Should Directors Reduce Executive Pay?

Abstract

This paper examines internal pay disparities in American public corporations and argues that wide gaps between the top and bottom of the pay scale can, in certain circumstances, directly and adversely affect firm value, that corporate boards should be informed about these effects, and that they should, in some cases, reduce internal pay differentials to address them. In support of this thesis, it analyzes numerous empirical studies that have shown that wide disparities in corporate pay scales can adversely affect firm value. These studies demonstrate that, at many types of organizations, as internal pay differentials grow, employees and lower level managers increasingly view themselves as being unfairly compensated in comparison to more highly paid top management. This perception adversely affects employee performance, productivity and willingness to work, and thereby reduces firm value. Directors' duty of care requires that they consider the spread between the high and low end of the corporate pay scale in setting firm compensation levels and act in the corporation's best interests to reduce it if necessary to maximize firm value.

Moreover, mega-grants of stock options are primarily responsible for these growing pay differentials. Corporate directors are uninformed about the real costs and benefits of these huge awards. Mega-grants of stock options to corporate managers are unjustified if their uncertain benefits are exceeded by their costs. As virtually no research has shown that mega-grants of stock options' costs exceed their benefits, directors need to more carefully determine if these programs maximize firm value. Once again, directors' duty of care obligates them to be reasonably informed about the value of these plans as that constitutes material information about their firm.

JEL Classification: K2, G3, J3, J33, J4, K22, M5