The popular press and scholarly studies have noted a number of trends in corporate governance. This paper addresses the broad question of whether these trends are linked. And, if so, how? The paper finds that a trend toward greater board diligence will lead to trends toward more external candidates becoming ceo, shorter tenures for ceos, more effort being expended by ceos (equivalently less perquisite consumption), and greater ceo compensation. A trend toward greater board diligence need not be exogenous. The paper shows how changes in firm hierarchies could result in a trend toward more independent boards.

We analyze how directors with financial expertise affect corporate decisions. Using a novel panel data set, we find that financial experts exert significant influence, though not necessarily in the interest of shareholders. When commercial bankers join boards, external funding increases and investment-cash flow sensitivity decreases. However, the increased financing flows to firms with good credit but poor investment opportunities. Similarly, investment bankers on boards are associated with larger bond issues but worse acquisitions. We find little evidence that financial experts affect compensation policy. The results suggest that mandating financial expertise on boards may not benefit shareholders if conflicting interests (e.g., bank profits) are neglected.

We consider a “managerial optimal” framework for top executive compensation, where top management sets their own compensation subject to limited entrenchment, instead of the conventional setting where such compensation is set by a board that maximizes firm value. Top management would like to pay themselves as much as possible, but are constrained by the need to ensure sufficient efficiency to avoid a replacement. Shareholders can remove a manager, but only at a cost, and will therefore only do so if the anticipated future value of the manager (given by anticipated future performance net future compensation) falls short of that of a replacement by this replacement cost. In this setting, observable compensation (salary) and hidden compensation (perks, pet projects, pensions, etc.) serve different roles for management and have different costs, and both are used in equilibrium. We examine the relationship between observable and hidden compensation and other variable in a dynamic model, and derive a number of unique predictions regarding these two types of pay. We then test these implications and find results that generally support the predictions of our model.

Compensation, status, and press coverage of managers in the U.S. follow a highly skewed distribution: a small number of ‘superstars’ enjoy the bulk of the rewards. We evaluate the impact of CEOs achieving superstar status on the performance of their firms, using prestigious business awards to measure shocks to CEO status. We find that award-winning CEOs subsequently underperform, both relative to their prior performance and relative to a matched sample of non-winning CEOs. At the same time, they extract more compensation following the award, both in absolute amounts and relative to other top executives in their firms. They also spend more time on public and private activities outside their companies, such as assuming board seats or writing books. The incidence of earnings management increases after winning awards. The effects are strongest in firms with weak corporate governance. Our results suggest that the ex-post consequences of media-induced superstar status for shareholders are negative.

This paper provides a theory of broad-based option plans. Wage payments to managers and employees drive a wedge between total firm output and the fraction of output received by the firm’s owners. Consequently, owners ’ decisions whether, e.g., to continue the firm, shut it down, or sell it to another firm, are biased. Broad-based option pay minimizes this inefficiency. By minimizing the firm’s total wage payments in marginally profitable states, broad-based option pay minimizes the gap between total firm output and the owners ’ share of it in precisely those states where the bias is greatest. Moreover, option pay remains uniquely optimal if decisions are made by managers instead of owners, suggesting that options are robust optimal contracts in the sense that their optimality does not depend on who has decision-relevant information.

Intermediation at the Crossroads. 1

Executive Compensation and Investor Clientele Executive compensation has increased dramatically in recent times, but so has trading volume and individual investor access to financial markets. We provide a model where due toalackofsophisticationortonaïveté, possibly arising from high opportunity costs of learning about accounting conventions and financial markets, small investors are unable to decipher true executive compensation accurately. Expected compensation is therefore higher when small investors form a more significant clientele in the market for a firm’s stock. Our model further suggests that increased information asymmetry between large and small traders may deter the entry of small investors and keep executive compensation in check. Technologies that lower the cost of trading facilitate entry of small investors and raise expected compensation. In general, such compensation can be reduced through requirements that increase disclosure transparency. Empirical tests provide support to the key implication of the model that indirect executive compensation is higher in stocks Issues surrounding executive compensation have taken on increased prominence in recent

Principal-agent theory suggests that a manager should be paid relative to a benchmark that removes the effect of market or sector performance on the firm’s own performance. Recently, it hasbeenarguedthatwedonotobservesuchindexationinthedatabecauseexecutivescanset pay in their own interests, that is, they can enjoy “pay for luck ” as well as “pay for performance”. We first show that this argument is incomplete. The positive expected return on stock markets reflects compensation for bearing systematic risk. If executives ’ pay is tied to market movements, they can only expect to receive the market-determined return for risk-bearing. This argument, however, assumes that executive pay is tied to bad luck as well as to good luck. If executives can truly influence the setting of their pay, they will seek to have their performance benchmarked only when it is in their interest, namely when the benchmark has fallen. Using industry benchmarks, we find that there is significantly less pay-for-luck when luck is down (in which case pay-for-luck would reduce compensation) than when it is up. These empirical results are robust to a variety of alternative hypotheses and robustness checks, and suggest that the average executive loses 25-45% less pay from bad luck than she gains from good luck. 2 1

Incentive compensation induces correlation between the portfolio of managers and the cash flow of the firms they manage. This correlation exposes managers to risk and hence gives them an incentive to hedge against the poor performance of their firms. We study the agency problem between shareholders and a manager when the manager can hedge his compensation using financial markets and shareholders can monitor the manager’s portfolio in order to keep him from hedging, but monitoring is costly. We find that the optimal incentive compensation and governance provisions have the following properties: (i) the manager’s portfolio is monitored only when the firm performs poorly, (ii) the manager’s compensation is more sensitive to firm performance when the cost of monitoring is higher or when hedging markets are more developed, and (iii) conditional on the firm’s performance, the manager’s compensation is lower when his portfolio is monitored, even if no hedging is revealed by monitoring. Moreover, the model suggests that the optimal level of portfolio monitoring is higher for managers of firms whose performance can be hedged more easily, such as larger firms and firms in more developed financial markets.

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