JOHN M. OLIN CENTER FOR LAW, ECONOMICS, AND BUSINESS
EXECUTIVE COMPENSATION AS
AN AGENCY PROBLEM
Lucian Arye Bebchuk and Jesse M. Fried
Discussion Paper No. 421
Harvard Law School
Cambridge, MA 02138
The Center for Law, Economics, and Business is supported by
a grant from the John M. Olin Foundation.
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This paper is also a discussion paper of the
John M. Olin Center's Program on Corporate Governance.
Last revision: April 2003
Executive Compensation as an Agency Problem
Lucian Arye Bebchuk* and Jesse M. Fried**
This paper provides an overview of the main theoretical elements and empirical underpinnings of a “managerial power” approach to executive compensation. The managerial power approach recognizes that boards of publicly traded companies with dispersed ownership do not bargain at arms’ length with managers, and that managers are able to influence their own pay arrangements. It thus views executive compensation not only as an instrument for addressing the agency problem between managers and shareholders, but also as part of the problem itself. We show that the managerial power approach can help explain many features of the executive compensation landscape, including ones that researchers have long viewed as puzzling. We explain that managerial influence produces efficiency costs because managers’ seeking and camouflaging of rents produces inefficient arrangements that result in weak or even perverse incentives. Keywords: Corporate governance, managers, shareholders, boards, directors, executive compensation, stock options, principal-agent problem, agency costs, rent extraction, golden parachutes, executive loans, compensation consultants. JEL classification: D23, G32, G34, G38, J33, J44, K22, M14.
* William J. Friedman Professor of Law, Economics, and Finance, Harvard Law School, and Research Associate, National Bureau of Economic Research. E-mail: email@example.com. ** Professor of Law, Boalt Hall School of Law, University of California at Berkeley. E-mail: firstname.lastname@example.org. We would like to thank J. Bradford De Long, Alexandra McCormack, Andrei Shleifer, Timothy Taylor, and Michael Waldman for their valuable suggestions. For financial support, we are grateful to the John M. Olin Center for Law, Economics, and Business (Bebchuk) and to the Boalt Hall Fund and U.C. Berkeley Committee on Research (Fried). © 2003 Lucian Bebchuk and Jesse Fried. All rights reserved. Executive compensation has long attracted a great deal of attention from financial economists. Indeed, the increase in academic papers on the subject of CEO compensation during the 1990’s seems to have outpaced even the remarkable increase in total CEO pay itself during this period (Murphy (1998)). Much research has focused on how executive compensation schemes can help alleviate the agency problem in publicly traded companies. To adequately understand the landscape of executive compensation, however, it is necessary to recognize that compensation schemes are also partly a product of this same agency problem. I. ALTERNATIVE APPROACHES TO EXECUTIVE COMPENSATION
Our focus in this paper is on publicly traded companies without a controlling shareholder. When ownership and management are separated in this way, managers might have a substantial degree of power. This recognition goes back, of course, to Berle and Means (1933) who observed that “[D]irectors, while in office, have almost complete discretion in management” (p. 139). Since Jensen and Meckling (1976), the problem of managerial power and discretion has been analyzed in modern finance as an “agency problem.” Managers may use their discretion to benefit their private interests in a...