Does One Hand Wash the Other? Testing the Managerial Power and Optimal Contracting Hypotheses of Executive Compensation

Abstract

The recent series of corporate scandals has heated up the executive compensation debate. Those who warn of problems with the current system marshal evidence of structural pressures on directors to comply with executives' desires. They also point to common elements in compensation packages that seem poorly designed to induce managers to run the corporation efficiently. Defenders of the status quo point to apparent correlations between pay and performance, as well as to the increasing number of independent directors. The evidence on both sides is indirect and therefore vulnerable to alternative explanations. The absence of conclusive data in the executive compensation debate is understandable. Direct evidence of boards' cooption would require the unlikeliest of confessions; directors are not apt to admit breaching their fiduciary duties in giving in to their chief executive's pay demands. On the other side of the debate, it is very difficult to prove a negative, that directors do not bend to their CEOs' will in setting managers' pay. This article attempts to fill this evidentiary gap with an empirical test. The article employs a classroom model of the pay-setting process, making it possible to isolate a single variable - here, managerial power - and measure its impact. In this study, executive power had a dramatic impact on compensation, producing salaries that were not only much higher than those under a pure market regime but, in fact, demonstrably excessive. The results support critics of the existing regime and argue for legal changes to reduce chief executives' power over directors.