Pay Without Performance

Lucian Bebchuk and Jesse Fried argue that American executive compensation is not the result of arm's-length bargaining between a board acting for shareholders and a chief executive, and that the standard optimal contracting account cannot explain the observed arrangements. Their alternative is the managerial power thesis: executives influence their own pay, and the constraint on how much they extract is outrage rather than negotiation.

The evidence is the design features that optimal contracting cannot explain. Options granted at the money with no performance conditions reward executives for general market movements they did not cause. Option repricing after share price declines removes the downside the instrument was supposed to create. Executives are permitted to hedge and to unwind their equity positions, which severs the link the grants were meant to establish. Severance payments exceed contractual entitlements. Retirement benefits, deferred compensation and perquisites are structured to be less visible in disclosure. Boards are populated by directors nominated by the chief executive and advised by consultants the company retains.

The authors call the constraint on extraction outrage costs, meaning that pay arrangements are limited by what can be defended publicly, which explains why compensation is camouflaged rather than minimised. Their proposals concern board independence, shareholder power to nominate directors, and disclosure of the full value of arrangements. The book influenced say-on-pay legislation and the subsequent shift toward performance-conditioned equity. Critics, particularly from the optimal contracting side, argue that the authors underweight the market for executive talent and that observed pay levels reflect firm scale. The design critiques have largely been accepted and many of the specific practices have changed.