Sunday, February 22, 2009

NY Times Economix Blog Joins the Discussion on Executive Compensation

The Economix blog argues against traditional economics-based models of executive compensation.

Ideally, boards would act as faithful representatives of the shareholders. Therefore, boards are assumed to structure the compensation of executives to also be aligned with shareholders’ interests. This is a phenomenon known as “optimal contracting,” with shareholders as principals and board members as their agents.

How often optimal contracting actually occurs, however, is up for debate. The Economix blog defers to the book “Pay Without Performance: The Unfulfilled Promise of Executive Compensation” to make its argument.

The authors of Pay Without Performance argue that American corporate governance really functions under a “managerial power” model, where CEOs enjoy enough power over boards to dictate their own compensation, subject only to an “outrage” constraint. The “outrage” constraint is described in the book as the shareholders’, the media’s, and the public’s reaction to what they might learn about executive compensation, thus rooting the success or viability of compensation on the practice of secrecy. This worked for a long time, as compensation was broken up to into multiple components not easily summarized in a single figure – that is, until the SEC required corporations to disclose more detail on executive compensation.

So can we characterize the current legislation on executive compensation limits as this “outrage” to which the authors of Pay Without Performance referred? How far will we take this outrage? What other forms might it take in the future? What will be the most effective channel for this public outrage - and will our normal democratic channels be enough to quell the public?