Excessive executive compensation is one of the prevailing topics in the business press. The “managerial power approach”, which is at the center of numerous publications of Bebchuk and Fried (Pay without performance: the unfulfilled promise of executive compensation, Harvard University Press, Cambridge, 2004) and Bebchuk and Grinstein (Oxford Rev Econ Policy 21:283–303, 2005), claims that chief executive officers (CEOs) corrupt the pay-setting process by influencing the board of directors. This paper analyzes the role of the board of directors in the pay-setting process for the CEO’s compensation schedule in an optimal contracting framework. The board’s role in our model is to provide information about the CEO’s ability to the shareholders. We assume that the CEO and other stakeholders, such as employees’ representatives, can influence the board to act in their respective favor when reporting to the shareholders. We show how the CEO’s influence on the board alters the optimal contract and the CEO’s incentives. Most interestingly, the influence of an interest group on the board can be the reason for high pay schedules, even though that was not the objective of the interest group.
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