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A disruptive idea on Executive Compensation

In this post I will introduce an article (1) providing a disruptive idea into current compensation practices: introducing Legal Limits on Executive (performance based) Pay for the main executives and using Informal contracts instead of formal ones could enhance social welfare and firms` profitability.

They state that in some circumstances restricting contract freedom enhances welfare, (2) and they propose to extend this assertion to compensation contracts. They try to argue against economic thinking (contrary to this kind of restriction) being applied everywhere and every time, disregarding those circumstances.

 

The argument relies on agency models and incomplete contracts; while directors observe managers`actions and their stochastic consequences, information about actions is not verifiable, so it is not enforceable; on the other hand, compliance reputation by directors (when they abide by informal obligations) helps them sign such informal contracts in the future. The cost of losing credibility depends on how far the next alternative is; and the alternative is a series of formal pay for performance contracts. If the alternative is very attractive for the board, a legal restriction on contingent pay can then be beneficial, turning the formal contract`s output worse.

 

The authors state that as the executive can`t be forced to pay if results are negative, he is actually capturing an (expected) rent when signing a formal contract, which damages efficiency and profitability. So, capping performance based pay in formal contracts helps boards choose more efficient informal contracts, (in the model, only when the board has the bargaining power, but not if the executive does).

 

Some conditions nevertheless arise to the welfare and profit positive result:

 

  • The board must be “patient” and the Ceo relatively “impatient” at least,
  • The hypothesis holds insofar as the board is capable enough to perceive what happens in the firm, (board quality),
  • The measure can push the firm`s strategy from a measurable one (inorganic growth and M&A, for instance), to a longer-term strategy, (organic growth for example).

 

These conditions are outstanding contributions by Cebon and Hermalin, as being met, the firm would be avoiding some of the more relevant Ceo-pay-related problems in recent times. Short-termism, unexperienced boards, (although the authors argue against independence in their case) and extreme Ceo focus on transactions rather than on operations.

 

A good reading! In practical terms, I think is out of the trend, but this is good!

 

  1. Cebon, Peter and Hermalin, Benjamin E., When Less is More: How Limits on Executive Pay Can Result in Greater Managerial Effort and the Adoption of Better Strategies (December 3, 2013). Available at SSRN: http://ssrn.com/abstract=2362967 or http://dx.doi.org/10.2139/ssrn.2362967
  2. Baker, George P., Robert Gibbons, and Kevin J. Murphy, in: http://www.people.hbs.edu/gbaker/pubs/SubjectivePerf.pdf
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