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Within the
executive compensation problem academics differ two major approaches: the
optimal contracting and managerial power. Several difficulties were presented
in the section above regarding the establishment of an optimal executive pay,
however the managerial entrenchment perspective comprises the most
inefficiencies in both frameworks, efficient contracting and managerial power model.
Therefore, the present section focuses its attention on the characteristics of
the entrenchment theory, as it depicts its particularities through the above
mentioned executive compensation frameworks.

 According to Bebchuck and Fried (2004) the
optimal contracting view is a more normative approach rather than descriptive,
as opposed to managerial power view. Thus, it is more suitable to present the
first principal-agent model through the managerial entrenchment view, presented
in the section 2 of this paper. An optimal contracting is a reaction to the
contracting environment (Weisbach, 2006). Hence, in the efficient contracting
model negotiations between executive and board of directors are occurring as a
matter of shareholders’ aim of profit maximization, subject to certain
constraints (Gümbel, 2006). Such constraints are proven to loosen the concept
of arm’s-length contracting approach and ‘encourage’ the board of directors to
favour CEOs while contracting, and pursue their own interests within the firm
(Gümbel, 2006; Bebchuck & Fried, 2004). One of these constrains,
behavioural, determines the link between incentive payment and subsequent CEO’s
performance. The second constraint is tax issues and regulatory requirements
which may not restrict top earners’ payment as much as it is needed. The third
constraint is the bargaining power of the counter party, which in case of
executive compensation, is higher for CEOs due to their skills, abilities and
potential contribution to the firm profit. As a consequence, many CEOs are being paid,
according to their performance, through stock option plans. In the efficient contracting view such method is
difficult to implement since there is a tendency to reward executives on absolute
performance (rather than relative). In addition, stock options favours
rent-seeking (Hall & Murphy, 2003) and their exercise price can be re-set
in case of poor manager’s performance, which certainly advantages CEOs. Furthermore,
numerous companies offer their CEOs other forms of incentive payment as well, such
forms of payment as retirement perks, ‘golden hand-shakes’ and parachutes which
come in contradiction to shareholders’ interests. Another inefficiency of arm’s
–length optimal contracting is that although regulations require full
disclosure on CEOs payment packages, there is still room for improvement
regarding how it actually occurs in practice (Gümbel, 2006). In this sense it
is also worth to mention that the ‘free-rider’ problem is as well a matter of
inefficiencies in optimal contracting framework. In majority of cases,
shareholders possess just a small fraction of the firm which cannot assure
disciplinary measures to be taken. They are also unable to reject some proposed
contracts, to take some actions when being expropriated and exercise their vote
regarding the executive option plans due to possible “potential crisis” that
may consequently appear (Gümbel, 2006). In an opposite case, when there is a
large shareholder, there is more incentive to “monitor management and invest
effort in reducing managerial opportunism” (Bebchuk & Fried, 2004). This
then results in better arrangements for shareholders. However, a set of
barriers are usually imposed by corporate governance that limit shareholders’
direct regulatory activity within the firm. Within shareholders and board of
directors’ agency- problem, a possible conflict of interests might determine
shareholders to be reluctant in rejecting a proposed executive (Gümbel, 2006).

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As stated above, compensation programs should
have as a goal “shareholder maximization, subject to a variety of constraints
“, however, often it is not the case. The managerial power view sets a number
of major constraints, in addition to ones of efficient contracting approach.
Still, as managerial entrenchment theory depicts, in practice those constrains
do not fulfil their designation completely. Consequently, CEOs often use their
attributes to increase their bargaining power and inquire high compensation
programmes. Bebchuck and Fried (2004) denote the idea that bargaining power is
in fact an agreement between the board of directors and executives which harms
shareholders’ interests. This comes as a result of directors having financial
and non-financial incentives to benefit CEOs’ interests, being so, the later
have a major influence over the board. The power the executives gain while contracting determines them
to extract “rents”, to “camouflage” some of their bonuses (under retirement
benefits for example) and try to decouple the pay-for-performance way of
compensation (Bebchuck & Friend, 2004). It is done so in order for
executives to bear less risk, put less effort and pursue strategies that would
serve themselves rather than shareholders. For the reason that the managerial
framework offers such a descriptive overview it is hard to provide normative
statements in this sense. Hence, academics more frequently present analysed
examples of inefficient compensation, as previously mentioned, through agency-problem
approach (Bebchuck & Fried, 2004; Murphy, 2012). One of
such inefficiencies is caused by the reluctance of board of directors to
develop individual payment models. “Directors lack adequate time and information
for investigation of alternative, efficient compensation arrangements” (Bebchuck & Fried, 2004), and
therefore, frequently
firms choose to conform to executive compensation plans similar to other firms.
As a result, the evolution of efficient compensation models is slowed down and
the unequal pay distribution problem persists (Bebchuck & Fried, 2004).
Human error (also called “honest stupidity” or “the perceived cost view”) is
another inefficiency. It occurs in the optimal contracting view in which human
imperfections may cause inefficient payment packages which favour managerial
power. The exercise price of the options paid to CEOs is another aspect of
executive compensation that must be reviewed. It is argued that linking the
stock exercise price to a stock market or industry (rather than the firm’s own
stock price) will help to establish an optimal level of executive payment and
reduce the ‘flaws’ caused by managerial approach (Bebchuck & Fried, 2004). Executive
loans under favourable conditions or even loan forgiveness are another
consequence of increased managerial power that harms the CEO compensation
issue. Retirement benefits, camouflaged bonuses and deferred compensation are
inefficiencies that provide once again that efficient contracting approach does
not depict all the aspects of an optimal executive pay package and certainly is
not a measurement to the argued problem.

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