Framed! The Failure of Traditional Agency Cost Explanations for Executive Pay Practices

Abstract

This is the second article in a series exploring the empirical evidence arising from the increasing use of certain executive compensation best practices. The first article, “How Good Are Our ‘Best Practices’ When It Comes to Executive Compensation?” summarizes research findings that these best practices are responsible for most of the growth in executive compensation, and lead to suboptimal corporate performance. It also suggests that the best practices currently in widespread use contradict practices that are often very helpful to directors in setting appropriate incentives in real world circumstances.

This article goes on to argue that failures in executive compensation are the result, not of overly powerful CEOs confronting supine boards, but rather of directors and management earnestly striving to follow bad “best practices” promulgated by the corporate governance industry. This can be seen in: (1) the pattern of cause and effect distinguishable in the history of changing North American and British pay practices; (2) the link between these questionable pay practices and various measures of board independence and managerial weakness; and (3) the increasing use of these pay practices in circumstances of increased shareholder power. The most obvious solution is to increase board autonomy in setting pay. Regulatory steps for doing so lay close at hand, and in some cases have been discussed for years.