Pay for Short-Term Performance: Executive Compensation in Speculative Markets

Abstract

ABSTRACT We argue that the root cause behind the recent corporate scandals associated with CEO pay is the technology bubble of the latter half of the 1990s. Far from rejecting the optimal incentive contracting theory of executive compensation, the recent evidence on executive pay can be reconciled with classical agency theory once one expands the framework to allow for speculative stock markets. I. INTRODUCTION In early September 2002 the news broke that HealthSouth Corporation's chairman sold 94 percent of his company stock just weeks before the nation's biggest chain of rehabilitation hospitals revealed regulatory concerns that battered its stock price.1 By that date such announcements were hardly news, given that several major company failures had already been widely covered in the financial press, the high drama congressional hearings on Enron, Global Crossing, WorldCom, and Adelphia had taken place, and the Sarbanes-Oxley Act had been signed into law. But, perhaps better than any previous headlines, this announcement epitomized what most commentators found so troubling about the reality of executive compensation: CEOs were able to secure high rewards early, in spite of their companies' subsequent dismal performances.2 As Bebchuk and Fried underline in the preface to their new book, Pay without Performance, [The] wave of corporate scandals that began in late 2001 shook confidence in the performance of public company boards and drew attention to potential flaws in their executive compensation practices. There is now recognition that many boards have employed compensation arrangements that do not serve shareholders' interests. But there is still substantial disagreement about the scope and source of such problems and, not surprisingly, about how to address them.3 Their well-informed and timely book deals with two broad and related corporate governance issues: (1) the flaws in the executive compensation process, and (2) the lack of accountability and excessive insulation of corporate boards. Our article deals only with the first issue. While we share many of their concerns about the deficiencies of boards of directors, we differ in our assessment of executive compensation: whether executives are overpaid, the role of managerial power, and why executive compensation has risen so much over the last 15 years. Bebchuk and Fried's main argument is that CEOs have essentially been able to set their own pay through captured boards and remuneration committees. One central regulatory and social constraint CEOs face, however, in setting their pay is mandatory disclosure of their remuneration and the potential outrage of outsiders upon the announcement of egregiously inflated compensation. CEOs, therefore, try to elude outsider wrath by camouflaging their high pay as highly complex and hard to value incentive pay. Another form of camouflage CEOs can engage in is to grant themselves inflated pension plans, life insurance contracts, and golden parachutes. Bebchuk and Fried argue that, upon closer inspection, what superficially looks like an optimal financial incentive contract is in reality just a sham. The official view, which sees executive compensation contracts as optimal incentive contracts, has little basis in reality and can only be seen as a clever CEO sales pitch for their rent extraction. As perspicacious as Bebchuk and Fried's observations may be, an obvious concern with their theory of camouflage of executive compensation is that it may not always live up to the basic Popperian test of falsifiability. Since they do not articulate precisely how to distinguish the reported forms of camouflaged compensation from forms of compensation that are consistent with optimal incentive contracting, it is not possible to determine which disclosed compensation contracts in reality might be inconsistent with their theory.4 But this is more of an academic quibble than our main critique to their theory. …