Board or Shareholders – Who Should Determine Management Compensation? A Model of Compensation Governance

31 Pages Posted: 21 Nov 2010 Last revised: 17 May 2018

See all articles by Shivendu Shivendu

Shivendu Shivendu

University of California, Irvine - The Paul Merage School of Business

Joseph Vithayathil

Southern Illinois University Edwardsville

Date Written: November 20, 2010

Abstract

The efficacy of boards of directors as a critical governance institution has attracted increasing scrutiny in the wake of the recent financial meltdown. CEO compensation which consequentially determines overall management compensation in a firm, is a key governance decision entrusted with the board. A relevant, though unexplored question would be whether shareholders are better served by making the compensation decision themselves. In this paper, in a game theoretic set up, we analyze shareholder payoffs under the traditional delegated- governance structure wherein shareholders set the compensation of the board, but delegate the management compensation decision to the board, and contrast such delegated- governance with an alternate owner-governance structure wherein shareholders determine the compensation contracts for both the board and management. Under unobservable effort, we consider both deterministic and stochastic firm performance, jointly determined by the effort of the board and management. We find that shareholders are never worse off under owner-governance, though management wages as well as effort are higher under certain conditions. Within a deterministic setting, board wages as well as effort are equal or higher with centralized governance. Under extreme stochastic effects, which might describe boom or bust environments, it does not pay to incentivize the board or management to expend effort. In a stochastic environment where output is determined primarily by board effort, it does not pay to incentivize management for effort. Our analysis suggests a possible explanation for the puzzling observation of rising managerial compensation, often not in congruence with firm performance, as the board faces no penalty for misaligned managerial wages under delegated-governance. We show that owner-governance generally eliminates non-aligned incentive structures.

Keywords: CEO Compensation, Incentive Wages, Board Of Directors, Say on Pay, Corporate Governance, Moral Hazard, Financial Meltdown

Suggested Citation

Shivendu, Shivendu and Vithayathil, Joseph, Board or Shareholders – Who Should Determine Management Compensation? A Model of Compensation Governance (November 20, 2010). Available at SSRN: https://ssrn.com/abstract=1712503 or http://dx.doi.org/10.2139/ssrn.1712503

Shivendu Shivendu

University of California, Irvine - The Paul Merage School of Business ( email )

SB 342
Irvine, CA 92617
United States

Joseph Vithayathil (Contact Author)

Southern Illinois University Edwardsville ( email )

Computer Management and Information Systems
School of Buisness, Campus Box 1106
Edwardsville, IL California 62026
United States

HOME PAGE: http://https://www.siue.edu/business/departments-staff/jvithayathil.shtml

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