October 18, 2005
Book Review--The False Promise of Pay for Performance: Embracing a Positive Model of the Company Executive
by William Baue
According to James McConvill, the problem with perverse executive compensation is not managerial
power, as an earlier book suggests, but rather the very pay for performance system.
What is wrong with the current pay for performance system? In their influential 2004 book Pay without Performance: The Unfulfilled Promise of Executive
Compensation, Law Professors Lucian Bebchuk and Jesse Fried (of Harvard and Berkeley, respectively) support the system that incentivizes
executives by linking compensation to company performance, but argue that the implementation of the
system needs reform.
The False Promise of Pay for Performance by Law Professor James McConvill of Deakin University in Australia advances an
extended rebuttal to Profs. Bebchuk and Fried, arguing that perverse executive pay results from the
structural foundations of the pay for performance system. Far from preventing perverse executive
perks, the pay for performance system helps create and exacerbate the very corruption is was
established to police.
"This book will challenge the underlying assumption of pay for
performance by focusing on empirical research and theoretical studies indicating that the
performance of executives, and the company generally, can be just as effectively improved by means
other than remuneration, and in fact--generally speaking--pay has very little real impact on the
motivation and utility of executives," writes Prof. McConvill in the book.
summarizes the pay for performance system before deconstructing it. He says the pay for
performance system rests on so-called "agency theory," which holds that the interests of managers
(or "agents") and shareholders in public companies inherently diverge, requiring the implementation
of systems to align these divergent interests. Pay for performance theoretically does so by using
money (tied to company performance) as a carrot-and-stick. When company performance falters, the
size of the carrot shrinks. Unfortunately, this is often not the case.
Profs. Bebchuk and
Fried subscribe to agency theory, and hence would have no problem with executive compensation
skyrocketing even higher, as long as it is linked to stellar company performance (a position that
troubles Prof. McConvill.) Profs. Bebchuk and Fried advance a "managerial power" thesis holding
that what corrupts pay for performance is the departure from "arm's length bargaining." The
problem, according to Profs. Bebchuk and Fried, is that corporate executives (especially CEOs)
exert too much influence on how boards set remuneration.
Prof. McConvill identifies what
he believes to be an inherent contradiction in this thesis.
"The managerial power thesis
rests on the assumption that social and psychological factors influence directors in their approach
to executive pay-setting arrangements, but at the same time, the managerial power thesis assumes
that only economic factors (based on agency theory) influence executives in their attitude towards
remuneration specifically and the corporation more generally," Prof. McConvill states.
Prof. McConvill allows that managerial power plays a role in excessive executive remuneration,
but focusing on this problem is like putting a butterfly band-aid on a slashed jugular.
"Rather than being an 'unfulfilled promise,' pay for performance is no promise at all," Prof.
The problem with pay for performance, in Prof. McConvill's mind, is that
it posits the agent (or manager) in a negative light, assuming untrustworthiness and therefore
requiring policing. According to Prof. McConvill, this system is a self-fulfilling prophecy,
creating untrustworthy managers by not trusting them.
The "empirical research and
theoretical studies" Prof. McConvill cites document an alternative means of viewing corporate
executives and their motivations. Essentially, the "science of happiness" studies reveal that
money does not create fulfillment or satisfaction, and so it is futile to try to motivate people by
continually raising their pay.
"If the motivation and utility of executives is not
dependent upon their level of pay, why go to such great efforts to link pay with performance,"
Prof. McConvill asks.
Instead of using extrinsic factors to motivate, why not leverage
intrinsic motivators, such as job satisfaction? At the theoretical level, Prof. McConvill suggests
replacing agency theory with stewardship theory, which holds that managers consider themselves
stewards of the corporation, thereby aligning corporate and manager interests in ways that agency
theory does not.
Prof. McConvill ends by proposing "positive corporate governance," a
structure that seeks to support managers in doing their best instead of policing their worst.
"If we are to embrace a positive model of the company executive, what would be the implications
for corporate regulation," Prof. McConvill asks. "If we can be confident that executives are
naturally inclined to pursue what is best for the company, and doing so is an incentive in itself,
external regulation can be dispensed with."
"This will of course be difficult as many
commentators and regulators will consider much of the argument underlying positive corporate
governance as being not only counterintuitive, but pure fantasy," he adds in recognition of the
provocative nature of his proposition.
Prof. McConvill's thesis presents a dilemma for
socially responsible investing (SRI) practitioners who advocate linking executive pay to social and
environmental performance metrics. Should they abandon this tack in favor of "positive corporate
governance"? Unfortunately, Prof. McConvill pays far too little attention on stakeholders,
including society and the environment. He asks his readers to trust that happy managers will
ensure a happy society and environment.
The distance between theory and reality may be
the primary limiting factor of Prof. McConvill's thesis. The book's deconstruction of agency
theory and pay for performance is worth the cover price alone. However, his recommended
replacement may prove elusive. Abolish regulation in favor of trusting executives? While the idea
sounds interesting, it seems too great a risk to implement, as it provides no checks and balances
in case of failure.