Required reading

1. D: AktG, §§ 78, 87, 112, 186(3), 192, 193; HGB, § 285

2. UK: CA 2006, secs. 188, 420–422, 439, 566, 1166; SI 2008 No. 410; FSA Listing Rules, Rules 9.4, 9.86, 9.8.8

3. US: DGCL, §§ 122(15), 141(h); 17 CFR §§ 229.402, 240.14a-101, Items 8 and 10; NYSE, Listed Company Manual, para. 303A.05

Incentives and risks of executive compensation

Performance-linked pay and moral hazard

Executive compensation can be used to create desirable incentives for management, and thus is an instrument of corporate governance, but, because management often controls the machinery used to grant itself compensation and also because of the nature of certain forms of compensation, it can equally present moral hazard – an incentive for directors to breach their fiduciary duties. Performance-linked compensation can align the interests of management with those of shareholders because a manager whose pay increases in relation to a company's success has an economic incentive to increase such success by her own performance. A manager who holds the company's shares or options to buy them can be expected to share the interests of the shareholders. On the other hand, giving directors shares and options can set the stage for governance risks that do not arise with a straight salary.

Compensation contracts entail the same risks as any contract between the directors and the company: directors stand on both sides of the transaction in setting their own pay, and, when setting officers' pay, their decisions may be influenced by such officers.