I. INTRODUCTION II. PEER BENCHMARKING: THE PROCESS A. Historical Origins B. The Problem with Peer Group Analysis III. EVALUATING MARKET-BASED PAY RATIONALIZATIONS A. Athletes, Musicians, and Corporate Superstars B. The Firm and Industry Leaping Superstars C. CEO Skills: The Generalist D. Evidence on CEO Skill Transferability: Performance E. Evidence on CEO Skill Transferability: Turnover IV. THIN LABOR MARKETS: ROOM FOR PEER GROUP INFLUENCE ON PAY A. The Definitive Peer Benchmark B. Balancing Costs in Setting Pay C. Board Guidance V. CONCLUSION
The dramatic rise in Chief Executive Officer (CEO) compensation over the past three decades has resulted in tremendous popular and shareholder discord. (1) Two distinct theories have long framed the analysis of this disconcerting trend. The first emphasizes board dynamics, alleging that management-dominated passive boards have allowed powerful executives to extract rent in the form of excessive compensation or perks at the expense of shareholders. (2) The second describes the operation of an efficient market for scarce and valuable executive talent. The rising level of pay observed among executives is then an unavoidable consequence of exogenous market forces and necessary for the retention of rare and able managers. (3) In essence, the theories describe the capture of boards by overbearing management in the former, and by omnipotent markets in the latter. (4) However, the cause of the escalation in pay, as this Article argues, is not fully susceptible to either explanation. (5)
The theory of management capture, vis-a-vis compensation, argues that the directors of large public companies allow rent-seeking executives to exert an outsized influence over the compensation negotiation process. Directors' personal and professional connections with the management inhibit the board from engaging in effective and autonomous oversight, and the board lacks a meaningful incentive to do so. The argument continues that executive compensation escalated unchecked because boards failed to negotiate rigorously with executives, but calls for reform in the early 90s from scholarly, (6) professional, and popular commentators, (7) and a concerted effort by institutional investors, (8) regulatory agencies, (9) and the Delaware judiciary (10) led to the reformation of modern corporate boards. They called for equity holding, independent directors, and open elections. Many believed that these reforms would serve as a mechanism for improving board performance and corporate accountability while concomitantly remedying the executive compensation conundrum.
These reforms quickly became accepted standards of practice. (11) Nonetheless, despite the promise that better boards would negotiate more reasonable remuneration, the rise in executive pay persisted. (12) We argue that the successes of such improvements in corporate governance were insufficient to rationalize this upward trend in median pay figures. The strengthening of oversight was successful in increasing managerial accountability for poor performance while also reducing the incidence of flagrantly high compensation awards because of an invigorated sensitivity to shareholder concerns. Nonetheless, while effective at reducing the ability of some managers to subsume rents relative to other managers, the reforms were unable to address that absolute, though possibly benign, ability of managers as a class to do so through institutional factors and norms. The problem is the standard practice of benchmarking pay to that of peers. While the directors may be well-intentioned, the consistent use of this simple referential process, which we later describe and critique, may better explain the persistent continuation of the systemic rise in pay.
on the other hand, many scholars, particularly financial economists, have derived a powerful ought from the empirical observation of what is by ascribing the cause of rising pay wholly to the operation of a competitive market--the market for scarce and valuable managerial talent. …