT )NVESTORS
SHOULD DEMAND MORE OPENNESS AND COMPANIES SHOULD NOT
CONTINUE TO FOLLOW A hLAWYERLYv APPROACH OF NOT DISCLOS
ING MORE THAN IS LEGALLY REQUIRED 4HE MEASURES DESCRIBED
BELOW COULD SUBSTANTIALLY INCREASE THE TRANSPARENCY OF PAY
ARRANGEMENTS
2ECOMMENDATION  0LACE A $OLLAR 6ALUE
ON !LL &ORMS OF #OMPENSATION

#OMPANIES SHOULD BE REQUIRED TO PLACE A DOLLAR VALUE ON

ALL FORMS OF COMPENSATION AND TO INCLUDE THESE AMOUNTS IN
THE SUMMARY COMPENSATION TABLES CONTAINED IN COMPANY
3%# lLINGS %XECUTIVES ROUTINELY RECEIVE SUBSTANTIAL hSTEALTH
COMPENSATIONv IN THE FORM OF PENSIONS DEFERRED COMPENSA
TION AND POST RETIREMENT PERKS AND CONSULTING CONTRACTS
!LTHOUGH CERTAIN DETAILS OF THESE BENElTS APPEAR IN VARIOUS
3%# lLINGS COMPANIES HAVE NOT BEEN REQUIRED TO PLACE A
DOLLAR VALUE ON ANY OF THESE FORMS OF BENElTS AND TO INCLUDE

 "EBCHUK AND &RIED   CITED EARLIER

*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

! -ORGAN 3TANLEY 0UBLICATION s &ALL 



THIS VALUE IN THE SUMMARY TABLES THAT RECEIVE THE MOST ATTEN
TION FROM INVESTORS AND THE MEDIA 4HESE BENElTS HAVE NOT
EVEN BEEN INCLUDED IN THE STANDARD DATABASE USED BY lNAN
CIAL ECONOMISTS TO STUDY EXECUTIVE COMPENSATION
)N OUR VIEW COMPANIES SHOULD BE REQUIRED TO PLACE A
MONETARY VALUE ON EACH BENElT PROVIDED OR PROMISED TO AN
EXECUTIVE AND TO INCLUDE THIS VALUE IN THE SUMMARY COMPEN
SATION TABLE IN THE YEAR THE EXECUTIVE BECOMES ENTITLED TO IT
4HUS FOR EXAMPLE THE COMPENSATION TABLES SHOULD INCLUDE
THE AMOUNT BY WHICH THE EXPECTED VALUE OF AN EXECUTIVES
PROMISED PENSION PAYMENTS INCREASES DURING THE YEAR )N
ADDITION IT MIGHT BE DESIRABLE TO REQUIRE COMPANIES TO PLACE
A DOLLAR VALUE ON AND REPORT ANY TAX BENElT THAT ACCRUES TO
THE EXECUTIVE AT THE COMPANYS EXPENSE FOR EXAMPLE UNDER
DEFERRED COMPENSATION 
2ECOMMENDATION  $ISCLOSE !LL
.ON $EDUCTIBLE #OMPENSATION

4HE TAX CODE PERMITS COMPANIES TO DEDUCT CERTAIN PAYMENTS

TO EXECUTIVES BUT NOT OTHERS #OMPANIES ROUTINELY INCLUDE
IN THEIR DISCLOSURE BOILERPLATE LANGUAGE NOTIFYING SHAREHOLD
ERS THAT SOME OF THE ARRANGEMENTS MAY RESULT IN THE lRM
BEING UNABLE TO DEDUCT A PORTION OF AN EXECUTIVES COMPEN
SATION "UT THEY DO NOT PROVIDE DETAILS ABOUT WHAT PARTICULAR
AMOUNTS END UP NOT BEING DEDUCTIBLE #OMPANIES SHOULD
PROVIDE FULL DETAILS ABOUT THE COMPONENTS OF PAY THAT ARE
NOT DEDUCTIBLE PLACE A MONETARY VALUE ON THE COSTS OF THIS
NON DEDUCTIBILITY TO THE lRM AND DISCLOSE THIS DOLLAR COST
TO INVESTORS
2ECOMMENDATION  %XPENSE /PTIONS

/PTIONS SHOULD BE EXPENSED &ROM AN ACCOUNTANTS PERSPEC

TIVE EXPENSING IS DESIRABLE BECAUSE IT LEADS TO A MORE ACCURATE
REmECTION OF THE COMPANYS lNANCIAL SITUATION )N OUR VIEW
EXPENSING IS BENElCIAL BECAUSE IT MAKES THE COSTS IMPOSED
BY OPTION BASED COMPENSATION MORE VISIBLE TO INVESTORS ON
AN ONGOING BASIS
2ATIONALIZING THE ACCOUNTING TREATMENT OF OPTION PLANS
WOULD ALSO LEVEL THE PLAYING lELD AMONG DIFFERENT TYPES OF
OPTIONS )T WOULD ELIMINATE A MAJOR EXCUSE USED TO AVOID
INDEXED AND OTHER REDUCED WINDFALL OPTIONS 4HE FACT THAT
SUCH OPTIONS MUST BE EXPENSED WHILE CONVENTIONAL OPTIONS
NEED NOT HAS LONG BEEN A CONVENIENT EXCUSE FOR USING CONVEN
TIONAL OPTIONS THAT REWARD MANAGERS FOR GENERAL MARKET OR
SECTOR RISES
2ECOMMENDATION  2EPORT THE 2ELATIONSHIP
BETWEEN 0AY AND 0ERFORMANCE

#OMPANIES SHOULD REPORT TO THEIR SHAREHOLDERS HOW MUCH

OF THEIR EXECUTIVES PROlTS FROM EQUITY AND NON EQUITY
COMPENSATION IS ATTRIBUTABLE TO GENERAL MARKET AND INDUS
TRY MOVEMENTS 4HIS COULD BE DONE BY REQUIRING lRMS TO
CALCULATE AND REPORT THE GAINS MADE BY MANAGERS FROM THE


*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

EXERCISE OF OPTIONS OR THE VESTING OF RESTRICTED SHARES IN

THE CASE OF RESTRICTED SHARE GRANTS AND TO REPORT WHAT FRAC
TION IF ANY REmECTS THE COMPANYS SUCCESS IN OUTPERFORMING
ITS INDUSTRY PEERS 3UCH DISCLOSURE WOULD HELP CLARIFY THE
EXTENT TO WHICH THE COMPANYS EQUITY BASED PLANS REWARD
THE MANAGERS FOR GOOD RELATIVE PERFORMANCE
2ECOMMENDATION  $ISCLOSE /PTION AND
3HARE 5NLOADING

#OMPANIES SHOULD BE REQUIRED TO MAKE TRANSPARENT TO SHARE

HOLDERS ON A REGULAR BASIS THE EXTENT TO WHICH THEIR TOP lVE
EXECUTIVES HAVE UNLOADED ANY EQUITY INSTRUMENTS RECEIVED
AS PART OF THEIR COMPENSATION !LTHOUGH A DILIGENT AND
DEDICATED RESEARCHER CAN OBTAIN THIS INFORMATION BY SIFTING
THROUGH STACKS OF EXECUTIVE TRADING REPORTS lLED WITH THE
3%# REQUIRING THE lRM TO COMPILE AND REPORT SUCH INFOR
MATION WOULD HIGHLIGHT FOR ALL INVESTORS THE EXTENT TO WHICH
MANAGERS HAVE USED THEIR FREEDOM TO UNWIND INCENTIVES
)MPROVING 0AY !RRANGEMENTS
7ELL DESIGNED EXECUTIVE COMPENSATION CAN PROVIDE EXECU
TIVES WITH COST EFFECTIVE INCENTIVES TO GENERATE SHAREHOLDER
VALUE 7E HAVE ARGUED HOWEVER THAT THE PROMISE OF SUCH
ARRANGEMENTS HAS NOT YET BEEN REALIZED "ELOW WE NOTE VARI
OUS CHANGES THAT COMPANIES SHOULD CONSIDER AND INVESTORS
SHOULD URGE COMPANIES TO ADOPT IN ORDER TO STRENGTHEN THE
LINK BETWEEN PAY AND PERFORMANCE AND THEREBY IMPROVE
EXECUTIVES INCENTIVES
2ECOMMENDATION  2EDUCE 7INDFALLS IN
%QUITY "ASED #OMPENSATION

)NVESTORS SHOULD ENCOURAGE lRMS TO ADOPT EQUITY COMPEN

SATION PLANS THAT lLTER OUT AT LEAST SOME OF THE GAINS IN THE
STOCK PRICE THAT ARE DUE TO GENERAL MARKET OR INDUSTRY MOVE
MENTS 7ITH SUCH lLTERING THE SAME AMOUNT OF INCENTIVES
CAN BE PROVIDED AT A LOWER COST OR STRONGER INCENTIVES CAN
BE PROVIDED AT THE SAME COST 4HIS CAN BE DONE NOT ONLY BY
INDEXING THE EXERCISE PRICE OF STOCK OPTIONS BUT IN OTHER
WAYS AS WELL &OR EXAMPLE BY LINKING THE EXERCISE PRICE OF
OPTIONS TO CHANGES IN THE STOCK PRICE OF THE WORST PERFORM
ING lRMS IN THE INDUSTRY MARKET WIDE MOVEMENT CAN BE
lLTERED OUT WITHOUT IMPOSING EXCESSIVE RISK ON EXECUTIVES
)T IS ALSO IMPORTANT TO NOTE THAT MOVING TO RESTRICTED STOCK
IS NOT A GOOD WAY TO ADDRESS THE WINDFALLS PROBLEM )N FACT
GRANTS OF RESTRICTED STOCK PROVIDE EVEN LARGER WINDFALLS THAN
CONVENTIONAL OPTIONS
2ECOMMENDATION  2EDUCE 7INDFALLS IN "ONUS 0LANS

&OR SIMILAR REASONS COMPANIES SHOULD DESIGN BONUS PLANS

THAT lLTER OUT IMPROVEMENTS IN lNANCIAL PERFORMANCE DUE
TO ECONOMY OR INDUSTRY WIDE MOVEMENTS %VEN ASSUMING
THAT IT IS DESIRABLE TO FOCUS ON ACCOUNTING RATHER THAN STOCK
PRICE PERFORMANCE AS MOST BONUS PLANS SEEK TO DO REWARD
! -ORGAN 3TANLEY 0UBLICATION s &ALL 

ING EXECUTIVES FOR IMPROVEMENTS IN ACCOUNTING MEASURES

ENJOYED BY ALL COMPANIES IN THE INDUSTRY IS NOT A COST EFFEC
TIVE WAY TO PROVIDE INCENTIVES 4HUS BONUS PLANS SHOULD
NOT BE BASED ON ABSOLUTE INCREASES IN EARNINGS SALES REVE
NUES AND SO FORTH BUT RATHER ON SUCH INCREASES RELATIVE TO
PEER COMPANIES
2ECOMMENDATION  ,IMIT THE 5NWINDING
OF %QUITY )NCENTIVES

)NVESTORS SHOULD ALSO SEEK TO CURTAIL EXECUTIVES BROAD FREE

DOM TO UNWIND THE EQUITY BASED INCENTIVES PROVIDED BY
THEIR COMPENSATION PLANS )T MAY BE DESIRABLE TO SEPARATE
THE VESTING OF OPTIONS AND MANAGERS ABILITY TO UNWIND
THEM "Y REQUIRING THAT EXECUTIVES HOLD VESTED OPTIONS OR
THE SHARES RESULTING FROM THE EXERCISE OF SUCH OPTIONS FOR A
GIVEN PERIOD AFTER VESTING BOARDS WOULD ENSURE THAT OPTIONS
ALREADY BELONGING TO EXECUTIVES WILL REMAIN IN THEIR HANDS
FOR SOME TIME CONTINUING TO PROVIDE INCENTIVES TO INCREASE
SHAREHOLDER VALUE &URTHERMORE SUCH RESTRICTIONS WOULD
ELIMINATE THE SIGNIlCANT DISTORTIONS THAT CAN RESULT FROM
REWARDING EXECUTIVES FOR SHORT TERM SPIKES IN THE STOCK PRICE
THAT DO NOT SUBSEQUENTLY HOLD 4O PREVENT CIRCUMVENTION
SUCH RESTRICTIONS SHOULD BE BACKED BY CONTRACTUAL PROHIBI
TIONS ON EXECUTIVES HEDGING OR USING ANY OTHER SCHEME THAT
EFFECTIVELY ELIMINATES SOME OF THEIR EXPOSURE TO DECLINES IN
THE lRMS STOCK PRICE
)N ADDITION IT MIGHT BE DESIRABLE AS ONE OF US PROPOSED
SOME TIME AGO TO REQUIRE EXECUTIVES TO DISCLOSE IN ADVANCE
THEIR INTENTION TO SELL SHARES PROVIDING DETAILED INFORMATION
ABOUT THE INTENDED TRADE INCLUDING THE NUMBER OF SHARES TO
BE SOLD 0ROVIDING EXECUTIVES WITH OPPORTUNITIES TO SELL THEIR
SHARES WHEN THEIR INSIDE INFORMATION INDICATES THE STOCK PRICE
IS ABOUT TO DECLINE CAN DILUTE AND DISTORT THEIR INCENTIVES
2ECOMMENDATION  4IE "ONUSES TO
,ONG 4ERM 0ERFORMANCE

%VEN ASSUMING IT WERE DESIRABLE TO REWARD MANAGERS FOR

IMPROVEMENTS IN ACCOUNTING RESULTS SUCH REWARDS SHOULD
NOT BE GIVEN FOR SHORT TERM RESULTS BUT ONLY FOR IMPROVE
MENTS THAT ARE SUSTAINED OVER A CONSIDERABLE PERIOD OF TIME
2EWARDING EXECUTIVES FOR SHORT TERM IMPROVEMENTS IS NOT
AN EFFECTIVE WAY TO PROVIDE BENElCIAL INCENTIVES AND INDEED
MIGHT CREATE INCENTIVES TO MANIPULATE SHORT TERM ACCOUNT
ING RESULTS
#OMPENSATION CONTRACTS SHOULD ALSO GENERALLY INCLUDE
hCLAWBACKv PROVISIONS THAT REQUIRE MANAGERS TO RETURN
PAYMENTS BASED ON ACCOUNTING NUMBERS THAT ARE SUBSE
QUENTLY RESTATED 3UCH RETURN OF PAYMENTS IS WARRANTED
 3EE *ESSE - &RIED h2EDUCING THE 0ROlTABILITY OF #ORPORATE )NSIDER 4RADING 4HROUGH
0RETRADING $ISCLOSUREv 3OUTHERN #ALIFORNIA ,AW 2EVIEW 6OL    PP  
 ,UCIAN ! "EBCHUK AND 9ANIV 'RINSTEIN h&IRM %XPANSION AND #%/ 0AYv CITED EAR
LIER
 #HRISTINE *OLLS h3TOCK 2EPURCHASES AND )NCENTIVE #OMPENSATIONv ."%2 7ORKING

*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

REGARDLESS OF WHETHER THE EXECUTIVE WAS IN ANY WAY RESPON

SIBLE FOR THE MISREPORTING 7HEN THE BOARD BELIEVES IT IS
DESIRABLE TO TIE EXECUTIVE PAYOFFS TO A FORMULA INVOLVING A
METRIC WHOSE VALUE TURNS OUT TO HAVE BEEN INmATED CORRECTLY
APPLYING THE FORMULA REQUIRES REVERSING PAYMENTS THAT WERE
BASED ON ERRONEOUS VALUES 4HE GOVERNING PRINCIPLE SHOULD
BE h7HAT WASNT EARNED MUST BE RETURNEDv
2ECOMMENDATION  "E 7ARY OF 0AYING FOR %XPANSION

"ECAUSE RUNNING A LARGER COMPANY INCREASES MANAGERS

POWER PRESTIGE AND PERQUISITES EXECUTIVES MIGHT HAVE AN
INCENTIVE TO EXPAND THE COMPANY AT THE EXPENSE OF SHARE
HOLDER VALUE %XECUTIVE COMPENSATION ARRANGEMENTS SHOULD
SEEK TO COUNTER RATHER THAN REINFORCE THIS INCENTIVE
! RECENT STUDY BY 9ANIV 'RINSTEIN AND ONE OF US lNDS
THAT EXECUTIVES DECISIONS TO EXPAND COMPANY SIZEBY
ISSUING NEW EQUITY TO lNANCE ACQUISITIONS OR INVESTMENTS
OR BY AVOIDING DISTRIBUTIONSARE ASSOCIATED WITH INCREASES
IN SUBSEQUENT EXECUTIVE PAY #ONTROLLING FOR PAST PERFOR
MANCE THE COMPENSATION OF CONTINUING #%/S IS POSITIVELY
AND SUBSTANTIALLY CORRELATED WITH lRM EXPANSION DURING
THEIR SERVICE 7HILE A LARGER lRM SIZE MIGHT LEAD THE BOARD
TO RAISE EXECUTIVE PAY BOARDS SHOULD KEEP IN MIND THAT AN
EXPECTATION THAT EXPANSION WILL RESULT IN HIGHER PAY CAN
PROVIDE EXECUTIVES WITH INCENTIVES TO EXPAND EVEN WHEN
DOING SO WOULD NOT BE VALUE MAXIMIZING
2ECOMMENDATION  2ESTORE $IVIDEND .EUTRALITY

5NDER CURRENT OPTION PLANS TERMS ARE NOT UPDATED TO REmECT

THE PAYMENT OF DIVIDENDS AND AS A RESULT EXECUTIVES PAYOFFS
ARE REDUCED WHEN THEY DECIDE TO PAY A DIVIDEND 4HERE IS
EVIDENCE THAT COMPANIES RUN BY EXECUTIVES WHOSE PAY HAS
A LARGE OPTION COMPONENT TEND TO PAY LOWER DIVIDENDS AND
INSTEAD DISTRIBUTE CASH THROUGH SHARE REPURCHASES WHICH
HAVE A LESS ADVERSE EFFECT ON THE VALUE OF MANAGERS OPTIONS
BUT MAY NOT BE THE MOST EFlCIENT FORM OF PAYOUT 4O
REDUCE DISTORTIONS IN MANAGERS PAYOUT DECISIONS ALL EQUITY
BASED COMPENSATION SHOULD BE DESIGNED IN SUCH A WAY THAT
IT NEITHER ENCOURAGES NOR DISCOURAGES THE PAYMENT OF DIVI
DENDS )N PARTICULAR IN THE CASE OF OPTION PLANS THE EXERCISE
PRICE OF OPTIONS SHOULD BE ADJUSTED DOWNWARD TO REmECT A
DIVIDEND PAYMENT
2ECOMMENDATION  2ETHINK %XECUTIVE 0ENSIONS

4HERE ARE REASONS TO DOUBT THE EFlCIENCY OF THE WIDESPREAD

PRACTICE OF USING 3UPPLEMENTAL %XECUTIVE 2ETIREMENT 0LANS
3%20S TO PROVIDE EXECUTIVES WITH A MAJOR COMPONENT
OF THEIR CAREER COMPENSATION 5NLIKE PENSION PLANS USED
0APER .O    *OLLS lNDINGS WERE SUBSEQUENTLY CONlRMED BY 'EORGE &ENN
AND .ELLIE ,IANG h#ORPORATE 0AYOUT 0OLICY AND -ANAGERIAL 3TOCK )NCENTIVESv *OURNAL OF
&INANCIAL %CONOMICS 6OL    PP  
 3EE *ESSE - &RIED h)NFORMED 4RADING AND &ALSE 3IGNALING WITH /PEN -ARKET 2EPUR
CHASESv FORTHCOMING IN #ALIFORNIA ,AW 2EVIEW  

! -ORGAN 3TANLEY 0UBLICATION s &ALL 



FOR NON EXECUTIVE EMPLOYEES 3%20S DO NOT ENJOY A TAX

SUBSIDY !ND GIVEN THAT COMPANIES HAVE BEEN MOVING AWAY
FROM DElNED BENElT PLANS TO DElNED CONTRIBUTION PLANS FOR
NON EXECUTIVE EMPLOYEES IT IS FAR FROM CLEAR THAT PROVIDING
EXECUTIVES WITH DElNED BENElT PLANS IS REQUIRED BY RISK
BEARING CONSIDERATIONS 5NLIKE DElNED CONTRIBUTION PLANS
WHICH FORCE THE EMPLOYEE TO BEAR THE RISK OF POOR INVEST
MENT PERFORMANCE DElNED BENElT PLANS SHIFT THE RISK OF
INVESTMENT PERFORMANCE TO THE lRM (OWEVER EXECUTIVES
DO NOT SEEM LESS ABLE TO BEAR SUCH RISK THAN OTHER EMPLOY
EES 7HILE THE EFlCIENCY BENElTS OF 3%20S ARE FAR FROM
CLEAR 3%20S IMPOSE INCENTIVE COSTS 4HEY PROVIDE EXECU
TIVES WITH PAY THAT IS LARGELY INDEPENDENT OF PERFORMANCE
THEREBY WEAKENING THE OVERALL LINK BETWEEN TOTAL PAY AND
PERFORMANCE "OARDS WOULD THUS DO WELL TO RECONSIDER THEIR
HEAVY USE OF 3%20S
2ECOMMENDATION  !VOID 3OFT ,ANDING
!RRANGEMENTS

3OFT LANDING ARRANGEMENTS WHICH PROVIDE MANAGERS WITH A

GENEROUS EXIT PACKAGE WHEN THEY ARE PUSHED OUT DUE TO FAIL
URE DILUTE EXECUTIVES INCENTIVES 7HILE COMPANIES SPEND
LARGE AMOUNTS ON PRODUCING A PAYOFF GAP BETWEEN GOOD
AND POOR PERFORMANCE THE MONEY SPENT ON SOFT LANDING
ARRANGEMENTS WORKS IN THE OPPOSITE DIRECTION NARROWING
THE PAYOFF GAP BETWEEN GOOD AND POOR PERFORMANCE
!T PRESENT EXECUTIVES ARE COMMONLY PROMISED GENER
OUS SEVERANCE ARRANGEMENTS IN THE EVENT OF TERMINATION
UNLESS THE TERMINATION IS TRIGGERED BY AN EXTREMELY NARROW
SET OF CIRCUMSTANCES SUCH AS CRIMINAL INDICTMENT OR
hMALFEASANCEv  "OARDS SHOULD CONSIDER PROVISIONS THAT
MAKE THE TERMINATION PAYOFF DEPEND ON THE REASONS FOR
THE EXECUTIVES TERMINATION AND THE TERMINATED EXECUTIVES
RECORD %VEN IF COMPANIES STICK TO THE EXISTING BROAD
DElNITION OF TERMINATION WITHOUT CAUSE THE PAYOFF IN SUCH
A TERMINATION SHOULD DEPEND IN PART ON THE lRMS PERFOR
MANCE RELATIVE TO ITS PEERS DURING THE EXECUTIVES SERVICE
!N EXECUTIVE WHO IS TERMINATED AGAINST A BACKGROUND OF
EXTREMELY POOR STOCK PERFORMANCE SHOULD GET LESS THAN AN
EXECUTIVE WHO IS TERMINATED WHEN THE COMPANYS PERFOR
MANCE IS REASONABLE
)MPROVING "OARD !CCOUNTABILITY
0AST AND CURRENT mAWS IN EXECUTIVE PAY ARRANGEMENTS HAVE
RESULTED FROM UNDERLYING PROBLEMS WITHIN THE CORPORATE
GOVERNANCE SYSTEM SPECIlCALLY DIRECTORS LACK OF SUFlCIENT
INCENTIVES TO FOCUS SOLELY ON SHAREHOLDER INTERESTS WHEN
SETTING PAY )F DIRECTORS COULD BE RELIED ON TO FOCUS ON SHARE
HOLDER INTERESTS THE PAY SETTING PROCESS AND BOARD OVERSIGHT
 ,UCIAN "EBCHUK h4HE #ASE FOR 3HAREHOLDER !CCESS TO THE "ALLOTv 4HE "USINESS
,AWYER 6OL    PP  
 &OR A FULLER ANALYSIS OF THE WAYS IN WHICH SHAREHOLDER POWER TO REMOVE DIRECTORS



*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

OF EXECUTIVES MORE GENERALLY WOULD BE GREATLY IMPROVED 4HE

MOST PROMISING ROUTE TO IMPROVING PAY ARRANGEMENTS IS THUS
TO MAKE BOARDS MORE ACCOUNTABLE TO SHAREHOLDERS AND MORE
FOCUSED ON SHAREHOLDER INTERESTS 3UCH INCREASED ACCOUNT
ABILITY WOULD TRANSFORM THE ARMS LENGTH CONTRACTING MODEL
INTO A REALITY )T WOULD IMPROVE BOTH PAY ARRANGEMENTS AND
BOARD PERFORMANCE MORE GENERALLY
2ECENT REFORMS REQUIRE MOST COMPANIES LISTED ON THE
MAJOR STOCK EXCHANGES THE .EW 9ORK 3TOCK %XCHANGE
.!3$!1 AND THE !MERICAN 3TOCK %XCHANGE TO HAVE A
MAJORITY OF INDEPENDENT DIRECTORSDIRECTORS WHO ARE NOT
OTHERWISE EMPLOYED BY THE lRM OR IN A BUSINESS RELATIONSHIP
WITH IT 4HESE COMPANIES MUST ALSO STAFF COMPENSATION AND
NOMINATING COMMITTEES ENTIRELY WITH INDEPENDENT DIREC
TORS !LTHOUGH SUCH REFORMS ARE LIKELY TO REDUCE MANAGERS
POWER OVER THE BOARD AND IMPROVE DIRECTORS INCENTIVES
SOMEWHAT THEY FALL FAR SHORT OF WHAT IS NECESSARY
/UR ANALYSIS SHOWS THAT THE NEW LISTING REQUIREMENTS
WEAKEN EXECUTIVES INmUENCE OVER DIRECTORS BUT DO NOT
ELIMINATE IT -ORE IMPORTANTLY THERE ARE LIMITS TO WHAT
INDEPENDENCE CAN DO BY ITSELF )NDEPENDENCE DOES NOT ENSURE
THAT DIRECTORS HAVE INCENTIVES TO FOCUS ON SHAREHOLDER INTER
ESTS OR THAT THE BEST DIRECTORS WILL BE CHOSEN )N ADDITION TO
BECOMING MORE INDEPENDENT OF INSIDERS DIRECTORS ALSO MUST
BECOME MORE DEPENDENT ON SHAREHOLDERS 4O THIS END WE
SHOULD ELIMINATE THE ARRANGEMENTS THAT CURRENTLY ENTRENCH
DIRECTORS AND INSULATE THEM FROM SHAREHOLDERS
4O BEGIN WITH SHAREHOLDERS POWER TO REPLACE DIREC
TORS SHOULD BE TURNED FROM MYTH INTO REALITY %VEN IN THE
WAKE OF POOR PERFORMANCE AND SHAREHOLDER DISSATISFACTION
DIRECTORS NOW FACE VERY LITTLE RISK OF BEING OUSTED 3HARE
HOLDERS ABILITY TO REPLACE DIRECTORS IS EXTREMELY LIMITED !
RECENT STUDY BY ONE OF US PROVIDES EVIDENCE THAT OUTSIDE
THE HOSTILE TAKEOVER CONTEXT THE INCIDENCE OF ELECTORAL
CHALLENGES TO DIRECTORS HAS BEEN PRACTICALLY NEGLIGIBLE IN THE
PAST DECADE 4HIS STATE OF AFFAIRS SHOULD NOT CONTINUE
4O IMPROVE THE PERFORMANCE OF CORPORATE BOARDS
IMPEDIMENTS TO DIRECTOR REMOVAL SHOULD BE REDUCED !S
A lRST STEP SHAREHOLDERS SHOULD BE GIVEN THE POWER TO PLACE
DIRECTOR CANDIDATES ON THE CORPORATE BALLOT )N ADDITION
PROXY CONTEST CHALLENGERS THAT ATTRACT SUFlCIENT SUPPORT
SHOULD RECEIVE REIMBURSEMENT OF THEIR EXPENSES FROM THE
COMPANY &URTHERMORE IT WOULD BE DESIRABLE TO LIMIT THE
USE OF STAGGERED BOARDS A FEATURE OF MOST PUBLIC COMPA
NIES TO IMPEDE DIRECTOR REMOVAL 3TAGGERED BOARDS PROVIDE
POWERFUL PROTECTION FROM REMOVAL IN EITHER A PROXY lGHT OR
A HOSTILE TAKEOVER !ND A RECENT STUDY BY !LMA #OHEN AND
ONE OF US lNDS THAT STAGGERED BOARDS ARE ASSOCIATED WITH
ECONOMICALLY SIGNIlCANT REDUCTIONS IN lRM VALUE 3HARE
COULD BE MADE VIABLE SEE ,UCIAN "EBCHUK h4HE -YTH OF THE 3HAREHOLDER &RANCHISEv
7ORKING PAPER (ARVARD ,AW 3CHOOL  

! -ORGAN 3TANLEY 0UBLICATION s &ALL 

HOLDERS SHOULD BE ABLE TO REPLACE ALL THE DIRECTORS EACH YEAR

OR AT LEAST EVERY OTHER YEAR
)N ADDITION TO MAKING SHAREHOLDER POWER TO REMOVE
DIRECTORS VIABLE BOARDS SHOULD NOT HAVE VETO POWERWHICH
CURRENT CORPORATE LAW GRANTS THEMOVER PROPOSED CHANGES
TO GOVERNANCE ARRANGEMENTS IN THE COMPANYS CHARTER
3HAREHOLDERS SHOULD HAVE THE POWER WHICH THEY NOW LACK
TO INITIATE AND ADOPT CHANGES IN THE CORPORATE CHARTER
5NDER CURRENT RULES SHAREHOLDERS CAN PASS ONLY NONBIND
ING RESOLUTIONS !ND AS DOCUMENTED IN A RECENT EMPIRICAL
STUDY BY ONE OF US BOARDS OFTEN CHOOSE NOT TO FOLLOW RESOLU
TIONS THAT RECEIVE MAJORITY SUPPORT FROM SHAREHOLDERS EVEN
IF THESE RESOLUTIONS HAVE PASSED TWO OR THREE TIMES 4HIS
STATE OF AFFAIRS SHOULD CHANGE
!LLOWING SHAREHOLDERS TO AMEND THE CORPORATE CHARTER
WOULD OVER TIME IMPROVE THE ENTIRE RANGE OF CORPORATE
GOVERNANCE ARRANGEMENTS WITHOUT OUTSIDE REGULATORY INTER
VENTION )F THERE IS CONCERN THAT SHAREHOLDERS ARE INmUENCED
BY SHORT TERM CONSIDERATIONS SHAREHOLDER INITIATED CHANGES
COULD REQUIRE APPROVAL BY MAJORITY VOTE IN TWO SUCCESSIVE
ANNUAL SHAREHOLDER MEETINGS "UT WE SHOULD NOT CONTINUE
DENYING SHAREHOLDERS THE POWER TO CHANGE THE CORPORATE
CHARTER NO MATTER HOW WIDESPREAD AND LONG LASTING THE

SHAREHOLDER SUPPORT FOR SUCH A CHANGE !LLOWING SHAREHOLD

ERS TO SET GOVERNANCE ARRANGEMENTS WOULD HELP MAKE BOARDS
MORE ACCOUNTABLE TO SHAREHOLDERS
4O FULLY ADDRESS THE EXISTING PROBLEMS IN EXECUTIVE
COMPENSATION AND CORPORATE GOVERNANCE STRUCTURAL REFORMS
IN THE ALLOCATION OF POWER BETWEEN BOARDS AND SHAREHOLDERS
ARE NECESSARY 'IVEN POLITICAL REALITIES SUCH REFORMS WILL NOT
BE EASY TO PASS "UT THE CORPORATE GOVERNANCE mAWS THAT WE
HAVE DISCUSSEDAND HAVE SHOWN TO BE PERVASIVE SYSTEMIC
AND COSTLYCALL FOR SUCH REFORMS

 ,UCIAN "EBCHUK AND !LMA #OHEN h4HE #OSTS OF %NTRENCHED "OARDSv *OURNAL OF
&INANCIAL %CONOMICS 6OL    PP  

 ,UCIAN "EBCHUK h4HE #ASE FOR )NCREASING 3HAREHOLDER 0OWERv (ARVARD ,AW 2E
VIEW 6OL    PP  

*OURNAL OF !PPLIED #ORPORATE &INANCE s 6OLUME  .UMBER 

LUCIAN BEBCHUK

IS THE 7ILLIAM * &RIEDMAN AND !LICIA 4OWNSEND

&RIEDMAN 0ROFESSOR OF ,AW %CONOMICS AND &INANCE AS WELL AS $IREC
TOR OF THE 0ROGRAM ON #ORPORATE 'OVERNANCE AT THE (ARVARD ,AW
3CHOOL (E IS ALSO A 2ESEARCH !SSOCIATE OF THE .ATIONAL "UREAU OF
%CONOMIC 2ESEARCH AND &ELLOW OF THE %UROPEAN #ORPORATE 'OVERNANCE
)NSTITUTE

JESSE FRIED

IS 0ROFESSOR OF ,AW AND #O $IRECTOR OF THE "ERKELEY

#ENTER FOR ,AW "USINESS AND THE %CONOMY AT THE "OALT (ALL 3CHOOL OF
,AW 5NIVERSITY OF #ALIFORNIA AT "ERKELEY

! -ORGAN 3TANLEY 0UBLICATION s &ALL