Executive Compensation, Corporate Governance, and the Partner-Manager

Abstract:     
In the debate over executive compensation, the assumption seems to be that the CEO of a publicly traded corporation is ultimately an employee of the corporation. According to the conventional view, the business belongs to the stockholders. Executive compensation is an expense like any other business expense that must be subtracted from income in reckoning stockholder return. The central problem has been that the CEO has too much power, and the board of directors has not acted as an effective monitor. Thus, the problem of executive compensation appears to be a thinly disguised problem of self-dealing.

Professor Booth argues here partnership law offers an alternative model that may explain some of the more puzzling aspects of executive compensation. Simply stated, if one sees a publicly traded corporation as a partnership between management and stockholders, the fact that a substantial share of gains goes to management does not seem problematic. For example, it is well known that using stock options as the primary form of executive compensation serves the purpose of focusing a CEO on stock price rather than second best metrics such as earnings or assets. What is less well-recognized is that options also force managers to assume additional risk. As a result, CEOs naturally insist on the prospect of greater returns. In effect, CEOs have bargained for a substantial piece of the action. They have come to insist on returns more consistent with those of a partner rather than an employee. It should thus come as no surprise that success will be more richly rewarded.

In addition, Professor Booth addresses several misconceptions about executive compensation that may be clarified somewhat by the partnership model. First, he shows that in the aggregate, executive compensation (including option-based compensation) has been remarkably stable over the last twenty years, suggesting that the perception of excess may be the result of redistribution and undue focus on those who have gained from the evolution to options. Second, he argues that unlike other forms of compensation, stock options are self-regulating and thus inherently less worrisome than other more fixed forms of compensation. Finally, he contends that the partnership model of the corporation sheds new light on the debate over how to account for stock options. If stock options are seen as a way for CEOs and other high-level managers to participate as equity partners in company returns, it makes little sense to treat the grant of stock options as an expense that reduces reported earnings.

Keywords: executive compensation, self-dealing, partnership model, stock options, diversification, risk, structural conflict, ownership interest, capital contribution, salary, established company, growth company, salary and bonus, company-specific risk, undiversified investor, conglomerate company, focused co

JEL Classifications: G32, G34, J33, K22, L22, M52

Accepted Paper Series