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Bangladesh University of Professionals

Term Paper on “Executive Compensation as an Agency Problem”

Submitted To:
Md. Mahedi Hasan, FCA
Adjunct Faculty
Department of Business Accounting & Information Systems
Faculty of Business Studies
Bangladesh University of Professionals
Submitted By:

Md. Sadman Ar Rahman 23213204020

Fahian Masrukh Huq 23213204039
Tahsina Tabassum 23213204045

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Letter of Transmittal
Date: 15 October 2023
Md Mahedi Hasan, FCA
Adjunct Faculty,
Department of Accounting & Information Systems,
Bangladesh University of Professionals.

Subject: Submission of Term Paper.

I hope this letter finds you well. It is with great pleasure that I submit to you my research paper
titled "Executive Compensation as an Agency Problem." As requested, this paper delves into the
complex issue of executive compensation and its relationship with agency problems within modern
corporations.

This research paper has been a labor of love and extensive investigation, and it encapsulates my
deep interest in corporate governance and the potential challenges that arise when executives'
interests do not align with those of shareholders. I believe this topic is highly relevant in today's
business environment, where stakeholders are increasingly focused on issues of transparency,
accountability, and the equitable distribution of resources.

Sincerely,

On behalf of the team

The Manhattan Project
Md Sadman Ar Rahman
ID: 23213204020
Department of Accounting & Information Systems,
Bangladesh University of Professionals.

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Abstract
In the realm of corporate governance, the structure of executive compensation has emerged as a
pivotal issue, underscoring its significance as a multifaceted challenge. This research paper
explores the intricate landscape of executive compensation, delving into its relationship with the
separation of ownership and control within public companies. The study reveals that executive
compensation transcends being a mere solution to the agency problem; it is inherently woven into
the fabric of this issue itself.

The research underscores that managerial influence, in tandem with rent extraction, exercises a
formidable impact on the design of executive compensation, particularly within organizations
characterized by a divide between ownership and control. Compensation consultants, although
considered essential for their role in optimizing compensation packages, often play a dual role in
masking rent extraction rather than facilitating optimization. The inherent incentive structures and
interests of these consultants raise pertinent questions about the effectiveness of their contribution.

This paper sheds light on the intricate web of relationships among executives, compensation
consultants, and corporate boards. It reveals how compensation consultants, even when not directly
influenced by CEOs, often align their advice with executive interests. The resulting compensation
arrangements are frequently justified through strategies that deviate from optimal contracting
principles, casting a shadow on the process.

Furthermore, the research examines the implications of these compensation practices on corporate
governance and highlights that the extent of managerial influence hinges on the awareness and
recognition of these issues by market participants, particularly institutional investors. By dissecting
the divergences between current practices and optimal contracting models, this study envisions a
path towards improving compensation structures.

Ultimately, this research underscores the intricate dynamics of executive compensation and the
underlying influence of managerial power. Recognizing these complexities is essential for
addressing the agency problem and promoting more effective corporate governance.

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Table of Contents
Letter of Transmittal ....................................................................................................................... 3
Abstract ........................................................................................................................................... 4
Introduction ..................................................................................................................................... 6
Literature Review............................................................................................................................ 7
Methodology ................................................................................................................................. 10
Sources ...................................................................................................................................... 10
Methodology Steps.................................................................................................................... 10
Discussion and Findings ................................................................................................................11
The Constraints of Ideal Contracting .........................................................................................11
The Perspective of Managerial Influence.................................................................................. 12
Influence and Concealment in Action ....................................................................................... 14
The Connection Between Influence and Compensation........................................................ 14
Compensation Consultants .................................................................................................... 16
Stealth Compensation ............................................................................................................ 17
Gratuitous Goodbye Payments .............................................................................................. 19
Suboptimal Pay Structures ........................................................................................................ 21
Pay Without Performance ...................................................................................................... 21
At-the-Money Options ........................................................................................................... 22
The “Perceived Cost” Explanation ........................................................................................ 24
Cost to Shareholders .............................................................................................................. 25
Conclusion .................................................................................................................................... 27
Bibliography ................................................................................................................................. 28

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Introduction
Researchers from a range of disciplines, including managerial accounting, organizational
management, economic theory, and finance, have thoroughly theoretically and empirically
examined the relationship between CEO salary and firm success. Numerous subjects are still open
for discussion despite the vast amount of study. Particularly, two topics seem to have received little
attention.

The relationship between CEO salary and corporate performance has several dynamic
components, which is the first concern. The existence of asymmetries and non-linearities in the
relationship between executive salary and business performance is the subject of the second worry.
Our study is on the second issue, how executive compensation conflicts with agency congruence.
Asymmetric responses may be included in compensation agreements as a way to change an
executive's risk preferences, get rid of disincentives, or increase incentives. According to this
viewpoint, asymmetry may be consistent with agency theory and ideal contracting arrangements
to the extent that it aligns the CEO's incentives with those of the shareholders by promoting risk-
taking behavior while protecting the executive from downside consequences. The concept of an
"agency problem" in corporate governance arises from the inherent conflict of interest between
company executives, who are entrusted with managing the organization on behalf of its
shareholders, and the shareholders themselves. This tension can lead to decisions and behaviors
by executives that prioritize their own interests over those of the shareholders, ultimately harming
the company's performance and value.

Executive compensation is at the heart of this conflict. The compensation packages awarded to top
executives encompass a myriad of components, including base salary, bonuses, stock options, and
other perks, all of which are intended to incentivize and reward executives for their performance
and contribution to the company. However, the way these compensation packages are structured
can inadvertently create misaligned incentives and exacerbate the agency problem.

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Literature Review
While compensation may be able to address agency issues, it can also contribute to those issues.
intended is an agency issue between boards and the firm they are intended to serve since, no matter
how well-intentioned, boards and compensation committees do not spend their own money. Even
the best-designed plans have weaknesses that may be exploited, and since smart executives have
a significant informational advantage, they can inevitably manipulate the compensation process to
their own advantage at the expense of the firm if they so want. In this part, we identify many
pervasive issues with pay methods and procedures and make adjustments to pay design and
corporate governance as a means of mitigating the issues.

Conceptual Framework begins by offering a means to evaluate executive compensation and

incentive structures. It refers to "agency problems," which can occur when the objectives of
executives—such as managers and board members—do not coincide with those of the company's
shareholders. It implies that while carefully thought-out wage structures and corporate governance
regulations might help lessen these issues, they cannot entirely solve them.

There’s also a segment which gives a brief history of executive compensation, tracing its
development from the 1970s to the present.

Share Options examines the reasons why businesses are using stock options as a form of executive
remuneration. It asserts that certain businesses have issued excessive numbers of stock options
because they mistakenly thought they were cheap.

“Overvalued Equity” The issues that develop when a company's stock is overvalued are covered
in this section. The ownership of large amounts of stock or options by managers may result in
further agency issues. It implies that conventional remedies, such as the market for corporate
control or incentive pay schemes, are ineffective in this circumstance and that corporate
governance systems are required to deal with the problems.

Pay Practices discusses a number of concerns with executive compensation and makes
suggestions for improvements to corporate governance and pay structure to address these
difficulties. This covers challenges with standard bonus schemes, stock-based pay plans, executive
appointment and compensation issues, and stock-based pay plan issues.

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Accountability for Strategic Value presents a novel idea known as "Strategic Value
Accountability," which focuses on making individuals responsible for the connection between a
company's strategy and the value it generates. It implies that many organizations have neglected
to consider this idea.

Relationships Between business Managers, Financial Analysts, and the Stock Market examines
the connections between business managers, financial analysts, and the stock market. It talks about
how businesses could manipulate their financial performance to match analyst expectations and
makes the case that doing so might undermine their moral character and worth. Additionally, it
draws attention to a troubling balance in the system that can point to collusion between analysts
and managers against the interests of investors.

“Pay discussions and the CEO market” Remuneration committees frequently overpay CEO
candidates, especially when recruiting CEOs from outside the organization. This occurs when
compensation discussions begin after the candidate has been chosen, greatly enhancing the CEO-
to-be’s negotiating position. Furthermore, some prospective CEOs use skilled negotiators who
specialize in securing huge remuneration packages. Well-known negotiator Joseph Bachelder
charges hefty fees to get generous wages, bonuses, stock options, retirement perks, and more.
Ironically, these CEOs sometimes ask their employers to pay their costs during negotiations, which
raises the total remuneration. Due to this procedure, CEOs may receive excessive remuneration,
which may result in less than desirable compensation plans.

Judgment calls go to the CEO Managing CEO remuneration is a difficult undertaking, whether
it's for an incumbent CEO or during the hiring process. There is a lot of pressure when hiring a
new CEO to retain their services, which might result in overpaying. The pay committee frequently
favors current CEOs when making decisions. They are hesitant to sour the relationship or start a
fight with a powerful CEO. Even in boardrooms with the best of intentions, decisions frequently
favor the CEO. Committees frequently choose higher compensation levels, favor management
preferences, and favor funding bonus pools too much rather than too little. As a result, CEO
remuneration is often more than it should be.

Companies frequently provide their executives with stock options without decreasing their base
pay or asking the executives to pay for the shares or options themselves. The misunderstanding

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that such incentives are essentially free is what leads to this behavior. As a result, CEOs frequently
receive excessive pay. The value of equity-based compensation is reduced when stock or options
are offered as bonuses. When compared to what they obtain for free, people cherish and strive
harder for things they have invested in. When executives use their own money to purchase business
stock, they are aware of the cost and possible rewards, which motivates them to work harder. If
shares are given out for free, however, there is little motivation for executives to quit the firm even
if they aren't adding value, which makes it more difficult for the company to grow.

Because they are unable to insure against the risks involved, managers are frequently risk-averse
and may not properly appreciate the stock options they are granted. According to research,
managers usually assign conventional stock options a value of roughly 55% of the price the
company paid to grant them. In other words, the managers would be as happy if the firm offered
them cash equal to 55% of the value of the options. However, even if it costs more, businesses are
ready to compensate managers in less effective methods (such with stock options) if the incentive
effects result in more value for the company. Companies may find it helpful to adopt outcome-
based, risky pay after beginning with a fixed-cash remuneration. When compensation and
performance are properly aligned, the value that is produced typically overcomes the costs (Jensen,
2004)

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Methodology
Sources
As for the methodology of completing this paper, all information taken has been of secondary in
nature. All resources necessary to complete the Discussion and Findings for the report have been
acquired from the following source(s):

1. Previous articles, research papers, journal publications on related topics.

Methodology Steps
The step-by-step process of completing the paper is as follows:

1. Information collected from the sources mentioned above.

2. This information was further scrutinized, and highlighted as per the requirements of the
topic of the paper.
3. Findings compiled with the corresponding papers cited and referred below in the
Bibliography.

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Discussion and Findings
The Constraints of Ideal Contracting
The optimal contracting perspective recognizes that managers face an agency problem and may
not naturally prioritize maximizing shareholder value. Therefore, it's essential to provide managers
with appropriate incentives.

From this viewpoint, the board, working in the shareholders' best interests, strives to efficiently
offer incentives to managers through their compensation packages. Optimal compensation
agreements can result from effective negotiations between the board and executives or market
pressures that lead them to adopt such contracts, even without formal negotiations. However,
neither of these factors can be expected to completely eliminate significant deviations from fair
outcomes.

Just as there is no automatic assumption that managers will inherently seek to maximize
shareholder value, there is also no prior assumption that directors will consistently do so. Directors
are similarly affected by an agency problem, which hampers their ability to effectively address the
agency issues within the manager-shareholder relationship.

Directors typically aim to secure reappointment to the board, with an average director
compensation of $152,626 in the largest U.S. corporations in 2001 (Meyers, 2002). Directorships
offer not only an attractive salary but also prestige and valuable business and social connections.

CEOs play a crucial role in renominating directors to the board, creating an incentive for directors
to align with the CEO's perspective.

In a scenario where shareholders select individual directors, directors might have an incentive to
build reputations as advocates for shareholders. However, board elections typically involve voting
for a slate proposed by management, making challenges from dissident shareholders exceedingly
rare.

Being included on the company's slate is the key to securing a board position.

Directors generally have limited equity stakes in the firm, reducing their personal motivation to
contest CEO compensation matters.

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Furthermore, directors often lack easy access to independent information and advice regarding
compensation practices, which is necessary to effectively challenge the CEO's pay decisions.

Market forces, including the market for corporate control, the capital market, and the executive
labor market, do impose some constraints on what directors agree to and what managers propose.
However, these constraints are not particularly strict and allow for substantial deviations from ideal
contracting.

For instance, the market for corporate control often faces obstacles, such as staggered boards and
golden parachute provisions, which reduce its effectiveness.

While the market for corporate control may impose certain costs on managers who are overly
aggressive in extracting benefits, it does not tightly restrict executive compensation.

Some responses to our previous work assumed that our analysis of the absence of arm's length
bargaining does not apply to cases where boards negotiate pay with an external CEO candidate.
However, even in such negotiations, directors are aware that the future CEO will influence their
renomination to the board and their compensation. Directors also aim to maintain positive
relationships with the incoming CEO and rely on information provided by the company's human
resources staff and compensation consultants, all of whom have incentives to please the incoming
CEO (Bebchuk L. A., 2002).

The Perspective of Managerial Influence

The doubts about the effectiveness of optimal contracting in explaining compensation practices
also suggest that executives have significant influence over their own pay. This suggests that the
more power managers have, the more they can gain in terms of compensation. While there are
limits to what directors and markets will accept, these restrictions do not prevent managers from
securing deals that are far more advantageous than what they could negotiate under standard terms.

A key aspect of the managerial power perspective involves considering the concept of "outrage"
costs and limitations. The degree of constraints faced by managers and directors depends, in part,
on the expected public reaction to a proposed compensation arrangement among relevant external
stakeholders. This public outrage can lead to embarrassment or damage to the reputation of
directors and managers, potentially diminishing shareholder support for them in proxy contests or

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takeover attempts. Directors' willingness to approve executive compensation arrangements that
benefit executives but are not optimal for shareholders is influenced by how these arrangements
are perceived by outsiders.

There is evidence that the design of compensation packages is indeed influenced by external
perceptions. For example, CEOs of companies that received negative media attention for their
compensation packages subsequently saw smaller pay increases and a stronger link between pay
and performance. CEOs of firms targeted by shareholder resolutions criticizing executive pay saw
reductions in their annual compensation over the following two years.

The importance of external perceptions of CEO compensation and outrage costs underscores
another aspect of the managerial power approach: "camouflage." To mitigate outrage resulting
from external recognition of rent-seeking behavior, managers have a strong incentive to hide and
legitimize their rent-seeking actions. This desire for camouflage can lead to the adoption of
inefficient compensation structures that undermine managerial incentives and firm performance.
The concept of camouflage helps explain various puzzling aspects of executive compensation.

In the realm of executive compensation, the transparency of disclosure is of significant importance.

While financial economists often emphasize the role of disclosure in incorporating information
into market pricing, in the context of executive compensation, the ability of plan designers to favor
managers depends on how these arrangements are perceived by a much broader group of external
stakeholders. Consequently, transparency and the visibility of disclosure can have a substantial
impact on CEO compensation.

Murphy (2002) and Hall and Murphy argue that our approach cannot explain the rise in managerial
pay during the 1990s. They contend that CEO power decreased during this period. However, it is
unclear whether CEO power diminished given the strengthening of takeover defenses during the
1990s. In any case, executive pay increases in the 1990s were driven by factors unrelated to
changes in managerial power and are not inconsistent with the managerial power approach.

To elaborate, first, regulators and shareholders encouraged the use of equity-based compensation
to align pay with performance. Executives took advantage of this trend to secure substantial option-
based compensation without reducing their cash compensation. Moreover, the options they
received were not strongly linked to their individual performance but allowed them to benefit from

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market and sector trends beyond their control. Consequently, executives were able to gain much
larger benefits than more cost-effective option plans would have provided. Second, since executive
compensation has historically been tied to market capitalization, the booming stock markets of the
1990s provided a convenient rationale for substantial pay increases at most firms, even for those
with poor performance. Third, during market upswings, outrage constraints tend to weaken, as
enthusiastic shareholders are less likely to scrutinize and object to generous pay arrangements, as
opposed to periods of market decline, which make shareholders more critical.

Influence and Concealment in Action

We demonstrate the potential utility of the managerial power perspective by examining four
patterns and practices that can be partially elucidated by the concepts of influence and
concealment: the correlation between influence and compensation; the employment of
compensation advisors; covert forms of compensation; and unwarranted severance payments to
departing executives.

The Connection Between Influence and Compensation

The managerial power approach posits that executive compensation will be higher and less linked
to performance in companies where managers wield more influence. Several factors contribute to
this managerial power, including:

1. Board Weakness: When the board of directors is less effective or weak in comparison to
the CEO, executive compensation tends to be higher. Factors contributing to this include
larger boards, where it's harder for directors to oppose the CEO, a significant number of
outside directors appointed by the CEO, and outside directors serving on multiple boards,
which can distract them. Additionally, CEO pay tends to be 20-40 percent higher if the
CEO also serves as the chairman of the board. CEO compensation is negatively correlated
with the share ownership of the board's compensation committee (Cyert, 2002).
2. Absence of Large Outside Shareholder: Having a substantial outside shareholder
typically leads to more rigorous monitoring, reducing the influence of top managers on
their compensation. Companies with a significant external shareholder ownership
experience lower CEO compensation, particularly in the non-salary component. In firms
lacking substantial external shareholders, CEOs tend to receive more "luck-based" pay

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 related to external factors rather than their efforts. The presence of large external
shareholders also affects the balance between cash and option-based compensation.
3. Concentration of Institutional Shareholders: A higher concentration of institutional
shareholders often results in more intensive scrutiny of CEO and board actions. Firms with
more concentrated institutional ownership tend to have lower executive compensation and
compensation that is more performance-sensitive (Bizjak, 2008).
4. Anti-takeover Arrangements: The adoption of antitakeover provisions makes CEOs less
susceptible to hostile takeovers. In such cases, CEOs tend to enjoy above-market
compensation, which is not easily explained by optimal contracting. These provisions
increase CEO excess compensation significantly. Moreover, CEOs of firms protected by
state antitakeover legislation have been found to reduce their shareholdings, suggesting
that they don't need as many shares to maintain control. This goes against the prediction of
optimal contracting, which would expect CEOs protected by antitakeover measures to buy
more shares to align their incentives with shareholders' interests (Agrawal, 1998).

In essence, these factors contribute to the observed deviations from optimal contracting in
executive compensation, reflecting the influence and power of managers in shaping their pay
packages.

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Compensation Consultants
U.S. publicly traded companies typically enlist the services of external consultants to contribute to
the process of determining executive compensation, as indicated by Bizjack, Lemmon, and Naveen
in 2000. The rationale for using consultants can be explained within the context of optimizing
compensation structures, as they are expected to provide valuable insights and expertise in
designing these packages. However, while compensation consultants can play a valuable role, they
can also inadvertently mask excessive executive pay. The motivations of compensation
consultants, along with the evidence of their utilization, suggest that these professionals are often
employed to legitimize executive compensation rather than to optimize it.

Compensation consultants have strong incentives to align their advice with the interests of the
CEO. Even when the CEO is not directly involved in selecting the compensation consultant, these
consultants are typically hired by the company's human resources department, which ultimately
reports to the CEO. Therefore, offering advice that could potentially harm the CEO's financial
interests is unlikely to bode well for the consultant's future prospects of being hired by this firm or
any other. Furthermore, executive pay specialists often work for consulting firms that have broader,
more significant projects with the hiring company, further complicating their motivations (as noted
by Crystal in 1991).

These pay consultants can favor the CEO by providing compensation data that are most conducive
to justifying high pay levels. For example, when companies are performing well, consultants argue
that executive pay should mirror this strong performance and should exceed industry averages,
especially in comparison to underperforming CEOs. Conversely, when companies are not doing
well, consultants shift the focus away from performance data and concentrate on peer group pay
to argue that CEO compensation should be higher to align with prevailing industry norms (as
observed by Gillan in 2001).

Once the compensation consultant has collected and presented the "relevant" comparative data,
the board typically establishes pay levels equal to or higher than the median CEO pay in the chosen
comparison group. An examination of compensation committee reports in 100 major companies,
conducted by Bizjack, Lemmon, and Naveen in 2000, revealed that 96 of them used peer groups
to determine management compensation. A significant majority of firms using peer groups set
compensation at or above the fiftieth percentile of the peer group. The combined influence of

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accommodating compensation consultants and sympathetic boards contributes to the well-known
phenomenon of "ratcheting up" executive salaries, as pointed out by Murphy in 1999.

Subsequent to the board's approval of the compensation package, companies utilize compensation
consultants and their reports to rationalize executive compensation to shareholders. An analysis of
Standard & Poor's 500 companies from 1987 to 1992, conducted by Wade, Porac, and Pollack in
1997, reveals that companies with CEOs receiving higher base salaries and those with more
concentrated and active outside ownership are more likely to cite the use of surveys and consultants
to justify executive pay in their proxy statements to shareholders. This study also shows that when
accounting returns are high, companies emphasize accounting returns while downplaying market
returns.

Stealth Compensation
As detailed in (Bebchuk L. A., 2003), companies utilize compensation strategies that obscure the
full extent of executive remuneration and its disconnection from managerial performance. These
tactics encompass pension plans, deferred compensation, post-retirement privileges, and
consulting agreements. A majority of the perks provided to executives through pension and
deferred compensation schemes do not benefit from the significant tax advantages available to
standard retirement plans offered to regular employees. Instead, these schemes frequently transfer
the tax burden from the executive to the company, sometimes even resulting in an increased overall
tax liability for both parties. The rationale for providing compensation in the form of retirement-
related benefits and guaranteed post-retirement consulting fees is also not entirely transparent.
Nevertheless, all of these maneuvers serve the purpose of making executive pay less conspicuous.

One concern is that, under existing disclosure regulations, companies are not obliged to assign a
specific monetary value to compensation awarded to executives after they retire, and this need not
be included in the publicly filed compensation tables. While the presence of executive retirement
schemes must be acknowledged in specific sections of a company's public filings, this disclosure
tends to be less conspicuous since external observers tend to concentrate on the monetary figures
presented in the compensation tables. In fact, these figures in the compensation tables are used by
databases such as ExecuComp, which forms the foundation for a significant portion of empirical
research on executive compensation.

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Another tactic employed to mask executive compensation is the provision of executive loans.
Although the Sarbanes-Oxley Act of 2002 now prohibits such loans, prior to the Act's enactment,
more than 75 percent of the largest U.S. companies provided loans to their executives (King, 2002).
It may not be immediately apparent that it is efficient for companies, rather than banks, to provide
loans to executives or to offer compensation in the form of favorable interest rates. Nonetheless,
loans are effective in reducing the visibility of managerial compensation.

For starters, the implicit compensation arising from loans with interest rates below the market
norm often goes unreported in the compensation tables of a company's annual filings. The
Securities and Exchange Commission (SEC) did mandate that companies disclose, under the
category of "other annual compensation," the disparity between the actual interest paid on
executive loans and the prevailing market rate. However, the SEC refrained from precisely
defining what constitutes the "market rate," allowing companies to interpret the term in ways that
permitted them to exclude the value of significant interest rate subsidies from the compensation
tables.

For example, WorldCom did not disclose any income in its compensation tables relating to CEO
Bernard Ebbers, despite his receipt of over $400 million in loans from WorldCom at a minimal
interest rate of 2.15 percent. The company later justified this omission by contending that 2.15
percent represented the "market rate" for WorldCom's borrowing under one of its credit facilities.
Nevertheless, this rate was considerably lower than the more than 5 percent that Ebbers would
have paid in the open market at the time. While the existence and terms of these loans were required
to be mentioned in other sections of the company's public filings as related party transactions, this
disclosure was less conspicuous since external observers with an interest in executive
compensation generally fixate on the compensation tables. In Ebbers's case, the considerable
financial advantage resulting from the exceptionally low loan interest rate did not attract public
attention or scrutiny until WorldCom became embroiled in an accounting scandal.

Another method employed by loans to obfuscate executive compensation was through the practice
of loan forgiveness. In cases where a company extended a loan to an executive for the purpose of
acquiring a significant amount of company stock, the company would often forego demanding full
repayment of the loan if the stock's value fell below the outstanding loan amount. Consequently,
this arrangement closely resembled the granting of an option to the executive to purchase shares

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at a price equal to the loan amount, although it can be demonstrated that it was often less tax-
efficient. However, option grants are required to be reported in the company's publicly filed
compensation tables in the year they are issued. In contrast, when granting a loan that was likely
to be forgiven in the event of a stock price decline, companies were not obligated to include the
option's value in the compensation tables in the year the loan was extended. Additionally, if the
stock price did decrease, the loan would often be forgiven when the executive departed from the
company, at a time when any resulting public outcry would likely have minimal personal impact
on the executive. For instance, George Shaheen, the CEO of Webvan, who resigned shortly before
the company's bankruptcy, had a $6.7 million loan forgiven in exchange for $150,000 worth of
Webvan stock (Lublin, 2002).

Gratuitous Goodbye Payments

In many instances, corporate boards bestow departing CEOs with payments and perks that exceed
the requirements outlined in the CEO's employment contract. These additional benefits are often
extended even when the CEOs have delivered such poor performance that the board finds it
necessary to replace them. Typically, executive compensation contracts include generous
severance packages, providing executives with a financial safety net even in cases of
underwhelming performance. While these arrangements may not seem to align with the most
efficient form of contracting, they effectively reduce the disparity in payoffs between strong and
weak performance, a contrast that companies usually aim to establish.

However, our primary focus lies in the extra payments that surpass what is stipulated in the
contracts. To illustrate, when Jill Barad, the CEO of Mattel, resigned amid controversy, the board
not only absolved her of a $4.2 million loan but also furnished her with an additional $3.3 million
in cash to cover the taxes associated with the forgiven loan. Additionally, they allowed her
unvested stock options to automatically become available. These gratuitous benefits were in
addition to the substantial entitlements she received under her employment agreement, which
included a termination payment of $26.4 million and yearly retirement benefits exceeding
$700,000.

It's challenging to reconcile these additional payments with the ideal, arms-length model of
contracting. Given that the board possesses the authority to terminate the CEO and provide her
with contractual severance benefits, there should be no necessity to incentivize a poorly

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performing CEO to resign. Furthermore, these payments may potentially weaken the motivation
of the next CEO to deliver strong results.

Nonetheless, the practice of granting these gratuitous payments is consistent with the idea that the
CEO may wield significant influence over the board. Due to their close relationship with the CEO,
some directors may be reluctant to remove her from her position unless they offer generous
treatment upon her departure. Others may be ready to replace the CEO regardless but prefer to
accompany this action with a goodbye payment to alleviate the discomfort associated with
terminating the CEO or to facilitate a more amicable separation process. In all these scenarios, the
willingness of directors to make these extra payments to a poorly performing CEO stems from the
CEO's close ties with the board members.

It's important to stress that, assuming managerial influence as a given, providing gratuitous
payments to departing CEOs may, in certain situations, be advantageous for shareholders. If
numerous directors are loyal to the CEO, these payments might be necessary to secure a majority
of the board in favor of her replacement. In such cases, this practice benefits shareholders when
the CEO's departure is more favorable for them than the cost of the goodbye payment. For our
purposes, what's significant is that these additional payments, whether they benefit shareholders
or not, highlight the existence and significance of managerial influence.

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Suboptimal Pay Structures
Pay Without Performance
Optimal compensation arrangements may necessitate substantial executive pay to provide strong
incentives for managers to enhance shareholder value, as discussed by Jensen and Murphy in 1990.
However, a notable issue with current compensation structures is that the generous pay offered to
executives is only loosely tied to their performance as managers. This disconnects between pay
and performance poses a puzzle when viewed through the lens of optimal contracting.

The significant portion of compensation that is not tied to equity has long been criticized for its
weak connection to managerial performance. For instance, in the 1990s, there was little correlation
between a CEO's salary and bonus and the performance of their company when adjusted for
industry norms, as highlighted by (Murphy, Executive compensation., 1999). Additionally, there's
evidence that cash compensation increases when a company's profits rise for reasons unrelated to
managerial efforts, as observed in studies by (Bebchuk L. A., 2003) and (Bertrand, 2001)
Furthermore, managers receive substantial non-equity compensation through arrangements that
have received minimal attention from financial experts, such as pensions, deferred pay, and loans,
and this compensation also shows limited sensitivity to managers' individual performance.

Given the historical weak linkage between managers' performance and non-equity compensation,
shareholders and regulators have increasingly turned to equity-based compensation to establish the
desired connection between pay and performance. In the early 1990s, institutional investors and
federal regulators aimed to promote the use of such compensation, resulting in a significant growth
in the use of stock options over the past decade. Unfortunately, managers have managed to exert
their influence to secure option plans that seem to deviate significantly from the optimal
contracting principles in ways that favor them.

We want to underscore our strong support for the concept of equity-based compensation, which,
when appropriately structured, can offer managers valuable incentives. However, the key lies in
the details. Below, we discuss several crucial aspects of existing option compensation plans that
are challenging to justify from an optimal contracting perspective but can be readily explained by
the influence of managers: the failure of option plans to prevent windfalls, the nearly universal use

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of at-the-money options, and the broad latitude given to managers to exercise their options and sell
shares.

One might wonder why risk-averse managers do not use their influence to secure higher cash
salaries instead of options. Holding the expected additional compensation constant, managers
would indeed prefer cash. However, during the 1990s, managers seeking higher pay did not have
the choice between additional cash compensation and additional compensation in the form of
options with the same expected value. Rather, the enthusiasm of external stakeholders for equity-
based compensation allowed managers to obtain additional compensation in the form of options
without a corresponding reduction in cash compensation. Furthermore, the potential benefits
arising from improved incentives provided valid reasons for granting substantial additional
compensation. For instance, Apple's CEO Steve Jobs was recently able to secure an option package
worth over half a billion dollars, albeit amid some controversy, as an equivalent cash compensation
of this magnitude remains largely inconceivable. The fact that better-designed options could have
delivered the same incentives at a considerably lower cost has not been prominent enough to render
conventional plans clearly unjustifiable.

At-the-Money Options
Almost all stock options granted as part of executive compensation are set "at-the-money,"
meaning their exercise price matches the market price on the grant date, as pointed out by Murphy
in 1999. In an ideal compensation scheme, the goal is to offer risk-averse managers cost-effective
incentives to put in effort and make decisions that maximize value. The perfect exercise price
under such a scheme would depend on numerous factors, varying between executives, companies,
industries, and over time. These factors might include the level of risk aversion among managers
(which can be influenced by their age and wealth), the available project choices for the company,
stock volatility, expected inflation rates, and the duration of the manager's contract, among other
variables. It's unreasonable to assume that a single exercise price is suitable for all executives at
all firms, across all industries, and at all times.

Therefore, it's highly unlikely that "out-of-the-money" options, where the exercise price is above
the current market price, are never the optimal choice. Out-of-the-money options have a lower
expected value compared to at-the-money options because they are less likely to pay off and, when
they do, they provide less value to the holder. Consequently, for every expected dollar of value, a

22
company can grant more out-of-the-money options than at-the-money options. By issuing more
out-of-the-money options, the company can enhance the reward for exceptional performance by
the manager. Thus, out-of-the-money options can offer significantly higher sensitivity of pay to
performance for each expected dollar of value compared to standard options, as discussed by Hall
in 1999. Some evidence even suggests that providing managers with out-of-the-money options
rather than at-the-money options would, on average, increase the overall value of the company, as
indicated by Habib and Ljungqvist in 2000. The widespread use of at-the-money options is,
therefore, challenging to rationalize from the perspective of optimal contracting. Economists
working within the framework of optimal contracting have even referred to this practice as a
"puzzle."

Nevertheless, the almost universal use of at-the-money options becomes less puzzling when
examined through the lens of the managerial power approach. All else being equal, executives
prefer a lower exercise price. Since at-the-money options might sometimes be optimal and are
used by nearly all other companies, their use in any given case won't typically provoke strong
objections. Therefore, those responsible for designing compensation plans have little incentive to
set the exercise price above the market price on the grant date.

It's worth noting that executives would benefit even more if stock options were issued with an
exercise price below the market price on the grant date. However, such "in-the-money" options
would represent a noticeable windfall and could generate some concerns or outrage. Moreover,
they would lead to an accounting charge that might undermine a key justification for not using
alternatives like indexed options or other options with reduced windfalls. The rationale behind not
using such options is often that they would negatively impact reported earnings, as highlighted by
Bebchuk, Fried, and Walker in 2002. Given these challenges and constraints related to in-the-
money options, and considering that at-the-money options are the most favorable for managers
within the available range of options, a consistent use of at-the-money options aligns with the
managerial power perspective.

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The “Perceived Cost” Explanation
Murphy in 2002, along with (Murphy, Explaining executive compensation: Managerial power
versus the perceived cost of stock options., 2002)in their recent work, have presented a theory
based on the "perceived cost" to explain why conventional at-the-money options are commonly
used. According to this explanation, executives and directors mistakenly view these conventional
options as "cheap" or even as having a cost close to zero because they can be granted without
requiring a cash expenditure and without reducing reported earnings.

However, we have reservations about the idea that executives and their advisors are oblivious to
the costs associated with conventional options for shareholders. Even if Hall and Murphy's
suggestion that managers believe the stock market is influenced more by accounting numbers than
economic reality were correct, it would imply, at most, that executives believe that investors
underestimate or disregard the costs of options that are not expensed for accounting purposes. It
doesn't mean that executives are blind to the substantial economic costs imposed on shareholders,
as these options dilute their ownership stake in the company.

One could also question whether directors, many of whom are themselves executives, truly lack
an understanding of the costs of options for shareholders. In fact, if directors were indeed lacking
in financial sophistication, it would indicate that the board-monitoring model of corporate
governance is in even worse shape than what our analysis suggests. Nevertheless, let's assume that
directors have been unaware of the genuine cost of conventional options. In this case, such a
misperception on the part of directors should not be viewed as an alternative to the managerial
power explanation but rather as a factor that contributes to managers' ability to exert significant
influence over their compensation terms.

As we mentioned earlier, there are various reasons why boards cannot be expected to engage in
impartial negotiations with the CEO regarding executive compensation, and one of these is the
directors' limited access to accurate and unbiased information. If directors indeed had
misconceptions about the cost of options, such a misperception would be a part of the broader
informational challenge contributing to their willingness to approve less-than-optimal
arrangements. If directors were uninformed about a matter as significant and widely discussed as
the actual cost of options, it's likely they would also lack information on other aspects of
compensation plans.

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In our view, incomplete information is just one of the factors, alongside inadequate incentives and
others, that might lead directors to accept compensation arrangements favoring managers.
However, it's important to note that directors' misunderstandings regarding the cost of options do
not explain the consistent relationship between power and pay or managers' efforts to make
compensation less conspicuous, as discussed earlier. Nonetheless, for many purposes, whether
directors' willingness to accept executive-favoring arrangements stems from conscious favoritism,
genuine misconceptions, insufficient incentives to put in effort, or a blend of these factors is not
the key concern. What matters is that directors do not effectively represent shareholders' interests
when negotiating with managers about their compensation, resulting in compensation
arrangements that deviate from the arm's length model in ways that favor executives.

Cost to Shareholders
What are the consequences faced by shareholders due to managers' ability to influence their own
compensation? To start with, there is the extra pay that managers receive as a result of their
influence—this is the difference between what managers can secure through their influence and
what they would receive under a neutral, arm's length arrangement.

Some might believe that this issue is purely symbolic and has a negligible impact on shareholders'
overall financial well-being. However, a closer examination of the sums involved reveals that they
add up to far more than just pocket change. In the year 2000, CEO compensation amounted, on
average, to 7.89 percent of corporate profits in the firms that constituted the 1500-company
ExecuComp dataset (Balsam, 2011).

Moreover, and possibly more significantly, managers' capacity to shape their own compensation
leads to compensation arrangements that create weaker incentives compared to what arm's length
contracts would provide. Managers have a vested interest in compensation schemes that hide the
extent of their rent extraction or that reduce the pressure on them to cut back on inefficiencies.
Consequently, managerial influence may lead to the adoption of compensation arrangements that
offer weak or even counterproductive incentives. In our viewpoint, the reduction in shareholder
value stemming from these inefficiencies, rather than the excess rents managers capture, could be
the most substantial cost arising from managers' ability to influence their compensation.

25
To begin with, the current compensation structures offer weaker incentives to reduce managerial
inefficiencies and enhance shareholder value compared to what might be offered by impartial
arrangements. As previously discussed, both the non-equity and equity components of managers'
compensation are considerably less connected to their own performance than they might appear.
Therefore, shareholders could greatly benefit from the enhanced performance that a shift toward
optimal contracting arrangements could produce.

The existing practices not only fail to offer efficient incentives to curtail slack but also create
incentives that work counterproductively. For instance, they incentivize managers to alter company
parameters in a way that would legitimize pay raises. Take the common issue of empire building,
for instance. It is often believed that providing managers with options incentivizes them not to
engage in value-reducing acquisitions. However, this holds true primarily in a static model where
all option grants are made before managers make acquisition decisions. In a dynamic model,
managers contemplating a somewhat value-reducing expansion have different incentives. While
such an expansion might decrease the value of their existing options, it could lead to a greater
increase in their overall future compensation because a larger company size can be used to justify
higher pay.

Furthermore, managers' extensive freedom to sell off their equity incentives can result in
significant inefficiencies. Executives who intend to sell their shares or options have weaker
incentives to put in effort when the payoff won't be recognized by the market at the time, they
dispose of their equity positions. Such executives also have incentives to misrepresent corporate
performance and suppress negative news. Additionally, they may be inclined to choose less
transparent projects or reduce the transparency of existing ones. The efficiency costs of these
distortions might outweigh, possibly by a significant margin, any liquidity or risk-bearing
advantages that executives gain from the ability to sell off their options and shares at their
convenience.

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Conclusion
There are compelling theoretical and practical reasons to conclude that the influence of managers
significantly shapes the structure of executive compensation in companies where ownership is
separate from control. Therefore, executive compensation can be analyzed not only as a means of
addressing the agency problem that arises due to this separation of interests but also as an integral
part of the agency problem itself.

The recognition that managerial power and rent extraction have a substantial impact on executive
compensation has important implications for corporate governance, as we discuss in our upcoming
book (Bebchuk L. A., 2004). It's essential to emphasize that this is an area where widespread
acknowledgment of the issue can contribute to its resolution. The extent to which managerial
influence can deviate compensation arrangements from optimal contracting outcomes depends on
how well market participants, especially institutional investors, understand the issues we've raised.
Financial experts, therefore, have a crucial role to play in enhancing compensation structures by
assessing how existing practices differ from what optimal contracting principles suggest. We hope
that future research on executive compensation will dedicate as much attention to the role of
managerial power as has been given to the optimal contracting model.

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