Economics of Legal Concepts for Management Compensation Schemes in the Credit Sector and of their Regulation – A Critical Contribution to the European Regulatory Discussion

by Christian Kirchner* and David Ehmke

(2013) Oxford U Comparative L Forum 2 at | How to cite this article

1. Introduction

Compensation schemes for managers in the credit sector are a core issue of vibrant and controversial discussions in context of the current ongoing international financial crisis.1 The questions of how management compensation schemes should be designed by shareholders or how the frame for private ordering design ought to be set by public regulators are, in the European discussion, primarily raised in conjunction with two major concerns. First, managers’ salaries are thought to be unjust, posing the normative question of what constitutes ‘fair’ or ‘just’ wages. Secondly, the compensation schemes are accused of providing misleading incentives, so that managers tend to take hazardous risks on the costs of third parties – employees, creditors, and taxpayers. This so-called opportunistic behaviour2 creates moral hazard and is said to have contributed to the outbreak of the financial crisis.

The first question leads us to the roots of the philosophical and ethical foundation of social relations, the issue of a just price. The discussion on setting prices on a moral basis and not via market transactions calls into question the concept of free market society. The legitimacy of any morally-based social principle can certainly be queried. But this more fundamental question is outside the scope of this paper, especially because it is commonly put forward as a populist claim by those who attribute the international financial crisis to ‘greedy bankers’ instead of examining structural defects: the claim often lacks a positive economic analysis as a basis for its normative analysis.

The second question is less an accusation and more a search for an economically solid design for compensation schemes in order to prevent managers from taking excessive risks which in turn may lead to the necessity of tax-funded bailouts for financial institutions thought to be too big or too connected to fail. The question is how to overcome structural deficits in order to prevent opportunism and moral hazard. There are diverse programmes proposed and established by politicians, public regulators, and private regulators that all aim to improve the institutional design of compensation schemes. In order to analyse these programmes (proposals for public or private regulation), it is necessary to first look into the private ordering institutional design of compensation schemes. On this basis, the regulatory proposals have to undergo a positive economic analysis. Unintended side-effects of such proposals have to be identified. This is a necessary step for a full impact analysis. Side-effects are often overlooked – intentionally or not – especially in case of public ordering. They often surface with delay, i.e. within the next legislative period, so that they are not taken into account by present legislators acting opportunistically. On the basis of this analysis, it is possible to normatively evaluate the regulatory proposals. Our approach in this paper is a consequentialist one – the attempt to answer the question ‘what is’ (positive analysis) instead of ‘what ought to be’ (normative analysis). While it is impossible to deduce ‘what ought to be’ from ‘what is’, a positive analysis can disclose the unforeseen consequences of regulation as well as provide the private and public ordering regulators with information about regulatory cost-benefit constraints so that they can pursue their goal – whatever it may be – in the most efficient way. Hence, we will try to answer the second question insofar as it is about providing a positive economic impact analysis of private ordering compensation schemes and public and private ordering regulation of these schemes. The normative analysis concerning the question of whether a proposal of regulation is recommendable or not, whether it is ‘good’ or ‘bad’, is not being conducted here, but it might be built upon and utilize the results of our positive analysis. Considering the fact that these processes are subject to both private regulation by shareholders and public regulation by the legislator and administration, we will further try to analyse the interplay between both.

2. Methodological Issues

The positive economic analysis of any institutional design as well as of its regulation is based on certain assumptions: (1) scarcity of resources,3 (2) methodological individualism4, (3) self-interested5 (bounded) rational6 behaviour, (4) systematically incomplete information,7 and (5) transaction costs.8

The positive economic analysis of private ordering institutions is typically focused on public ordering regulation of these institutions. It would be unhelpful to limit our analysis in this way. Private ordering regulation, e.g. in informal agreements or formal codes of conduct, and public ordering regulation complement, overlap, substitute for, hamper, or suspend one another. Public and private ordering are in reciprocal relation. We will take a closer look at the complementarity, competition, and overlapping between public and private ordering regulation regarding management compensation schemes. We are interested in formal and informal institutions.9 Whereas formal institutions are characterised by formal procedures for rule-making and rule-enforcement, informal ones are created in an informal procedure of social interactions and fortified by informal sanctions such as reputational damage in cases of noncompliance.10 Any positive economic analysis without observing the role of private ordering regulation and informal rules would be incomplete.

3. Economics of the Regulation of Management Compensation Schemes in the Credit Sector

3.1 Economics of the Design of Management Compensation Schemes in the Credit Sector

3.1.1 Preliminary Considerations

The positive economic analysis of either private or public ordering management compensation schemes regulation requires an analysis of the schemes’ design. What may be of benefit to the firm from a microeconomic perspective does not necessarily translate to advantage for society from a macroeconomic perspective.

3.1.2 Fixed and Variable Salaries

Salaries of managers in the credit sector regularly comprise a fixed and a variable part. The variable part especially is designed in order to set incentives so as to direct the managers and associate their interests with those of the shareholders (3.1.3). Fixed and variable salaries are not perfectly interchangeable because of their different capacity to influence the manager’s behaviour.

3.1.3 Incentives, Opportunistic Behaviour, and Moral Hazard

Variable salaries are designed to function as a control mechanism to affect the behaviour of managers who are assumed to act rationally and in their own self-interest.11 Different stakeholders of a firm such as shareholders, employees, and customers pursue different, sometimes divergent goals. The managers’ edge is their information advantage compared to other stakeholders. Shareholders, therefore, seek to ally managers’ interest to their own by setting incentives through variable payments for performance favourable to the shareholders’ interest, e.g., the return on capital employed (ROCE). Due to the fact that incentive-oriented contracts, as other relational long-time contracts, are necessarily incomplete, managers could try to make use of the information asymmetry in order to increase their benefit to the detriment of the other parties after the contract has been concluded (ex post opportunistic behaviour).12 If they were able to profit from certain risky transactions in case of success and could shift the costs onto third parties in case of failure, moral hazard would prevail.13

Although managers are often described as taking excessive risks – surely an apt description in some cases – this finding is as often misleading. The shareholders have much better opportunities to diversify their risk in their portfolio, while the managers’ risk is concentrated in their position in the firm and their reputation on the market. Thus, it is the shareholders’ intention to move the managers through the implementation of incentive-orientated compensation schemes into the direction of being less risk averse.

3.2 The Economics of the Regulation of Management Compensation Schemes in the Credit Sector

3.2.1 Starting Point

The focus of most regulation is macroeconomic. This encompasses the consideration of negative side-effects for third parties not directly related to the firm. Primarily we mean taxpayers, who may be liable for publicly funded bailouts of banks that are too big or too connected to fail. Hence, the discussion is not confined to the reduction of misleading incentives for managers; it also encompasses the reduction of adverse incentives for shareholders. The regulation of management compensation schemes works hand in hand with the regulation of minimum equity capital requirements. The primary problems that arise include information problems, unintended side-effects, and the opportunistic behaviour of political decision-makers.

3.2.2 Information Problems

Compared to public rule-makers, private rule-makers systematically possess better and more comprehensive information because they are closer to the information source. Problems arise because of different targets which are pursued by either the private or the public rule-maker. Maximizing ROCE may conflict with the public rule-maker’s concept of avoiding a distortion of financial markets, which they should aim to prevent. Or, ROCE maximization may be contradictory to the goal of shielding taxpayers from the costs of bank bail-outs. The latter problem is fostered by the vagueness of the question of whether a bank is too big to fail or not, which gives room to strategic behaviour and moral hazard.

According to the basic economic model of regulation, rule-makers set rules fortified by sanctions. The addressees respond by calculating the costs of sanctions, e.g. the fine applicable and reputational damage, times the probability of detection, in relation to the costs of compliance, e.g. monitoring costs or disadvantages in the competition for qualified managers. Expenditures are made up to the point to where marginal benefit and marginal cost meet (change in total benefit and cost if a next unit is produced, or, in this case, if further effort is made).

In the light of systematically incomplete information, we have to modify the basic model of regulation. If, for instance, legal terms are not sufficiently defined, and if salaries are required to be ‘appropriate’,14 as it is the prerequisite in German regulation, this leads to legal uncertainty. In order to clarify the substance of these legal terms, the addressees bring their case for interpretation in court – a process which is even more costly in continental European jurisdictions in absence of a doctrine of binding precedent. So, they can try to sort out the borders for permissible behaviour in order to achieve legal certainty, and thus to reduce transaction costs, the costs of information procurement. Of course, reaching legal certainty is a transaction cost itself. However, the addressees may follow this strategy in order to (1) achieve planning certainty, and (2) in order to play an active part in the determination of the legal terms’ definition in favour of the addressees’ interests. These benefits are balanced against possible reputational damage in the event that third parties (e.g. clients) assume that a firm’s shareholders or managers are acting to the detriment of macroeconomic goals.

3.2.3 Unintended Side-Effects

If the regulation of compensation schemes leads to adverse consequences, if performance pay cannot solely be dependent on revenue, and if working for a credit institution in a certain jurisdiction becomes less attractive for qualified managers, regulation will seriously harm the competiveness of credit institutions within this jurisdiction. In order to retain competitiveness, the decision-makers in firms in the credit sector may engage in regulatory arbitrage by transferring their seat to jurisdictions with less restrictive rules. Because large banks in Europe commonly operate in various markets within the European Union and outside, at least in key markets like Switzerland, Hong Kong, Singapore, and the United States of America, where they are represented by affiliated corporations, they can simply shift priorities within the consortium without having to transfer the companies themselves.

3.2.4 Populist Tendencies of the Political Decision-Makers

The essence of public-choice theory is the assumption that political decision-makers act in their own self-interest and thus strive for their own advantage instead of to citizens’ benefit.15 Because their goal is retention of power, which, in a democracy, means winning the citizens’ vote in regular elections, there are intersections, so that politicians endeavour to at least let the voters think that they would aspire to meet their preferences. The chance of re-election determines the extent and intensity of populist tendency. A fatal constellation will emerge if described problems of populism tendency coincide with problems of time inconsistency, i.e. if negative side-effects surface time-inconsistently with considerably delay, not before (re-)election. In this case, politicians may favour a decision without balancing the alleged benefits with not yet apparent flaws. This problem, again, is intensified when it accumulates with opaque and conflicting goals such as ‘fair salaries’ and ‘macroeconomic growth’.

4. Economics of Different Regulatory Concepts of Management Compensation Schemes

4.1 Preliminary Considerations

Building on our arguments in part 3, we will now turn to the evaluation of concrete regulatory concepts. We shall include both proposals and already enacted concepts from the European Union, Germany, and Switzerland from a comparative-law perspective with the methodological instruments of institutional economics. First, we shall take a closer look at different aspects targeted by public and private regulators. Secondly, we shall summarize these points under the concrete regulatory proposals and already enacted concepts by public regulators. Thirdly, we shall examine the relationship between formal and informal, both public and private ordering regulation.

4.2 Competences

The Swiss ‘Minder-Initiative’ (so-called ‘rip-off-initiative’) has energized the discussion about who should decide on managers’ salaries. According to this initiative, there has to be an obligatory binding vote of the shareholders about managers’ salaries. For Swiss financial institutions listed on US stock exchanges, the Sarbanes-Oxley Act of 2002 also comes into play. These institutions are required to create a compensation committee which is obliged and entitled to prepare a concept of managers’ salaries. However, the last and decisive vote, according to the terms of the referendum, is to be that of the shareholders.

The economic impact of the competence to decide on compensation schemes varies with the structure of the shareholders and the underlying legal framework.

Initially, one might assume that there is no difference between cases where the shareholder-elected board decides on compensation versus those where the shareholders themselves make the decision. However, if the members of the board (agents) have more information than the shareholders (principals), and thereby seek to realise different interests, this will lead to principal-agent problems.16 The members of the board may have different interests because of the proximity to the managers. Principal-agent problems, in turn, result in costs for the shareholders, which they have to balance against the transaction costs which would emerge if they were engaged in collecting and evaluating the relevant market information in order to design an appropriate compensation scheme. These costs can be tremendous when combined with a number of collective action problems, e.g., in cases of diffuse shareholdings, where the parties have to invest heavily in coordination in order to reach a majority decision. A decision, moreover, which was made on basis of incomplete or wrong information can weaken the firm’s position in international competition with competitors who benefit from less restrictive regulation.17

A shift in competencies to the general shareholders’ meeting has a further impact in those jurisdictions where the committee which has to decide on the managers’ salaries is not exclusively composed of the owners’ delegates. In Germany, employees and shareholders are represented in the supervisory board. As previously mentioned, owners with an option to diversify their portfolio tend to be less risk-averse than managers. Employees, by contrast, are generally at least as risk averse as managers. As a result, the compensation scheme agreed by the delegates of shareholders and employees may be seen as a compromise between both sides. The outcome is likely to be that of a compensation scheme which encourages the managers to take fewer risks than if it were designed by the owners alone.

4.3 Absolute and Relative Limitations for Salaries

4.3.1 Absolute Limitations for Salaries

Absolute limitations for salaries include fixed and variable payments, any other monetary compensation, like gratuities, and equity options. A regulation of absolute limitations faces two major concerns: circumvention and ‘sufficient’ sanctions.

It can be expected that absolute limitations for salaries would weaken firms in competition with competitors in other jurisdictions where absolute limitations do not apply. In order to maintain their position, managers and shareholders would attempt to circumvent the limitation. A regulation which geographically applies only to certain jurisdictions can be skirted by transferring the firm’s seat or the manager’s position within the consortium (3.2.3). A regulation applicable to one country within the European Union opens a regulatory competition with other EU members, whereas a regulation applicable to all European Union Member States opens a regulatory competition with Switzerland, the Channel Islands, Hong Kong, Singapore, and the United States. Because circumvention strategies are connected with costs, they will only be undertaken when the absolute limitations are considerably lower than salaries in other jurisdictions.

Additionally, the material terms of regulation can be evaded. If the regulation of compensation does not cover all forms of compensation recognized as benefits by managers, it is incomplete. Because the regulators can only include those elements which are known to them at the time of regulation, there perspective is narrowed. The addresses can respond to this ‘regulatory challenge’ by developing new instruments of remuneration, e.g., by promising options for prospective benefits in regulatory-free sphere. These options may be guaranteed not by formal but by informal agreements.

The interests of managers and shareholders are presumably the same, especially where shareholders have to expect highly qualified managers to migrate. Employees, instead, will suffer from a geographical circumvention which does not only include the transfer of manager positions but of whole corporations or certain divisions if they are made redundant with the firm’s transfer.

4.3.2 Regulation of the Relationship between Fixed and Variable Salary Components

A regulation of the relation of fixed and variable salary components aims to reduce their incentive effect. Shall the total salary be limited by this kind of regulation, it has to be kept in mind that the scope for setting variable payments widens with the increase of the fixed component.18 In order to maintain the incentive benefits, informal roles could play a role. Hence, annual re-negotiations on the ‘fixed component’ in light of the manager’s past performance can substitute for a limited variable component. These informal rules are fortified by the interest of the shareholders and their delegates in maintaining and increasing the reputation of the corporation as a contracting partner in competition for highly qualified managers.

4.3.3 Regulation of Salary in Relation to other Employees’ Salaries

A flexible upper limit for managers’ salaries is much influenced by the intention to achieve ‘just’ or ‘fair’ wages. This model is especially appealing to politicians who can argue that managers’ salaries should not exceed a fixed proportion to either the average salary or the lowest-paid worker’s salary. The Swiss 1:12-initiative19 follows this concept. According to the initiative’s proposal, the amount of the highest salary within a firm must not exceed twelve times that of the lowest salary.

If the vertical compensation scheme within the firm is kept constant, this regulation will affect managers’ salaries significantly. However, this is not the most likely outcome. In order to maintain competitiveness, the employees with lower income will presumably be outsourced. A credit institute with only highly qualified and highly paid managers in which service functions are outsourced is certainly conceivable. Expecting, as we outlined above, the interests of managers and shareholders to broadly coincide, this regulation can serve those interests as long as it is part of a voluntary binding commitment based on private ordering. Managers and shareholders may agree upon a moderate cut of managers’ salaries and an increase in lower-income salaries in order to reach a relative approximation so as to boost morale in the firm and foster reputation. The condition for this private ordering commitment is that it does not negatively affect competitiveness and that the benefits in reputation gains and company morale exceed or equal expected negative implications. A regulation as far-reaching as the Swiss 1:12-initative, which would have had a vast impact on managers’ salaries if it had been implemented, can be expected to seriously harm competiveness. However, the most likely outcome in case of such a radical regulation would be circumvention rather than straightforward compliance.

If the regulation of the proportion of managers’ salaries to those of the lowest-paid employees or the firm’s salary average is intended to ensure ‘just’ or ‘fair’ wages and thus follows a social intention, this may be a textbook example of unindented side-effects bringing about an outcome exactly opposed to the intent of the legislator. Those who were meant to be advantaged would probably suffer the most from this regulation – the lowest-paid, now outsourced employees.

4.4 Criteria for Sustainablility and Long-Term Oriented Management in Regulation

4.4.1 Preliminary Considerations

Misleading incentives were, among other causes, made responsible for the international financial crisis. Managers were said to have focused on short-time success in order to gain high bonus payments and thereby have neglected high risks for which they could expect to escape any liability.20 This behaviour is characterized as moral hazard is stimulated by the ‘herd effect’ – repeated imitations of other players’ behaviour leading to inefficiency.21 Firms encourage their competitors to copy their compensation schemes’ strategies. At first glance, one might assume that shareholders should be interested in minimizing excessive risk-taking which would endanger their property. But moral hazard will influence both managers and shareholders, if they can expect a tax-funded bailout in case a risky business venture fails. Regulators, therefore, aim to limit risk-taking by manipulating the criteria for bonus payments. One could argue here that regulators, in doing so, tend to treat a symptom instead of the disease itself.

4.4.2 Option Models

The concept of option models in regulation is that of linking long-term success to variable payments. This can include a lock-up period for share options or the regulatory definition of measured points for variable compensation on fixed dates in the future. In this respect, problems of time inconsistency occur. The relational link between performance and compensation could be broken. A ‘good’ performance could be paradoxically punished by low bonus payments if the beneficial effect of one manager’s work is destroyed by their successor’s ‘bad’ performance. On the contrary, a ‘bad’ performance by a predecessor can be rewarded because of the ‘good’ performance of their successor. The problem that a third parties’ performance is reciprocated is, in particular, important in situations where there is high fluctuation and a relatively short period of employment in any one firm.

Another problem which may result because of this regulation is that the morale of the employees could be negatively affected if managers were paid high salaries for their ‘good’ performance some years ago while their performance on pay-day is recognized by the employees to be ‘bad’.

4.4.3 Risk-Sharing

A regulation requiring the managers to bear part of the entrepreneurial risk burden starts with the assumption that this would be the equivalent to bonus payments. Moreover, this regulation should increase risk aversion and should, thus, reduce excessive risk-taking. The concept of managers’ bail-in found its way into the German Stock Corporation Act (§ 93(2) AktG, see part 5.2 of this paper). The underlying assumption that a manager’s bail-in is an equivalent to bonus payments is too short-sighted. The equivalent to bonus payments in case of success is non-payment and reputational damage in case of failure. If the manager is further burdened with the entrepreneurial risk, there are two main possible reactions: First, regulatory interference could be circumvented through a cross-subsidised insurance solution. An insurance provider offers to cover the retention to the manager. The insurance rate is artificially low because the shareholders informally agree to pay a relatively higher insurance rate for their part in order to decrease the burden for the manager. If this gap is closed by the regulator, the extra risk will be compensated in higher salaries. Secondly, if regulatory rules for mandatory risk-sharing and a limitation for the manager’ salaries are combined, this will increase the attractiveness of geographic, industry-specific, or informal circumvention.22

5. A Positive Economic Impact Analysis of Cencrete Pulic Ordering Regulatory Concepts

5.1 European Union: CRD IV Directive

The CRD IV Directive,23 which has to be implemented by European Union member states, focuses mainly on the limitation of the variable component relative to the fixed component of managers’ salaries. According to the directive, the upper limit for the variable part is 100 per cent of the fixed part, and it can be increased up to 200 per cent by a qualified majority decision of shareholders. The most likely outcome of this regulation is a rise in the fixed salary or circumvention by informal arrangements (4.3.2). Pressure on the actors who have to decide on compensation to evade regulation would be piled by stricter minimum equity capital requirements and national rules for sustainability and risk-sharing if the credit sector is weakened in competition for qualified managers with other industries.

5.2 Germany: Vorstandsvergütungsgesetz (Management Compensation Act)24

The Vorstandsvergütungsgesetz has modified several compensation rules in the Stock Corporation Act (Aktiengesetz, AktG), the Commercial Code (Handelsgesetzbuch, HGB) and in their respective implementing legislation. According to § 87(1) AktG, it is the supervisory board’s obligation to ensure that the managers’ salaries are appropriate25 in relation to the managers’ position, duties, performance, and to the firm’s financial and economic situation, and to cut the managers’ salaries in case the firm’s situation changes for the worse (§ 87(2) AktG). The supervisory board’ members are liable for ‘inappropriate salaries’ (§ 116(3) AktG).26 What has to be understood as ‘appropriate compensation’ and ‘inappropriate compensation’ is vague. Reference points such as ‘usual compensation’ (§ 87(1)(1) AktG) or ‘orientation to sustainability’ (§ 87(1)(2)) exist but are not sufficient to eliminate legal uncertainty. Informational problems arise from the vague legal terms and the various divergent interests which could potentially be used to substantiate this term. The private actors may bring their cases to court in order to clarify the legal terms and test the borders, but being aware of effects for their reputation (3.2.2).

Some guidance for what is meant by a ‘sustainable design for compensation schemes on a multi-annual basis’ as required by § 87(1) AktG can be found in § 193(2)(4) AktG, in which a four-year lock-up period is stated. The four-year lock-up period imposes a lower limit for the time after which certain options may be executed in case of conditional capital increase. Applying this concept to management compensation, one could argue that the time basis of assessment for how to determine managers’ salaries should be a fixed point of at least four years in the future. The problem of time inconsistency arises in this context (4.4.2). Additionally, § 92(2)(3) AktG27 stipulates the required retention, i.e. the share of loss which a manager has to pay in case that he is unable to prove due diligence (the burden of proof is on the manager) and which is not be covered by insurance concluded by the firm in order to cover losses caused by managers’ misbehaviour so that the manager, eventually, has to bear part of the burden. We discuss likely reactions to such rules above at 4.4.3. This package of German public ordering regulation is, if it is not simply circumvented, likely to weaken the international competitiveness of the German credit sector.

5.3 Germany: Institutsvergütungsgesetz (Institution Compensation Regulations)

The ‘appropriateness of the compensation schemes’ design’ is required by § 3(1) of the Financial Institution Compensation Regulations (Institutsvergütungsverordnung). According to the regulations, this should be the case if incentives for managers to take ‘inappropriately high risks’ were being avoided and if decision-making was not being hampered: § 3(3). A term in need of clarification (‘appropriateness’) is defined by another term in need of similar clarification itself (‘inappropriate high risks’, § 3(3)). The same problems and reactions mentioned above at 5.2 can be expected here as well.

5.4 Switzerland: ‘Minder-Initiative’

The ‘Minder-Initiative’28 regulation, approved in a plebiscite, transfers the competency to decide on compensation to the shareholders, thus strengthening their property rights. Principal-agent problems probably decline, but collective action problems may increase. Collective actions will become an issue if many diverse and anonymous minor shareholders have to agree in order to reach the requisite majorities (4.2). Furthermore, this regulation is not likely to prevent risk-taking (3.1.3). Another problem could occur in case the Swiss regulatory model is transplanted to e.g. Germany. Such ‘legal transplants’29 can have totally different effects in another legal system, as in Germany, where the employees’ representatives would be partly deprived of their current power (4.2).

6. Interplay between Informal and Formal Private and Public Ordering Concepts for Management Compensation Schemes

So far, we have examined how private actors can avoid formal private ordering regulation in order to avoid significantly adverse effects for their business. Thus, we have focused on the interplay between informal private ordering reactions to formal public ordering regulation. Now, we shall assess the interplay between private ordering and public ordering regulation of private ordering compensation schemes’ design.

We have to also recognize private ordering regulation of private ordering compensation schemes, which has not been in the centre of the general discussion. Private actors, individually or cooperatively, could be interested in committing themselves in a binding voluntary agreement to abide to certain regulatory rules drafted by them. At a first glance, this may seem paradoxical. Why should private actors propose a self-binding agreement limiting their options and thereby their chances to flexibly adjust their compensation schemes’ design in order to succeed in competition? According to the methodological principles introduced in this paper, self-interested, rational actors should expect a benefit in consideration for a concession that can be seen as a disadvantage in competition for highly qualified managers. Above (4.3.3.), we have already mentioned the possible benefit of a modest regulation of the managers’ salaries in relation to the employees’ salaries. Such a self-binding commitment of the decision-makers within the firms could boost employee morale and could contribute to a good working atmosphere, which could also be perceived as an advantage by the managers themselves. Another benefit of such a private ordering regulation could be an increase in public reputation of participating firms and of those managers’ public reputation who voluntary relinquish part of their compensation. These benefits can compensate for or can even exceed the regulatory disadvantages. The question arises of how a commitment to abide to certain private ordering regulatory rules is secured, or how it is fortified by sanctions. If one drew a graph of reputation gains and reputation losses, reputation capital would be acquired in a long-lasting process by exercised compliance in reciprocal trust games while losses would occur promptly and sharply. While the benefits of a certain self-binding regulatory commitment for managers and the shareholders reflected in the managers’ and the firms’ market value takes time to emerge, noncompliance can dramatically destroy the acquired reputation capital.

In case the regulation is set and imposed in public ordering procedures, the consequences are different. Public benefits of public ordering regulation are not ascribed to the private actors who abide by these rules. Compliance is taken for granted, and addressees are only hit by the regulatory flaws without being compensated for these by reputation gains. Of course, noncompliance would be punished with reputational damage. This is expressly applicable to legal noncompliance. Legal and informal strategies to circumvent regulation can lead to reputation losses as well. But because no reputational capital has been acquired through regulation and because compliance has not been made part of a self-binding commitment in trust games30 with employees and the concerned public (e.g. customers), the possible losses are comparatively low. Hence, the public ordering regulation could prevent private ordering regulation, and, if the latter is already in place, could even effectively suspend it by giving companies nothing to lose. As a result, on the one hand, public ordering regulation for management compensation schemes is marred by an institutional deficit if it implemented as an alternative to private ordering regulation and therefore is less likely to achieve the regulatory goals. On the other hand, public ordering regulation has the potential to overrule private ordering regulation by nearly causing the regulatory benefits for the addressees to vanish.

7. Outlook

We have shown that the different approaches of public and private ordering regulation have their benefits as well as their flaws. Focus must therefore be not only on the intended but also on the unintended (side-)effects. In the light of a comprehensive impact analysis, one can normatively evaluate the regulation and thereon decide which regulatory path to follow. In this article, we tried to lay the groundwork for this decision. Whichever goals one follows in private and public ordering regulation of management compensation schemes, the valuable contribution of positive economic analysis is to display regulatory cost-benefit constraints of actions taken and to illuminate the factual instead of the intended outcome.


* Prof. Dr. Dr. Dr. h.c. Christian Kirchner, LL.M. (Harvard), Humboldt-University of Berlin (; David Christoph Ehmke, PhD-candidate at Humboldt-University of Berlin, and graduate student at the University of Oxford ( We are very grateful to Professor Dr. Gerhard Dannemann, Christoph Schuller, and an anonymous referee for their valuable and helpful comments.

1 A proposal for how to overcome the sovereign financial distress crisis: Christian Kirchner and David Ehmke, ‘Private Ordering in Sovereign Debt Restructuring: Reforming the London Club’ (2012) Oxford University Comparative Law Forum 3 accessed 9 November 2013.

2 Oliver Williamson, ‘Opportunism and its Critique’ (1993) 14 Managerial and Decision Economics 97–107.

3 Eirik Furubotn and Rudolf Richter, Institutions and Economic Theory (2nd edn, University of Michigan Press 2005) 11.

4 Charles Blankart, Öffentliche Finanzen in der Demokratie (8th edn, Vahlen 2011) 2 f.

5 Furubotn and Richter (n 3) 3.

6 The assumption of rationality is challenged and replaced by the assumption of bounded rationality, e.g., by Mathias Erlei, Martin Leschke, and Dirk Sauerland, Neue Institutionenökonomik (2nd edn, Schaefer Poeschel 2007) 2-6; Richter and Furubotn (n 3) 2-14; Stefan Voigt, Institutionenökonomik (2nd edn, UTB 2009) 19-33.

7 Blankart (n 4) 12 ff.

8 Ronald Coase, ‘The Nature of the Firm’ (1937) 4 (16) Economica 386.

9 For different types of institutions see: Voigt (n 3) 25–33.

10 Christian Kirchner and David Ehmke, ‘State and Law’ in Wolfgang Merkel, Hans-Jürgen Wagener, and Raj Kollmorgen (eds) Handbook of Transformation Research (VS-Verlag 2014).

11 For a critical analysis of the principal agent problem in the relation of managers and shareholders, and thereby the role of compensation schemes see: Lucian Bebchuk and Jesse Fried, ‘Executive Compensation as an Agency Problem’ (2003) 17 (3) Journal of Economic Perspectives

12 Christian Kirchner, ‘Privatrechtsmethodik: ökonomische und transnationale Ansätze’ in Stefan Grundmann et al. (eds), Festschrift 200 Jahre Juristische Fakultät der Humboldt-Universität zu Berlin (De Gruyter 2010) 937, 946 f

13 Jonathan Ben Shlomo and Tristan Nguyen, ‘Reformierung der Vergütungssysteme für die Finanzbranche – eine rechtsökonomische Analyse’ (2011) 19 Journal für Rechtspolitik 147 ff.

14 See Chapter 5.2 and 5.3. A detailed overview for the German regulation concerning the question of appropriateness is provided by Elske Meyer, Vorstandsvergütung, Eine rechtsökonomische Analyse zur Angemessenheit der Vorstandsvergütung (Nomos 2013), 182 ff. However, legal scholarship can not fully eliminate the legal uncertainty caused by not clearly defined terms open to various interpretations by judges, especially in the absence of a doctrine of binding precedent.

15 Christian Kirchner, ‘Public Choice and New Institutional Economics’ in Pio Baake and Rainald Borck (eds) Public Economics and Public Choice, Contributions in Honor of Charles B. Blankart (Springer 2007) 19, 21 – 23.

16 Michael Jensen and William Meckling, ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’ (1976) 3 Journal of Financial Economics 305.

17 For an analysis of the benefits and flaws of decision-making by the shareholders (e.g. in general shareholders meeting) see: Thomas Krautz, Mitentscheidungsrechte der Aktionäre – eine ökonomische Analyse am Beispiel der Holzmüller- und Gelatine-Entscheidungen des Bundesgerichtshofs (Nomos 2012).

18 A recent report by Mercer reflects that a majority of institutes surveyed by Mercer plan to increase the fixed component of the management compensation scheme in order to maintain the overall compensation package for their managers. [Mercer, ‘Global Financial Service Executive Remuneration Report’ (Mercer, 18 July 2013) accessed 10 November 2013.

19 For more information about the from the initiators see: Swiss 1:12 initiative < > accessed 9 November 2013.

20 Alexander Hagelüken, ‘Gegen die Zockerei der Banker’ Sueddeutsche Zeitung (Munich, 28 February 2013) accessed 9 November 2013; Marcel Fratzscher, ‘Falsche Reize’ (2013) DIW <http:”” sixcms=”” detail.php?id=””> accessed 9 November 2013.</http:>

21 Abhijit Banerjee, ‘A Simple Model of Herd Behaviour’ (1992) 107 The Quarterly Journal of Economics 797

22 For an analysis of possible benefits and flaws of liability, or limited liability respectively see: Ingo Pies and Peter Sass, ‘Wie sollte die Managementvergütung (nicht) reguliert werden? – Ordnungspolitische Überlegungen zur Haftung von und in Organisation’ (2011) working paper accessed 28 August 2013.

23 The CRD-IV-Directive can be found here: accessed 29 August 2013.

24 Gesetz zur Angemessenheit der Vorstandsvergütung (VorstAG), 31.07.2009 BGBl. I S. 2509 (Nr. 50), in force on 05.08.2009.

25 See footnote 14.

26 For the liability of the supervisory board members in Germany see: Meyer (n 14) 129 – 142.

27 Meyer (n 14) 253 – 264.

28 For more information about the initiative see: <http:””></http:>.

29 Kirchner and Ehmke (n 10).

30 Tanja Ripperger, Ökonomik des Vertrauens, Analyse eines Organisationsprinzips (Mohr Siebeck 1998) 45 – 51.

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