Academic journal article Journal of Corporation Law

Tournament of Managers: Lessons from the Academic Leadership Market

Academic journal article Journal of Corporation Law

Tournament of Managers: Lessons from the Academic Leadership Market

Article excerpt

I. INTRODUCTION II. EXECUTIVE COMPENSATION CONTROVERSY AND REFORM        A. The Problem With Disclosure: The Market for External CEOs           is not Robust III. WHY FAVOR AN INTERNAL CANDIDATE?        A. Internal Candidates Perform Better        B. Firm-Specific Capital        C. Information Asymmetry        D. Tournament Theory        E. Irrelevance of Leadership Theories IV. THE LACK OF A TOURNAMENT IN ACADEMIA        A. Selection Process: President        B. Literature V. THE DATA        A. Descriptive Statistics        B. Methodology            1. Hypothesis One            2. Hypothesis Two            3. Hypothesis Three            4. Hypothesis Four            5. Hypothesis Five        C. Apples and Oranges: The Generalizability Question VI. IMPLICATIONS VII. CONCLUSION 


In Brehm v. Eisner, a defining corporate law case, (1) critics viewed the Disney board's decision to hire Michael Ovitz, and then fire him fourteen months later with a $140 million severance package, as the epitome of the problem of excess executive compensation: compliant, complacent boards who were overly generous with shareholder money. (2)

Despite the many law review articles focused on the Disney case, and the countless others that cite it, one important lesson remains overlooked by the legal literature. Corporate law scholars, like the Delaware courts, focused on the board's faulty process in negotiations to hire and fire Ovitz. (3) And, catalyzed by Lucian Bebchuk and Jesse Fried's Pay Without Performance: The Unfulfilled Promise of Executive Compensation, they have discussed the topic of executive compensation at great length. (4)

However, legal scholars start with the firing, all but ignoring the first step in the process: the hiring of Michael Ovitz as the next chief executive of Disney. (5) The responsibility of a public company board is to manage in situations where internal management faces a conflict of interest, and chief among these is the selection, monitoring, and firing of the CEO. (6) Yet, the board's choice of Ovitz--an industry outsider--received relatively little attention.

Hiring Ovitz, an external candidate, was an anomaly. For-profit corporations generally favor internal candidates, hiring externally only about 22% of the time. (7) The literature is divided as to why boards would favor internal candidates over external ones, (8) but the answer to this question is of paramount importance for evaluating arguments about compensation. Optimal contracting scholars point to the market for managerial talent as a major justification for large pay packages. (9) "If we don't pay our CEO the market rate, we will lose her," or so the argument goes. The compensation committees of public firms typically engage compensation consultants who "benchmark" pay by reporting the pay packages of the chief executives of comparable companies. (10) Critics of benchmarking cite its inexorable tendency to ratchet up pay: if all boards regularly aim for their CEO to exceed the median pay level, pay inevitably rises. (11) But the numbers make clear a more fundamental issue: most CEOs come from inside an organization. (12) This simple fact casts doubt on the existence of a market for managerial talent. And, if there is no market for CEOs, then perhaps firms can safely pay them significantly less.

A potential objection is that benchmarking is what prevents more of a market for CEOs: by this logic, firms who break with industry practice and pay their CEOs less than market rate risk poaching by other firms. (13) Thus, the question this Article seeks to answer: why do publicly traded firms favor internal CEOs, and what effect does that reason have on determining the appropriate level of executive compensation?

One potential explanation for favoring internal CEOs is that they perform better. Unlike legal scholars, other literatures focus a great deal of attention on the question of CEO selection. …

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