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Executive Compensation in America: Optimal Contracting or Extraction of Rents?

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  • Bebchuk, Lucian Arye
  • Fried, Jesse M.
  • Walker, David I.
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    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 U.S. 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.

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    Bibliographic Info

    Paper provided by Berkeley Olin Program in Law & Economics in its series Berkeley Olin Program in Law & Economics, Working Paper Series with number qt1x24r7st.

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    Date of creation: 01 Nov 2001
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    Handle: RePEc:cdl:oplwec:qt1x24r7st

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    Cited by:
    1. Bruno S. Frey & Margit Osterloh, . "Yes, Managers Should be Paid Like Bureaucrats," IEW - Working Papers 187, Institute for Empirical Research in Economics - University of Zurich.
    2. Choe, Chongwoo, 2003. "Leverage, volatility and executive stock options," Journal of Corporate Finance, Elsevier, vol. 9(5), pages 591-609, November.
    3. Dirk Jenter & Fadi Kanaan, 2006. "CEO Turnover and Relative Performance Evaluation," NBER Working Papers 12068, National Bureau of Economic Research, Inc.
    4. Wim Fonteyne, 2007. "Cooperative Banks in Europe," IMF Working Papers 07/159, International Monetary Fund.

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