OMARI SCOTT SIMMONS, Wake Forest University School of Law
Email: simmonos@wfu.edu

No other corporate governance issue captures the imagination and frustration of the American public and politicians more than executive compensation. Despite decades of varied responses to address soaring executive compensation such as tax measures, board independence requirements, and mandated disclosures, executive compensation levels continue to soar, as does the saliency of executive compensation as a political issue. Most of the legal literature on executive compensation has focused on the conduct of wayward managers. This article, however, examines the impact of political behavior (i.e., lawmaker opportunism) on executive compensation reform. For lawmakers, executive compensation reform operates as a blue pill - a mechanism for lawmaker diversion and responsibility-shifting that diverts corporate constituent and scholarly attention away from more important corporate governance and socio-economic issues. This scenario threatens the prospect of optimal reform.

Executive compensation reform is analogous to a service exhibiting credence characteristics. Credence characteristics are service attributes whose quality cannot be fully determined even after significant use. Examples of services with substantial credence characteristics include automobile repair services, medical treatments, and corporate law. In the corporate law context, corporate lawmakers - the state of Delaware and the federal government - not only provide reform services, but also act as experts and diagnose corporate governance problems. Information asymmetries between lawmakers and various corporate constituencies (e.g., managers, shareholders, and populist groups) create perverse incentives for opportunistic lawmaker behavior. The unobservable impact of executive compensation reform provides lawmakers with added discretion that is often used for incremental, moderate, or conservative corporate reforms, even in the face of crisis. On the other hand, sweeping reforms are unlikely because they pose a serious risk to political capital. Therefore, lawmaker cries for executive compensation reform should be approached with vigilance.

CAROLA FRYDMAN, MIT Sloan School of Management
Email: Frydman@mit.edu

In recent years, a large academic debate has tried to explain the rapid rise in CEO pay experienced over the past three decades. In this article, I review the main proposed theories, which span views of compensation as the result of a competitive labor market for executives to theories based on excess of managerial power. Some of these hypotheses have found support in cross-sectional evidence, but it has proven more difficult to determine which factors have caused the observed changes in pay over time. An alternative strategy is to evaluate the fit of plausible explanations out of sample by contrasting them with the evolution in executive pay and the market for managers during earlier time periods. A case study of General Electric suggests that evidence for earlier decades can speak to the recent trends and reveals the limitations of current explanations to address the long-run data.

J. ROBERT BROWN, University of Denver Sturm College of Law
Email: jbrown@law.du.edu

The current waive of turmoil in the financial markets has cast attention on the problem of executive compensation. Companies that have failed or disappeared in shot-gun mergers have nonetheless paid exorbitant sums to officers who arguably played a substantial role in their demise. In response, Congress for the first time established federal standards for determining compensation, including clawbacks and limits on golden parachutes.

The congressional efforts, although mild, represent a deep frustration with the system used by the Delaware courts in assessing executive compensation. With the CEO on the board, executive compensation has traditionally been examined under the duty of loyalty. Through legal legerdemain, the Delaware courts have accorded the decisions the all but insurmountable protection of the business judgment rule, requiring only that the board contain a majority of "independent directors." By largely reducing the test to a rote head count, the courts did little to ensure that compensation decisions were unaffected by the interested influence. At the same time, the courts did little to ensure that independent directors were in fact independent.

The paper provides some suggested reforms. The efficacy of the process must be improved. Most importantly, however, fairness needs to be returned to the analysis. Only with some obligation to show the fairness of the compensation decision with the interests of shareholder be adequately protected.

QIANG KANG, University of Miami - Department of Finance
Email: q.kang@miami.edu
OSCAR A. MITNIK, University of Miami, Institute for the Study of Labor (IZA)
Email: omitnik@miami.edu

There is a debate on whether executive pay reflects rent extraction due to "managerial power" or is the result of arms-length bargaining in a principal-agent framework. In this paper we offer a test of the managerial power hypothesis by empirically examining the CEO compensation of U.S. public companies that were ever in financial distress between 1992 and 2005. Using a bias-corrected matching estimator that estimates the causal effects of financial distress, we find that, for the distressed firms, CEO turnover rates increase markedly and their CEOs, both incumbents and successors, experience significant reductions in total compensation. The bulk of the reduction in total compensation derives from the decline in value of stock option grants, which we argue is due to a change in the opportunistic timing of option grants. We define "lucky" grants as those with grant prices below or at the lowest stock price of the grant month, and we find that the proportion of lucky grants for financially distressed firms is higher before insolvency and lower upon and after insolvency, while the proportion for similar but solvent firms remains stable throughout the period. We interpret this evidence as consistent with a decrease in managerial power induced by a tightening in the "outrage" constraint due to the episode of financial distress.

CYNTHIA E. DEVERS, University of Wisconsin - Madison
Email: cdevers@bus.wisc.edu
ROBERT M. WISEMAN, Michigan State University - Department of Management
Email: WISEMA13@MSU.EDU
R. MICHAEL HOLMES, affiliation not provided to SSRN
Email: holmes@lsu.edu

Assuming a positive influence of stock price volatility on stock option value, incentive alignment proponents argue that stock option compensation encourages managerial risk seeking and, thus, aligns managers' and shareholders' risk preferences. Our findings show that stock option holders overvalue unexercisable options relative to options being offered and to normative (e.g., Black-Scholes) valuations. Further, the influence of stock price volatility on holders' subjective valuations depends on stock price trend. In sum, results suggest that during stock option valuation, managers draw on heuristics that financial options theory and models fail to capture. We discuss
implications for compensation design and research.

CYNTHIA E. DEVERS, University of Wisconsin - Madison
Email: cdevers@bus.wisc.edu
GERRY MCNAMARA, Michigan State University - The Eli Broad College of Business and The Eli Broad Graduate School of Management
Email: mcnama39@msu.edu
ROBERT M. WISEMAN, Michigan State University - Department of Management
Email: WISEMA13@MSU.EDU
MATHIAS ARRFELT, affiliation not provided to SSRN
Email: arrfelt@msu.edu

We examine the influence of CEO equity-based compensation on the strategic risk taking by the firm. Building off of the Behavioral Agency Model, Agency Theory, and Prospect Theory, we develop arguments about when equity-based compensation elements will increase and when they will decrease executive risk propensity and, in turn, strategic risk taking. Incorporating a behavioral perspective into our models of incentive alignment provides us with new and potentially more accurate predictions about how individual elements of CEO pay will influence risk selection, as well as how equity compensation interacts with cash compensation and with other factors to influence risk preferences. In general, this study provides evidence that CEO equity-based compensation significantly influences strategic risk, but that this influence is more nuanced and complex than conventional treatments of executive compensation assume. In particular, we find that different forms of equity-based pay exhibit dissimilar influences on strategic risk and that their influence changes as their value and vesting status change. Second, we find that cash-based forms of pay moderate the incentive properties of equity-based pay, indicating that cash-based pay may affect how executives perceive risks associated with equity pay. Finally, we find that stock price volatility and board actions each also moderate the incentive effects of equity-based pay. In sum, our results argue for increased recognition of a behavioral perspective on executive compensation and greater precision in how we measure and model the incentive alignment properties of CEO compensation.

CHRISTIAN LAUX, Goethe University Frankfurt
Email: laux@finance.uni-frankfurt.de
VOLKER LAUX, University of Texas at Austin - Department of Accounting
Email: volker.laux@mccombs.utexas.edu

We analyze the board of directors' equilibrium strategies for setting CEO incentive pay and overseeing financial reporting and their effects on the level of earnings management. We show that an increase in CEO equity incentives does not necessarily increase earnings management because directors adjust their oversight effort in response to a change in CEO incentives. If the board's responsibilities for setting CEO pay and monitoring are separated through the formation of committees, the compensation committee will increase the use of stock-based CEO pay, as the increased cost of oversight is borne by the audit committee. Our model generates predictions relating the board committee structure to the pay-performance sensitivity of CEO compensation, the quality of board oversight, and the level of earnings management.