Working Paper: CEPR ID: DP3112
Authors: Lucian Arye Bebchuk; Jesse Fried; David I. Walker
Abstract: This Paper develops an account of the role and significance of rent extraction in executive compensation. Under the optimal contracting view of executive compensation, which has dominated academic research on the subject, pay arrangements are set by a board of directors that aims to maximize shareholder value by designing an optimal principal-agent contract. Under the alternative rent extraction view that we examine, the board does not operate at arm?s length; rather, executives have power to influence their own compensation, and they use their power to extract rents. As a result, executives are paid more than is optimal for shareholders and, to camouflage the extraction of rents, executive compensation might be structured sub-optimally. The presence of rent extraction, we argue, is consistent both with the processes that produce compensation schemes and with the market forces and constraints that companies face. Examining the large body of empirical work on executive compensation, we show that the picture emerging from it is largely compatible with the rent extraction view. Indeed, rent extraction, and the desire to camouflage it, can better explain many puzzling features of compensation patterns and practices. We conclude that extraction of rents might well play a significant role in US executive compensation; and that the significant presence of rent extraction should be taken into account in any examination of the practice and regulation of corporate governance.
Keywords: agency costs; corporate governance; executive compensation; private benefits of control; rent extraction; stock options
JEL Codes: D23; G32; G34; G38; J33; J44; K22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| executive power (H11) | excessive pay (J33) |
| lack of indexing in compensation schemes (M52) | rent extraction (H13) |
| absence of filtering mechanisms (Q53) | rent extraction (H13) |
| prevalence of at-the-money options (G13) | rent extraction (H13) |
| freedom to unwind incentives (M52) | rent extraction (H13) |
| management control over director appointments (G34) | board dynamics favoring executive interests (G34) |
| board dynamics favoring executive interests (G34) | excessive pay (J33) |
| information disparities between directors and executives (M12) | excessive pay (J33) |