Research report - Rotterdam School of Management

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Exhibit 1: Pay-setting process in the Netherlands Vote on new remuneration. policy or major changes to existing policy during the AGM Remuneration Remuneration policy policy Propose/set rem. policy Pay level, pay mix + incentive design Shareholders Shareholders Supervisory Supervisory Board Board (SB) (SB) Remuneration Remuneration Committee Committee (sub (sub committee) committee) Management Management Board Board (MB) (MB) Other determinants Economic factors: size, industry, growth opportunities, performance, risk Institutional factors: law, fiscal regime, corporate governance codes Public opinion: media, politics External advisors: compensation consultants, proxy advisors Appoint individual members in AGM (max 3 terms of 4 years) Select members Negotiate Terms Terms of of emloyemloymentment +target +target setting setting Negotiate Performance review Annual Annual compensation compensation Performance
2. The relation between corporate governance and executive compensation 2.1. The balance of power within the pay-setting process In the previous section we described the pay-setting process in the Netherlands and its specific features. The outcomes of executive pay-setting process in general are however widely debated. In the literature two competing theories exist that explain the determinants of executive compensation. These are (1) the efficient or optimal contracting model and (2) the managerial power model 13 . The efficient contracting model, introduced by Jensen and Meckling (1976), assumes that pay is set by an remuneration commission consisting of independent non-executive board members (vis-à-vis managers) on behalf of the shareholders. This at arm’s length bargaining process should result in a cost-effective compensation package that provides risk averse executives with incentives to increase shareholder value. Since this model had been the dominant theory in studies on executive pay, Bebchuk and Fried (2004) labeled it as the “official view”. Various empirical studies provided evidence inconsistent with the efficient contracting theory. Examples are amongst others Bertrand and Mullanaithan (2000), Core et al (1999), Hambrick and Finkelstein (1995) and Yermack (1997). These inconsistent results lead into a new model, the managerial power model, heavily advocated by Bebchuk and Fried (2004) in their book Pay without performance: the unfulfilled promises of executive compensation. The managerial power model argues that agents/managers have the power to heavily influence the pay setting process resulting in rent extraction at the expense of shareholders. So where the efficient contracting theory assumes that executive compensation is used by shareholders to reduce agency costs, the managerial power theory sees inefficient executive compensation arrangements as an agency problem on itself. Bebchuk and Fried (2004) list several limitations to the at arm’s-length contracting view. We will discuss some of these limitations. First, non-executive directors or supervisory board members enjoy financial and non-financial benefits of holding board positions. Hence they have a desire to be reelected on the board. To avoid internal friction and unpleasantness, directors avoid disputes over CEO’s compensation. Second, CEOs have substantial power over the firm’s resources and their positions sometimes give them significant influence outside the firm. CEOs can use this power to benefit directors directly or indirectly ranging from directors’ compensation to donations to charity foundations that employ or are headed by a non-executive director. Third, there are 13 See Otten (2007) for an extensive overview of existing theories on executive pay.
Page 1 and 2: The Impact of Ownership and Board S
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Page 13 and 14: study; their sample covers the peri
Page 15 and 16: and Hambrick (1989) find no signifi
Page 17 and 18: 2.3.2. Independent board members Co
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Page 21 and 22: potentially conflicting direct comm
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Page 25 and 26: Exhibit 3: Model and variable defin
Page 27 and 28: Board characteristics Forty-five pe
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Page 39 and 40: With regard to the board characteri
Page 41 and 42: 7. References Agrawal, A. and T. Na
Page 43 and 44: Finkelstein, S. and D.C. Hambrick,
Page 45 and 46: Tosi, H.L. and L.R. Gomez-Meija, 19

Research report - Rotterdam School of Management

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