Framed! The Failure of Traditional Agency Cost Explanations for Executive Pay Practices

Abstract

This is the second paper in a series exploring the empirical evidence arising from the increasing use of certain executive compensation best practices. The first paper, “How Good are our “Best Practices” When it Comes to Executive Compensation?,” summarizes research finding that these best practices are responsible for most of the growth in executive compensation and lead to sub-optimal corporate performance. It also suggests that the best practices currently in wide-spread use contradict practices that are often very helpful to directors in setting appropriate incentives in real world circumstances.

This paper goes on to argue that failures in executive compensation are the result, not of over-powerful CEOs confronting supine boards, but of directors and management earnestly striving to follow bad “best practices” promulgated by the corporate governance industry. This can be seen in: (1) the pattern of cause and effect distinguishable in the history of changing North American and U.K. pay practices; (2) the link between these questionable pay practices and various measures of board independence/managerial weakness; and (3) the increasing use of these pay practices in circumstances of increased shareholder power.

The most obvious solution is to increase board autonomy in setting pay. Regulatory steps for doing so lay close to hand and in some cases have been discussed for years.

Keywords: corporate governance, securities, executive compensation, executive pay, agency cost, corporate law, directors, boards of directors

JEL Classification: K22, M52, Z18