Managing Corporate Risks by Regulating Executive Pay: A Legal and Economic Analysis

Abstract

Excessive risk taking due to a flawed remuneration design is widely regarded as the cause of the recent Financial Crisis. This article endeavours to examine the problem from a legal and economic perspective. A remuneration package should reward managers for successfully advancing the interests of their companies/shareholders. The key is to motivate loyalty by tying the monetary returns of the former directly to those of the latter. Despite the existence of different legal strategies, such as directors’ fiduciary duties and shareholders’ decision rights, to constrain managers’ opportunistic behaviour, the problem is that shareholders have not been keen to take actions. Essentially some more passive mechanisms such as a reward strategy may be more meaningful in protecting shareholders, which require minimal participation from shareholders. The first part of this article will look at the importance of aligning the interests between shareholders and managers and especially enquire why the shareholders are powerless to protect themselves despite the law has given them the powers to do so. The second part will examine the reward strategy from a legal and economic perspective. How it works and the relevant legal rules are investigated. The third part will enquire why it does or does not make sense to regulate executive pay as a response to various corporate scandals, especially by discussing what has gone wrong. This article points to the conclusion that although the recent outcry for better corporate governance should not be taken lightly, the very basic objective of executive remuneration to attract, retain and motivate the executives should never be forgotten.

Keywords: executive pay, company law, agency problem, corporate risks, law and economics

JEL Classification: A12, G30, K00, K22