Give 'Em Enough Rope : Optimal Design of Executive Pay and Rent Extraction

In his novel contribution to the ongoing debate over executive compensation, Share Repurchases, Equity Issuances, and the Optimal Design of Executive Pay, 89 Tex. L. Rev. 1113 (2011), Professor Jesse M. Fried points to a problem that has been, as of yet, unexplored by legal scholars. He argues that managers whose compensation is equity-based obtain extra returns when their firms engage in bargain share repurchases and overpriced equity issuances. Consequently, managers have perverse incentives to effect these transactions even when they potentially reduce shareholder value. Fried suggests that to remedy these inefficiencies, managers should participate in their firms’ share repurchases and equity offerings on the same terms that are offered to the firms’ investors. This would eliminate the opportunity for managers to take in extra returns, thereby inducing them to engage in those transactions only when they are value-increasing. This Response offers two criticisms of Fried’s argument. First, it challenges the idea that preventing managers from capturing extra returns always leads to increased efficiency. Since the problem of managerial moral hazard can take multiple forms, leaving managers some extra returns may reduce the likelihood that managers will waste corporate assets. Second, this Response argues that as opposed to the social cost implied by share repurchases, that of overpriced equity offerings is unclear. Indeed, while bargain share repurchases may inefficiently substitute corporate assets, no substitution of assets takes place when the firm conducts an equity offering