Explaining the International CEO Pay Gap: Board Capture or Market Driven?
135 Pages Posted: 15 May 2003
One of the most puzzling aspects of executive compensation is the pay gap that exists between American and foreign Chief Executive Officers (CEOs). Commentators and the financial press have been quick to argue that such differences are the result of high agency costs, or "board capture," a theory that claims powerful American executives take advantage of weak domestic boards of directors and passive, dispersed shareholders to overpay themselves exorbitantly. According to these theorists, American CEOs orchestrate the appointments of friendly, passive outside directors, and their obedient subordinates as inside directors. The net result is a board comprised of compliant directors and a Compensation Committee that lacks the aggressive hard-nosed negotiators needed to keep executive pay in check.
The international pay gap arises, under this theory, because foreign CEOs don't have the same power over their boards. In most foreign corporations, control shareholders act as strong checks on executive pay. Control shareholders will recoup most of the firm's surplus that is not paid out to the factors of production, such as CEOs, and therefore have strong financial incentives to keep executive pay abroad low. Thus, by comparison to U.S. levels, foreign CEOs are paid less.
In this article, I am critical of the board capture explanation and offer several more plausible, market-based explanations. Board capture, while it may lead to some inflation in U.S. CEO pay levels, it does not fully explain CEO pay levels. For example, it does not tell us why executive pay in the U.S. grew so rapidly after the early 1980's. There is no evidence that CEOs' power over their boards grew during this time period; in fact, most evidence is to the contrary. Nor does this theory offer a persuasive explanation of why bigger firms pay their executives more than smaller ones, or why the supply of executives has not dramatically increased in response to the alleged huge rents that CEOs have been receiving for the last twenty years. Furthermore, board capture does not explain why boards pay incoming CEOs so much where they have no prior relationship with the directors. Finally, even if we accept the theory, we still will need a mechanism to set executive pay. Market-driven forces seem necessary to accomplish this result.
I offer four alternative market-based justifications for higher pay for American CEOs. The first rests on the marginal revenue product of executive labor. American CEOs should be paid more, on average, than foreign CEOs because American CEOs contribute more to their firms' value. American firms have greater growth opportunities, have greater resources to be deployed because they are bigger, and American CEOs play a much larger role in the decision-making process at their firms than CEOs at foreign firms. Furthermore, American CEOs receive more of their pay in the form of stock options, and may hold more of their wealth in company stock, than foreign CEOs and therefore their pay will reflect a risk premium.
Next, I examine the international pay gap by examining the workings of corporations' internal labor markets and tournament theory. The tournament to become the CEO is, under this theory, a much bigger one at American firms because these CEOs have so much more power than their foreign counterparts. After all, in the U.S., the CEO is normally also the Chairman of the Board, whereas in foreign countries this is rarely the case. American CEOs' power is further enhanced compared to those of their biggest foreign rivals, Japan and Germany, because boards of directors are smaller in the U.S. than in Japan, and have only one tier, instead of the two tier structure in Germany. Furthermore, the "winner take all" culture in the U.S. may condone bigger prizes in these tournaments than are socially acceptable abroad.
Third, I show that there are differences in the opportunity costs for American and foreign CEOs. The opening up of financial markets since the early 1980s has given U.S. CEOs better access to capital markets for financing their own start-up businesses, raising the value of their alternative opportunities. This occurred first through the use of the leveraged buyout (LBO) as a method of financing a new firm, then with the tremendous growth in venture capital financing, and later on (at least for a period of years) when the technology boom made available massive amounts of capital to finance start-ups. Established American businesses that wished to compete for managerial talent were thereby forced to offer executives larger pay packages.
By comparison, foreign CEOs have not had nearly the same access to financial markets to launch their own businesses. Foreign financial markets are more fragmented, more regulated, offer less venture capital financing and experience fewer MBOs. Only recently has there been an expansion of executive job opportunities with the deregulation of some capital markets and increased managerial migration. These changes have increased pressure on foreign companies to pay their executives more like Americans, but they have yet to catch up.
Finally, there are big differences in the amount of bargaining power that American CEOs have compared to that of foreign CEOs. These differences derive from two important forces at work in the U.S.: first, the shift in the 1980's in the relative bargaining strength of American CEOs in vetoing takeovers of their corporations; and second, the concurrent acceptance of the idea of pay-for-performance by domestic institutional investors. These changes gave American CEOs tremendous power to stop a hostile takeover unless the sale of the firm was perceived as in that executive's personal best interests.
Top managers of foreign firms have not enjoyed the same increase in bargaining power because, while hostile takeovers in most foreign countries continue to be almost impossible to pull off, these firms generally have control shareholder ownership structures. Thus, in foreign firms control shareholders make the decision whether or not to sell the company. There is no reason for the dominant shareholder to offer the firm's CEO more money for agreeing to a sale, unless the CEO happens to be the control shareholder himself.
JEL Classification: K22, J30, J31, J33, J40, M21, M52
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