Corporate governance is generally considered to be the set of complementary mechanisms that help align the actions and choices of managers with the interests of shareholders. Monitoring actions by the board of directors, debtholders, or institutional blockholders can have an important impact on the economic performance of an organization (for example, Jensen , Mehran , Core, Holthausen, and Larcker , and Holderness ). Another important and often debated component of the governance structure is the compensation contract selected for providing remuneration to managers (for example, the level of remuneration or choice of performance measures).
Executive compensation has been the subject of extensive prior research, and excellent general reviews already exist for the interested reader (for example, Murphy ). For our purposes here, we will not reproduce this discussion but rather focus on the more narrow, but crucial, topic of stock-based compensation and incentives.
Stock and option compensation and the level of managerial equity incentives are aspects of corporate governance that are especially controversial to shareholders, institutional activists, and governmental regulators. Similar to much of the corporate finance and corporate governance literature, research on stock-based compensation and incentives has generated not only useful insights, but also has produced many contradictory findings. Not surprisingly, many fundamental questions remain unanswered, and one of our goals is to highlight topics that seem especially appropriate for future research.
Within the corporate governance literature, and more specifically within the executive compensation literature, there are alternative views on the efficiency of observed contracting arrangements between firms and their executives. For the purposes of this survey and as an organizing principle of our literature review, we follow a traditional agency-theory framework and define an efficient contract as one that maximizes the net expected economic value to shareholders after transaction costs (such as contracting costs) and payments to employees. An equivalent way of saying this is that we assume that contracts minimize agency costs. Clearly, the types of contracts that are efficient at any particular time or in a particular sector of the economy are a function of various transaction costs. For instance, a contract that was efficient in the United States fifty years ago may not be efficient today because information costs have fallen greatly and the optimal organizational form has changed as a result. Over time, optimal contracting arrangements evolve with changes in contracting technology. As part of this evolutionary process, firms are experimenting with new contracting technologies. Some experiments succeed and others fail as firms update their beliefs and learn about the efficiency of their governance structures. Throughout this process, firms may be uncertain about the optimal contracting technology. As a result of this uncertainty and because of differences in beliefs about optimal incentive levels, one would expect variation in the observed contracts across firms. However, unless beliefs are systematically biased, we expect that compensation contracts are efficient, on average, and that average equity incentive levels across firms are neither "too high" nor "too low." (For an example and discussion of how an evolutionary process converges to an efficient outcome, see Lazear [1995, pp. 8-10].)
In contrast to this economic perspective, a number of scholars and practitioners either implicitly or explicitly take the view that contracting arrangements are largely inefficient and do not minimize agency costs (for example, Morck, Shleifer, and Vishny , Crystal , and Jensen ). A view that sees most firms behaving inefficiently is hard to support. At the opposite extreme is the view that transaction costs in the labor market, the stock market, and the market for corporate control are so small that all agency costs are eliminated. …