Can powerful managers extract rents?

Abstract

The extant financial literature has typically examined compensation decisions from the perspective of a board of directors that attempts to establish an optimal contract in order to mitigate agency conflicts. Recent research, however, suggests that the process of determining compensation is better described as a negotiation between the board and the CEO and that the power of CEOs to influence boards provides an explanation for the lack of pay-performance sensitivity. For instance, Hermalin and Weisbach (1998) model a bargaining game in which the CEO’s compensation is negotiated between the two parties. Bebchuk et al. (2002) argue that the CEO’s power over the board of directors distorts optimal compensation contracts and that the existing empirical evidence better supports the bargaining model than the optimal contracting paradigm. In a large review of the executive pay literature Gomez-Mejia and Wiseman (1997: 320) suggest that “executive pay is a compromise between CEO power to inflate their compensation and societal pressures on boards to limit CEO pay” and that “the power of CEOs to influence boards provides a better explanation for the lack of pay-performance sensitivity than alternative explanations” (Gomez and Wiseman, 1997: 321).

Keywords

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