sri-advisor.com
where checking accounts rebuild communities
Back to homepageInstitutional ReportsSRI Financial Professionals DirectoryToolsNewsSRI Performance and TrendsAbout Us   
News


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.

Prof. McConvill 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. McConvill states.

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.

 

 
Home
| Reports | SRI Financial Professionals Directory | Tools | News | SRI Performance and Trends | About Us | Contact
© SRI World Group, Inc. - All rights reserved
Terms of use - Privacy Policy - OneReportTM Network