Seminar in Law , Economics , and Organization

In this paper, I analyze how the influence of executives affects the compensation decisions of boards of directors. Boards vary in their degree of independence, and compensation decisions not only serve to motivate executives and allocate rents, but also affect a board’s reputation for independence. Although greater managerial influence over the board has the obvious effect of increasing the level of pay, there is a more subtle relationship between the extent of this influence and the composition of pay. The theory predicts that it is not necessarily the most captured boards that are prone to choose inefficient pay-for-performance sensitivities and transfer rents in opaque ways as commonly argued. Reputational concerns may cause comparatively independent boards to place excessive weight on investor perception at the expense of efficiency, resulting in pay packages that, for example, provide excessive incentives. By making the decisions of boards extremely visible, mandatory disclosure of executive compensation lowers the level of pay at the expense of distortions in the structure. Finally, I show that boards exploit investor uncertainty about the outside opportunities of executives and the appropriate strength of incentives to justify higher levels of compensation. ∗Harvard University, [email protected]