[Michael] Jensen's best-known work is the 1976 paper he co-authored with William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,[3] one of the most widely cited economics papers of the last 30 years. Besides reigniting interest in the theory of the public corporation as an owner-less entity made up of only contractual relationships (a field pioneered by Ronald Coase), the paper laid the foundation for the widespread use of stock options as executive compensation tools.
It was a 1990 Harvard Business Review article CEO Incentives: It's Not How Much You Pay, But How[4] by Jensen and Kevin J. Murphy that prescribed executive stock options in order to maximize shareholder value. The justification they gave was that shareholders were the "residual claimants" of the corporation, meaning that they had the sole right to profits. This idea that shareholders are residual claimants was later rejected by legal scholars (e.g., Stout 2002).
After Jensen and Murphy (1990), Congress passed a law,[5] making it cost effective to pay executives in equity. As a result, executives focused their efforts on increasing stock price. In the short run, many executives manipulated accounting numbers (e.g., Enron, Global Crossing).NYT article 2005 In the long run, executives outsourced labor to reduce costs, then used the cost saving to repurchase stock; thus, increasing their own compensation. Over the last 20 years, stock buybacks total a few trillion.[6Bill comments:
In some ways, however, it was remarkable that the intellectual father of modern executive compensation, Michael Jensen, has turned on his creation. Further, he turned on it vehemently – in 2001. Subsequently, scholars whostudy executive compensation have agreed that it has created perverse incentives.New Economic Perspectives
CEO Compensation: “Cheaters Prosper”
William K. Black | Associate Professor of Economics and Law, UMKC
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