Making Sense of Executive Compensation

Simone M. Sepe

On July 21, 2010, President Obama signed the Dodd-Frank Act. The Act implements a number of significant regulations regarding executive compensation. This article argues that Congress has failed to accurately answer three basic questions in the enactment of this legislation: (i) what are the key problems that plague executive compensation, (ii) what is the possible solution, and (iii) what is the role of regulation in implementing the solution?

Addressing these questions, the article comes to three conclusions.

First, it argues that any comprehensive reform of executive compensation must take into account two moral hazard problems: inducing managers to perform and preventing them from taking either too much or too little risk.

Second, it suggests that analyzing manager employment contracts as relational in nature, as they are in reality, offers crucial insights into how to implement efficient compensation schemes. Because continuation of employment matters to managers, expectation of high fixed payments can promote effort. Under this result, the use offixed compensation emerges as an efficient means ofcountering the incentive for excessive risk produced by equity-based compensation. This property of fixed pay allows the firm to implement mixed payment schedules that induce managers to perform while fully internalizing risk externalities.

Third, the article argues that regulation is necessary for remedying inefficiencies within the organizational structure of the public corporation that hamper adoption of optimal mixed payment schedules. It discusses why the Dodd-Frank Act fails to meet this goal and outlines the measures that should be on the agenda of future compensation reform.