Texas Law Review, Volume 96, Number 2, December 2017 Page: 231
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CEO Pay Redux
2. Dynamic Pay and Committed Managers.-In addition to the above
challenges, a dynamic setting simultaneously offers additional avenues for
efficient incentive design, as it allows boards to spread the rewards for good
managerial performance over time while periodically reviewing the
manager's performance. In other words, in a dynamic setting, the board can
"exploit" a manager's continuation value-that is, a manager's expected
payoffs from future employment periods (assuming that the manager is not
fired for poor performance)-as a powerful bonding mechanism to commit
the manager to the creation of long-term firm value.
This dynamic approach to executive-pay design sheds new light on the
function served by allegedly inefficient entrenchment rents-that is,
compensation premiums that exceed a manager's total rent, as given by the
sum of agency rents and market rents. Contrary to the assumptions of
managerial power scholars, this approach shows that such rents can help to
commit executives to the exercise of long-term effort.
Consider, for example, the use of fixed compensation, which managerial
power scholars describe as the quintessential form of "pay-without-
performance" and, hence, as primary evidence of inefficient rent
extraction. 108 In contrast with this view, in a multi-period setting, fixed
compensation can provide efficient incentives, as long as the manager's
expected gains from future employment periods offset her disutility cost of
effort. A rational manager anticipates that low effort increases the likelihood
of poor interim performance109 and, therefore, that she might be removed in
the near future. Because managerial removal triggers the loss of continuation
payoffs, the manager will then have incentives to exert effort.110
Fixed compensation may likewise provide a mechanism to mitigate the
negative externalities that competition may introduce in incentive schemes.
Consider again our example. Recall that in a competitive, dynamic setting,
paying the Manager the total rent of $40 (that is, the $16 agency rent plus the
$24 market rent) is no longer sufficient to satisfy the participation constraint
of a talented Manager over time. In this context, paying the Manager more
than the $40 total rent-for example, by granting the Manager an additional
fixed bonus of $10 to be paid out each period the Manager continues to be
employed-should thus be regarded as an efficient, rather than inefficient,
rent. Under this compensation arrangement, the Manager will trade off any
potential future increase in her reservation utility against her expected
continuation payoffs, including expected future bonuses. It follows that
providing the Manager with extra compensation may help promote the
108. See supra section I(B)(2).
109. See supra note 19.
110. See Sepe, supra note 17, at 219-23 (providing a formal model that explores the incentive
function of fixed-compensation contracts in a dynamic setting).231
2017]
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Texas Law Review Association. Texas Law Review, Volume 96, Number 2, December 2017, periodical, December 2017; Austin, Texas. (https://texashistory.unt.edu/ark:/67531/metapth1115391/m1/39/: accessed July 18, 2024), University of North Texas Libraries, The Portal to Texas History, https://texashistory.unt.edu; crediting UNT Libraries Government Documents Department.