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IsU.S.CEOCompensationInefficientPaywithoutPerformance?areviewofPAYWITHOUTPERFORMANCE:THEUNFULFILLEDPROMISEOFEXECUTIVECOMPENSATION.ByLucianBebchukandJesseFried.Cambridge:HarvardUniversityPress2004.Pp.304.Cloth,$24.95.ByJohnE.Core,*WayneR.Guay**andRandallS.Thomas***Draft:March24,2005*AssociateProfessorofAccounting,TheWhartonSchool,UniversityofPennsylvania.B.A.1983,YaleUniversity,Ph.D.1995,UniversityofPennsylvania.**AssociateProfessorofAccounting,TheWhartonSchool,UniversityofPennsylvania.B.S.1989,ClarksonUniversity;M.B.A.1993,NortheasternUniversity;Ph.D.1998,UniversityofRochester.***JohnS.BeasleyIIProfessorinLawandBusiness,VanderbiltUniversitySchoolofLaw,ProfessorofManagement,OwenSchoolofManagement,VanderbiltUniversityB.A.1977,HaverfordCollege;Ph.D.(economics)1983,J.D.1985,UniversityofMichigan.WewouldliketoacknowledgehelpfulcommentsfromImanAnabtawi,LucianBebchuk,JenniferBlouin,DavidLarcker,ChristianLeuz,LuannLynch,andScottRichardson.Allmistakesandomissionsareoursoleresponsibility.1IsU.S.CEOCompensationInefficientPaywithoutPerformance?AbstractInthispaper,wereviewPayWithoutPerformancebyProfessorsLucianBebchukandJesseFried.ThebookdevelopsandsummarizestheleadingcritiquesofcurrentexecutivecompensationpracticesintheU.S.,andoffersanegative,ifmainstream,assessmentofthestateofU.S.executivecompensation:U.S.executivecompensationpracticesarefailing,andsystemicreformisneeded.Thisreviewsummarizesthebookinsomedetailandofferssomecounter-arguments.Thebook'sthesisisthatexecutivecompensationpracticesarebadforshareholders(notoptimal)becausetheyaretheproductofmanagerialpower.Managerialpowerarisesbecauseboardsofdirectorsatpubliccompaniesarenotindependentofexecutives.WeakcompensationcommitteesthusdolittletoprotectthefirminitspaynegotiationswiththeCEO,leadingtolevelsofexecutivepaythatarebothinappropriatelyhighandhaveinappropriatelylowlevelsofincentives.TheauthorsofferafourpartanalysisofCEOpay.First,theydescribeandcritiqueoptimalcontractingtheory,whichpositsthatexecutivecompensationarrangementsaredesignedtobenefitshareholders.Second,theyexplainmanagerialpowertheory,inpartthroughanin-depthanalysisofcurrentexecutivecompensationpractices.Theyassertthemanagerialpowertheoryprovidesasuperiorexplanationofcurrentpracticestotheoptimalcontractingperspective.Theyalsodrawthestrongimplicationthatifmanagerialpowerexists,itmeansthatsomethingiswrongwiththecontractingprocess.Third,theyclaimthatCEOcompensationdoesnotvarysufficientlywithfirmperformance.Theyconcludewithpolicyrecommendationsforchangingcompensationplansandimprovingcorporategovernance,forexamplebyrequiringthatdirectorsbemoreindependent.Weagreethatitisusefultoconsidertheeffectofmanagerialpoweroncompensation,butwedisagreewiththeirinterpretationoftheconsequencesofthispower.ItistruethatcontractstructuresreflectCEOpower,andthatCEOswithmorepowergetmorepay,butthisdoesnotnecessarilyleadtotheconclusionthatCEOpayisnotoptimizedforshareholders,nordoesitimplythatCEOpayneedsreform.Weshowthatinmanysettingswheremanagerialpowerexists,observedcontractsanticipateandtrytominimizethecostsofthispower,andthereforemayinfactbewrittenoptimally.Asaresult,theoptimalcontractingandmanagerialpowerperspectivesarecomplementary,andnotcompeting,explanations.WenextexamineBebchukandFried'sclaimthatU.S.compensationisinefficientpaywithoutperformance.TheiranalysisfocusesonwhetherCEOannualpayvarieswithfirmperformance.WhilethebookconductsanextensiveanalysisoftheincentivesprovidedbyannualgrantsofstockoptionsandequityitlargelyignoresthemainsourceofCEOincentives:Largeholdingsofstockandoptions.TheselargeequityholdingsprovidepowerfulperformanceincentivesandensurethatthewealthofmostCEOsvariesstronglywiththeirfirm'sstockprice.Thebooks'claimthatCEOcompensationispaywithoutperformancedoesnotappearcorrectonceoneconsidersthismainsourceof2CEOincentives.U.S.executiveshaveverylargepay-performanceincentives,andtheiroverallpaylevelsdonotseeminappropriate.WeconcludebyexaminingsomeofBebchukandFried'spolicyrecommendations.BebchukandFriedhavemissedsomeimportantaspectsofexecutivepayandincentives.TheyhavenotshownthattherearesystematicfailureswithU.S.CEOcompensation,andthereforehavenotshownthatreformisneeded.3IntroductionInPayWithoutPerformance,ProfessorsLucianBebchuk1andJesseFried2developandsummarizetheleadingcritiquesofcurrentexecutivecompensationpracticesintheUnitedStates.Thisbook,andtheirhighlyinfluentialearlierarticle,“ManagerialPowerandRentExtractionintheDesignofExecutiveCompensation,”withDavidWalker3offeranegative,ifmainstream,assessmentofthestateofU.S.executivecompensation:U.S.executivecompensationpracticesarefailinginawidespreadmanner,andmuchsystemicreformisneeded.ThepurposeofourReviewistosummarizethebookandtooffersomecounterargumentstotrytobalancewhatisbecominganincreasinglyone-sideddebate.Thebook’sthesisisthatexecutivecompensationpracticesintheU.S.benefitcorporateexecutivesattheexpenseofshareholdersthroughimplicitandexplicitcorruptionofthepay-settingprocess.ItarguesthatCEOemploymentcontractsarebadforshareholders(notoptimal)becausetheyaretheprod