Abstract

http://ssrn.com/abstract=1758952
 


 



Regulating Compensation


Christine Hurt


University of Illinois College of Law

February 9, 2011

Entrepreneurial Business Law Journal, Forthcoming
Illinois Program in Law, Behavior and Social Science Paper No. LBSS11-10
Illinois Public Law Research Paper No. 10-27

Abstract:     
In the Fall of 2008, the United States economy experienced what has been called a financial crisis, and what this Article labels a “contracts crisis.” Commentators have blamed those who incurred losses, from homeowners to financial institutions, as contributing to systemic risk, and one common criticism focused on the contracts to which these parties agreed. Though these various firms and individuals legally contracted to accept risks, these risks, at least in hindsight, were unacceptable risks, and these contracts became toxic. In addition, the structuring of these networks of contracts made them difficult to modify to cure eventual problems. That the contracting parties entered into these agreements nevertheless can be ascribed to various failures: individual decisionmaking failures, captive gatekeepers, skewed incentives, complexity or just plain greed. Theoretically, if new regulation could mandate that contracting parties volunteer more information, retain certain amounts of risk or forbear from entering into certain kinds of contracts, then nationwide economic disaster could be avoided in the future. Viewed in this way, the financial crisis can be framed as a “contracts crisis.” Just as perceived torts crises, which create unpalatable torts obligations for repeat players, spawned legislative efforts at tort law reform, the perceived contracts crisis has in turn inspired legislators to try to reform existing and future contracts and the law that governs them.

This energized regulatory spirit in the financial sector, after decades of a more laissez-faire approach to capital markets, intersected with a pre-existing but largely stalled movement to regulate executive compensation. For years, commentators had argued that shareholders suffered when executives were awarded excessive pay packages that were not tied to whether the executives were maximizing shareholder wealth. Suddenly, the “pay with performance” movement had a new narrative that resonated with lawmakers and regulators: flaws in compensation schemes created incentives for individuals in firms to take on excessive risk, and in the aggregate, this creates systemic risk that threatens the U.S. economy. Once proponents of executive compensation reform were able to link pay without performance concerns to systemic risk concerns, then regulation was almost inevitable. The Dodd-Frank Wall Street Reform and Consumer Protection Act. was passed in July 2010 and addresses many aspects of the financial industry, including executive compensation.

The reform that has emerged, however, is simple executive compensation regulation wrapped up in financial crisis clothing. Neither theory nor data suggests that the compensation of a handful of individual officers at large firms, even financial firms generated levels of firm-level risk that then contributed to the 2008 financial crisis or exacerbates systemic risk going forward. Moreover, the reforms that are now law bear little theoretical connection to the types of incentive compensation plans that do lead to firm-level risk. Yet, this old solution to the old problem of management agency costs is now a proposed new solution to the new problem of systemic risk, arguably an amalgamation of management agency costs.

However, the solution of regulating executive compensation may not only prove ineffective in alleviating systemic risk, but it may also open the door to public intermeddling with other private contracts, even in hindsight, particularly when the losing contract party is unsympathetic. In fact, the new targets of compensation regulation may be blue-collar, middle-class and largely outside any of the institutions that participated in activities associated with the financial meltdown. For example, the next targets of the “undeserved” compensation debates may well be the unionized private employees and the public employees, both unionized and nonunionized. Overcoming any qualms that exist to interfering with negotiated contracts in the first instance may lead to an appetite to do so in the second instance.

Number of Pages in PDF File: 36

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Date posted: February 11, 2011 ; Last revised: March 13, 2011

Suggested Citation

Hurt, Christine, Regulating Compensation (February 9, 2011). Entrepreneurial Business Law Journal, Forthcoming; Illinois Program in Law, Behavior and Social Science Paper No. LBSS11-10; Illinois Public Law Research Paper No. 10-27. Available at SSRN: http://ssrn.com/abstract=1758952

Contact Information

Christine Hurt (Contact Author)
University of Illinois College of Law ( email )
504 E. Pennsylvania Avenue
Champaign, IL 61820
United States

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