Top Management Pay: Impact of Overt and Covert Power

Johannes M. Pennings [*]

'Despite his diminishing share of the company -- some 11 percent -- Patey acted the omnipotent owner' (from In All His Glory: The Life of William S. Paley, Smith 1990)

Abstract

This paper examines variations in executive pay as a function of CEO power. We assume that CEOs optimize their pay conditional upon their ability to shape decisions that favour their interests. Power is inferred from overt manifestations such as share holdings, but also from covert sources such as a CEOs' social capital. Two components of compensation are considered: base pay and bonus. While financial performance, firm size, and other factors are held constant, the results show overt power as measured by CEO, and CEO-family equity holdings, to have a curvilinear relationship with executive compensation. Proxies of covert power include tenure, being (one of) the founder(s), and firm diversification. These variables magnify or moderate the effect of equity holdings on compensation. The power effects are most pronounced for the size of CEO bonus.

Descriptors: executive compensation, shareholdings, corporate governance, power, agency theory

Introduction

Executive compensation is a prominent topic in management research. During the last 75 years, there have been more than 300 studies on executive compensation (for reviews, see Gomez-Mejia 1994; Gomez-Mejia and Wiseman 1997). The most researched topic in this literature is the relationship between executive compensation and firm performance. This relationship is consistent with agency theory -- the dominant paradigm in this research -- which implies that self-serving managers can be motivated by tying their interests to the fate of the firm. However, empirical studies have typically found weak pay-performance relationships, although wide variations have been found. In a recent Special Research Forum on executive compensation and firm performance in the Academy of Management Journal, Barkema and Gomez-Mejia (1998) argued that an important reason for these unsatisfactory results is that previous research has typically ignored a firm's governance structure (e.g. ownership conditions, boards of directors, the mark et for corporate control) and other contingencies for executive pay (e.g. firm strategy, industry structure). Additonal research is needed that provides more insight into how executive pay is influenced by a firm's governance structure and by other contingencies.

The present paper adds to the emerging literature on how top management pay is influenced by a firm's governance structure (e.g. McEachern 1975; Gomez-Mejia, Tosi and Hinkin 1987; Finkelstein and Hambrick 1989, 1996; Westphal and Zajac 1994). We focus on manager-owners. It is often thought that ownership wields power, in particular if owners are also managers in their firms. In that case, the voting power from shareholdings is magnified by having a position in the firm, and managers can use the implied power to serve their personal goals. This paper looks at one particular application of such power: its impact on the manager's own compensation (i.e. salary, bonus).

A key insight of our paper will be that manager-owners do not have power per se. Rather, their power depends on their embeddedness in the firm and on the social relationships they have built up over the years with its directors, other managers, suppliers, and other parties. The embeddedness will magnify their power to serve their own goals, for instance, to manipulate their salary and bonus. This paper develops this key insight further and derives various testable implications by examining data on 143 top executives in medium-sized firms in the Netherlands.

Background

The major theoretical framework for researching CEO pay comes from economics and has been captured in the notion of agency theory. The CEO, as the agent, performs the role of maximizing the value of the firm for the shareholders, i.e., the principal. With the separation of ownership and control, there is often the potential problem that the interests of the manager and owners do not converge, and so-called agency problems ensue. For example, the stockholders might lack a full overview of the conduct and performance of the CEO. Likewise, the CEO might be motivated to make decisions that conflict with the shareholders' best interests. In fact, a classic idea in agency theory is that manager incentives are optimal when the manager is the full owner of the firm and, in this capacity, bears the full pecuniary consequences of his actions (Jensen and Meckling 1976). In contrast, when the CEO is a partial owner, there is potential divergence in interest between owners and managers.

(Partial) ownership might also confer power to the manager, and substantial leverage to manipulate compensation, under conditions in which the CEO might no longer be inclined to maximize shareholder value. The CEO might also enjoy other sources of power, including visible as well as more hidden ones, due to the recruitment and retention of lesser team members; again these sources of power might be exploited to maximize CEO rather than shareholder interests. Within the agency literature, issues of politics and power are typically ignored. Our paper explores whether such political behaviour does indeed occur, focusing on the executives' salaries and bonuses. Moreover, we explore how top managers use their holdings to manipulate their pay, and how this conspicuous form of power interacts with other surreptitious sources of power.