Implicit Compensation

Cite this Article
Todd Henderson, Implicit Compensation, Truth on the Market (May 12, 2010),

The expansive executive compensation literature has two camps: one camp believes markets generally work; the other that they don’t. I am in the former camp, but believe markets and individuals that comprise them make mistakes and that those with power can sometimes use that power to serve their own, selfish ends. The only difference between my views and those of, say, Lucian Bebchuk, is how pervasive we think those mistakes and abuses are. Prof. Bebchuk thinks managers are systematically overpaid and game the compensation setting process to constantly turn out in their favor. He cites, for instance, the fact that managers earn “secret” profits on trades in company shares that do not show up in disclosure about pay, and believes this is consistent only with a managerial power theory of CEO compensation.

In a paper just posted to SSRN, I examine Bebchuk’s claim empirically by looking at what happens to CEO pay when firms liberalize opportunities for insiders to trade their shares. If markets work reasonably well, the explicit pay of these insiders should fall, since their implicit pay is rising. This is what I find. Markets work. Not always. Not perfectly. But they work.

And, if I’m right, this evidence makes a strong case for the laissez-faire view of insider trading most closely associated with the work of Henry Manne. If boards bargain with insiders about the profits they earn from informed trading, it is hard to see who is harmed by this conduct.