648 PART • Information, Market Failure, and the Role of Government For years, many economists believed that executive compensation reflected an appropriate reward for talent Recent evidence, however, suggests that managers have been able to increase their power over boards of directors and have used that power to extract compensation packages that are far out of line with their performance and contributions to the growth of their firms In essence, managers have steadily increased their ability to extract economic rents How has this happened? First, most boards of directors not have the necessary information or independence to negotiate effectively with managers Directors often cannot monitor executives’ activities and therefore cannot negotiate compensation packages that are tightly linked to their performance Furthermore, boards consist of a mix of inside members, who either are or represent top executives, and outside members, who are chosen by and are often on close terms with top executives.13 Therefore, directors have a strong incentive to support executives in order to be re-nominated to the board or otherwise rewarded Research has shown that high levels of CEO pay are negatively correlated with a firm’s accounting value and profitability.14 In other words, the higher the CEO’s pay, the lower the firm’s profitability is likely to be In addition, CEOs with unusually high pay were more likely to stay at a company despite poor economic results These effects are intensified at companies where the board is entrenched and shareholder rights are limited “Golden parachutes,” generous severance packages that CEOs can negotiate with their boards, have also come under fire recently Some argue that such guarantees free CEOs from board and shareholder pressure to focus on short-term growth and enable them to focus instead on their firms’ longterm growth However, it has been shown that CEOs with golden parachutes are less likely to worry about long-term growth, and—when negotiating the sale of their firm to another company—are more likely to agree to acquisition terms that hurt shareholders.15 Reward structures that focus on profitability over a 5- to 10-year period are more likely to generate efficient incentives than more shortsighted reward structures We will consider some additional solutions to this important principal–agent problem in the next section The Principal–Agent Problem in Public Enterprises The principal–agent framework can also help us understand the behavior of the managers of public organizations These managers may also be interested in power and perks, both of which can be obtained by expanding their organization beyond its “efficient” level Because it is also costly to monitor the behavior of public managers, there are no guarantees that they will produce the efficient output Legislative checks on a government agency are not likely to be effective as long as the agency has better information about its costs than the legislature has Although the public sector lacks some of the market forces that keep private managers in line, government agencies can still be effectively monitored 13 Killinger was the chairman of Washington Mutual’s board until he was forced out two months before the bank failed 14 In 2007, Killinger, who was also chairman of Washington Mutual’s board of directors, was paid $18.1 million, making him the highest paid CEO of any publicly traded company (http://www equilar.com/NewsArticles/062407_pay.pdf) This was especially true when the CEO took home the largest portion of the pay going to the firm’s top-five executives For more detailed discussion and analysis, see Lucian A Bebchuk, Martjin Cremers, and Urs Peyer, “The CEO Pay Slice,” Journal of Financial Economics (Spring 2012) 15 Lucian A Bebchuk, Alma Cohen, and Charles C Y Wang, "Golden Parachutes and the Wealth of Shareholders,” Harvard Law School Olin Discussion Paper No 683, December 2010