Making Sense of Executive Compensation

In the attempt of promoting financial stability and better risk-management practices, the Dodd-Frank Act has introduced a number of significant executive compensation rules affecting all public U.S. companies. In my paper, Making Sense of Executive Compensation, which was recently made publicly available on SSRN and is forthcoming in the Delaware Journal of Corporate Law,  I argue that the Congress has failed to accurately answer three basic questions in enacting the new legislation:

• (i) what are the key problems that plague executive compensation,
• (ii) what is the possible solution, and
• (iii) what is the role of regulation in implementing the solution?

Addressing these questions, I come to three conclusions.

First, I argue that any comprehensive reform of executive compensation must take into account two moral hazard problems: inducing managers to perform (i.e., the problem of effort) and preventing them from taking either too much or too little risk (i.e., the problem of inefficient risk-taking).

Second, I suggest that analyzing manager employment contracts as relational in nature, as they are in reality, offers important insights into how to implement efficient compensation schemes. Contrary to conventional wisdom, because continuation of employment matters to managers, expectation of high fixed payments can promote effort. At the same time, the use of fixed compensation can constrain managerial incentives for excessive risk (i.e., over-investment). These properties of fixed pay allows the firm to implement mixed payment schedules that induce managers to perform while fully internalizing risk externalities.

Crucially, I show that the firm’s capital structure is the critical factor in determining the appropriate fixed-equity mix in executive pay. High levels of leverage increase the risk of over-investment by providing a “debt cushion” that absorbs most losses in the case of failure. Hence, in such firms the fixed and equity components of manager pay should be tied to the firm’s debt-equity ratio, in order to exploit the property of fixed compensation of countering managers’ incentives for excessive risk. In contrast, equity-based compensation should be preferred in low-leveraged firms, where over-investment concerns are less severe. In this case, the equity-based portion of executive pay should exceed the fixed-pay portion, since equity-based compensation is generally more effective in inducing managers to perform.

Third, I claim that regulation of executive pay is necessary for remedying inefficiencies within the organizational structure of the public corporation that hamper adoption of optimal mixed payment schedules. Especially in high-leveraged firms, shareholders might prefer compensation schemes that give managers over-investment incentives. As a result, the corporate pay setting process might be equity-compensation biased, causing boards to prefer equity-pay components over fixed-pay components, regardless of what the most efficient solution may be. In addition, within the organizational structure of the large corporation, shareholders have limited effective power to displace the board and its management. As a result, they lack the credible retaliatory power that relational-contract analysis of executive compensation shows necessary to implement efficient compensation schemes.

Yet, the Dodd-Frank Act is unlikely to achieve the goal of promoting more efficient compensation practices. By failing to put together all of the pieces of the compensation puzzle, the Act only provides partial solutions to the two-dimensional moral hazard problem of effort and risk that plagues executive compensation. The non-binding approval of executive compensation by shareholders (i.e., say-on-pay) can produce benefits to deter managers’ excessive risk-taking from the shareholders’ viewpoint. However, it cannot eliminate managers’ over-investment incentives, because shareholders are served by them. In addition, because the Act limits the amounts of executive pay, firms could be prohibited from offering the high levels of fixed compensation that are necessary to make continuation of employment valuable to managers.

I suggest that a more effective regulatory approach to improve current compensation practices should provide for intervention that primarily takes two forms. First, regulators should implement rules to tackle equity-compensation biases in the corporate pay-setting process, such as an SEC-mandated standardized procedure for regulating the activity of the compensation and risk committees. Because such a procedure would help solve the problem of over-investment, shareholders would always have the right incentives to remove under-performing management. Therefore, the second intervention I propose is strengthening shareholder powers to displace managers.

The full paper is available for download here.