Indexing Executive Compensation Contracts

The Harvard Law School Forum on Corporate Governance and Financial Regulation 2014-01-29

Summary:

Editor's Note: The following post comes to us from Ingolf Dittmann, Professor of Finance at Erasmus University Rotterdam; Ernst Maug, Professor of Finance at the University of Mannheim; and Oliver Spalt of the Department of Finance at Tilburg University.

Standard principal-agent theory prescribes that managers should not be compensated on exogenous risks, such as general market movements. Rather, firms should index pay and use contracts that filter exogenous risks (e.g., Holmstrom 1979, 1982; Diamond and Verrecchia 1982). This prescription is intuitive and agrees with common sense: CEOs should receive exceptional pay only for exceptional performance, and “rational” compensation practice should not permit CEOs to obtain windfall profits in rising stock markets. However, observed compensation contracts are typically not indexed. Specifically, stock options almost never tie the strike price of the option to an index that reflects market performance or the performance of peers. Commentators often cite this glaring difference between theory and practice as evidence for the inefficiency of executive compensation practice and, more generally, as evidence for major deficiencies of corporate governance in U.S. firms (e.g., Rappaport and Nodine 1999; Bertrand and Mullainathan 2001; Bebchuk and Fried 2004). This paper therefore contributes to the discussion about which compensation practices reveal deficiencies in the pay-setting process.

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Link:

http://blogs.law.harvard.edu/corpgov/2014/01/29/indexing-executive-compensation-contracts/

From feeds:

Blogs.law Aggregation Hub » The Harvard Law School Forum on Corporate Governance and Financial Regulation

Tags:

academic research empirical research executive compensation ernst maug executive performance ingolf dittmann market conditions oliver spalt pay for performance performance measures risk stock options

Authors:

R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation,

Date tagged:

01/29/2014, 13:10

Date published:

01/29/2014, 09:00