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

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  • Lucian Arye Bebchuk
  • Jesse M. 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 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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8661.

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Date of creation: Dec 2001
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Handle: RePEc:nbr:nberwo:8661

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Cited by:
  1. Dirk Jenter & Fadi Kanaan, 2006. "CEO Turnover and Relative Performance Evaluation," NBER Working Papers 12068, National Bureau of Economic Research, Inc.
  2. David de Meza & David C. Webb, 2006. "Incentive design under loss aversion," LSE Research Online Documents on Economics 24523, London School of Economics and Political Science, LSE Library.
  3. Dutta, Sunil & Reichelstein, Stefan J., 2002. "Leading Indicator Variables, Performance Measurement and Long-Term versus Short-Term Contracts," Research Papers 1756, Stanford University, Graduate School of Business.
  4. David de Meza & David C. Webb, 2004. "Principal agent problems under loss aversion: an application to executive stock options," LSE Research Online Documents on Economics 24676, London School of Economics and Political Science, LSE Library.
  5. Choe, Chongwoo, 2003. "Leverage, volatility and executive stock options," Journal of Corporate Finance, Elsevier, vol. 9(5), pages 591-609, November.
  6. Bechmann, Ken L. & Jørgensen, Peter Løchte, 2003. "The Value and Incentives of Option-based Compensation in Danish Listed Companies," Working Papers, Copenhagen Business School, Department of Finance 2003-2, Copenhagen Business School, Department of Finance.
  7. Wim Fonteyne, 2007. "Cooperative Banks in Europe," IMF Working Papers 07/159, International Monetary Fund.

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