Too Much Pay, Too Much Deference: Is CEO Overconfidence the Product of Corporate Governance?

97 Pages Posted: 14 Sep 2004

See all articles by Troy A. Paredes

Troy A. Paredes

Washington University in St. Louis - School of Law

Date Written: September 5, 2004

Abstract

This article focuses on potential causes of CEO overconfidence, a problem that to date has not been central to corporate governance. Instead, corporate governance has focused on solving conflicts of interest and on motivating managers to work hard; it has not emphasized the need to remedy the kind of good faith mismanagement that results when CEOs are overconfident, although well-intentioned and hard working.

I theorize that CEO overconfidence is a product of corporate governance in two key ways. First, high executive compensation gives positive feedback to a CEO and signals that the chief executive is a success. Studies show that positive feedback and recent success build confidence. Indeed, the very process of winning the tournament to become the top executive probably makes a CEO more confident. Stressing the possible link between CEO pay and CEO overconfidence offers a new behavioral approach to executive compensation that emphasizes the psychological consequences of executive pay - namely, the risk of bad business decisions, particularly overinvestment, rooted in growing CEO confidence - as opposed to the incentive effects or fairness concerns associated with how and how much CEOs are paid. Second, a CEO-centric model of corporate governance is predominant in the U.S. as boards, subordinate officers, gatekeepers, judges, and shareholders largely defer to the chief executive, even in the Sarbanes-Oxley era. My theory is that CEOs become more confident as a result of the great deal of corporate control that is concentrated in their hands and the fact that their business judgment is largely deferred to, even as conflicts of interest, disloyalty, and fraud are more carefully monitored.

I conclude by considering how corporate governance could incorporate techniques for managing CEO overconfidence, chief among them being efforts to ensure that the CEO and the board of directors consider the opposite (i.e., arguments against some course of action). One possibility is to appoint a chief naysayer whose job is to be a devil's advocate. This article also addresses what managerial overconfidence might mean for defensive tactics to hostile takeovers and for derivative lawsuits brought by shareholders, as well as for the law of fiduciary duty and the business judgment rule, exploring the possibility of extending the law of fiduciary duty to cover mismanagement that is rooted in managerial overconfidence.

The general message of this article is that in the future, corporate governance should move beyond managerial motives to account more for human psychology and how managers actually behave and make business decisions, including when they are trying to do their best.

Keywords: chief executive officer, CEO, agency costs, behavioral corporate finance, behavioral finance, executive compensation, Sarbanes-Oxley, devil's advocate, fiduciary duties, business judgment rule, mergers and acquisitions, winner's curse, hubris hypothesis, empire building, psychology

JEL Classification: G3, G34

Suggested Citation

Paredes, Troy A., Too Much Pay, Too Much Deference: Is CEO Overconfidence the Product of Corporate Governance? (September 5, 2004). Available at SSRN: https://ssrn.com/abstract=587162 or http://dx.doi.org/10.2139/ssrn.587162

Troy A. Paredes (Contact Author)

Washington University in St. Louis - School of Law ( email )

Campus Box 1120
St. Louis, MO 63130
United States
314-935-8216 (Phone)
314-935-5356 (Fax)

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