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Supersize Pay, Incentive Compatibility, and the Volatile Model of the Shareholder

46 Pages Posted: 29 Sep 2005 Last revised: 12 Aug 2010

William W. Bratton

University of Pennsylvania Law School; European Corporate Governance Institute (ECGI)

Date Written: August 11, 2010

Abstract

This Article intervenes in the debate over executive compensation to assert that evaluation of prevailing practices concerns more than the quality of the bargaining space. The discussants posit shareholder value maximization as the firm's objective and agree that value can be enhanced by aligning management's interests with those of the shareholders. They tend not to address the follow up question as to how the shareholder should be modeled for the purpose of incentive design. This Article unpacks the unitary notion of the shareholder into a differentiated cast of characters made up of investors, speculators, noise traders, fundamental value investors, short term holders, long term holders, dumb money, and smart money. Most will agree that compensation should be designed so as to encourage managers to take the view of a long term, fundamental value investor. Despite this, prevailing practices invite alignment of management interests with those of short term speculators. Perverse effects result for investment policy, payout policy, and the quality of financial reports, particularly when the market overvalues the firm's shares. Although long term restraints on alienation on equity grants would substantially ameliorate these problems, they are not seen in practice because they diminish the value of equity grants by impairing liquidity and inhibiting diversification. A persistent question emerges: At the margin, what is the purpose of incentive compensation, to incentivize or to compensate? To the extent that the answer is "both" rather than "incentive compatibility," perverse effects remain a constant possibility. Leaving the matter over to case-by-case negotiation in an appropriate bargaining environment holds out an incomplete solution. Nor would shareholder empowerment solve the problem of perverse effects because the behavioral shortcomings of shareholders create the problem in the first place.

JEL Classification: G30, G34, J33, J44, K22

Suggested Citation

Bratton, William W., Supersize Pay, Incentive Compatibility, and the Volatile Model of the Shareholder (August 11, 2010). Georgetown Law and Economics Research Paper No. 808027; Virginia Law & Business Review, Vol. 1, p. 55, 2006. Available at SSRN: https://ssrn.com/abstract=808027 or http://dx.doi.org/10.2139/ssrn.808027

William Wilson Bratton (Contact Author)

University of Pennsylvania Law School ( email )

3501 Sansom Street
Philadelphia, PA 19104
United States

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050
Brussels
Belgium

HOME PAGE: http://www.ecgi.org

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