Research Handbooks in Corporate Law and Governance series
Edited by Randall S. Thomas and Jennifer G. Hill
Chapter 8: How to Avoid Compensating the CEO for Luck: The Case of Macroeconomic Fluctuations
Lars Oxelheim,* Clas Wihlborg and Jianhua Zhang** 1 2 1 INTRODUCTION Executive compensation is under scrutiny and there are calls for regulation and “codes of conduct” with respect to levels as well as forms of compensation. Although the level of compensation in Europe remains below that in the US, the level in most European countries has increased rapidly in the new millennium. According to Fernandes et al. (2008) the difference between Europe and the US can be explained to a large extent by the larger variable component of executive compensation in the US. The higher variability in the US seems to be associated with a risk-premium. This observation implies that levels and forms of compensation are not independent. One common view in the current debate is that CEO compensation should be linked to “sustainable” profits that presumably are the result of skill and effort. Regulation seems to be emerging in many countries stating that the reward for improved performance should not be fully realized unless the improved performance is observed for a period of 3–5 years. Increased compensation would be linked to performance surpassing some benchmark for some duration. The argument behind such proposals would be that improved performance is likely to be caused by other factors than executive skill and effort if it does not exceed a benchmark for duration of time. The other factors could be earnings management by the executives and some sort of luck. There are a number of difficulties associated with proposals of the...
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