Serial CEO incentives and the structure of managerial contracts

I explore CEOs’ incentives to select firm strategies and to acquire firm-specific skills when CEOs have job-hopping opportunities. Several features of managerial compensation, such as benchmarking of pay to larger and more prestigious companies, payments unrelated to past performance, unrestricted stock awards for highly paid CEOs, long-term incentives, and higher pay in companies granting long-term incentives, emerge in the optimal contract. I argue that the model can explain the change in the structure and the surge in US CEO compensation as well as differences across countries and across firms within a country.     

Earnings vs. stock-price based incentives in managerial compensation contracts

We develop a theory of stock-price-based incentives even when the stock price does not contain information unknown to the firm. In our model, a manager must search for and decide on new investment projects when the market may have a difference of opinion about the quality of the firm’s investment opportunities. The firm optimally provides incentives based solely on realized earnings, leading to an efficient investment policy, when the market has congruent or pessimistic beliefs; however, the firm optimally introduces stock-price-based incentives, leading to an inefficient investment policy, when the market has optimistic beliefs. If the firm can raise equity capital on favorable terms, negative NPV projects from the perspective of the firm may be positive NPV projects from the perspective of current shareholders. The firm motivates the manager to take such projects by basing some compensation on the current stock price.     

Secured debt and managerial incentives

Financial theory holds that firms can control agency costs through the use of short-term and secured debt. We examine the relation between the use of secured debt and the incentive of the manager to increase the risk of the firm, as measured by vega. We find that firms utilize secured debt to a lesser extent when managerial volatility sensitivity is higher. Our results suggest that these same firms employ short-term debt as the primary tool to control risk-shifting. Managers with a high risk appetite avoid secured debt, but appear to do so without compromising the interests of the shareholders.     

Insider trading and managerial incentives

We derive conditions under which permitting manager “insiders” to trade on personal account increases the equilibrium level of output and the welfare of shareholders. These increases are produced by two effects of insider trading. First, insider trading impounds information about hidden managerial actions into asset prices. This impounding of information allows shareholders to make better personal portfolio-allocation decisions. Second, allowing insider trading can induce managers to increase, on average, the correlation between their personal wealth and firm value beyond the level dictated by the employment relationship alone. This increased correlation increases managerial incentives. When these two effects are only weakly present, permitting insider trading harms shareholders, because insider trading reduces shareholder control over the performance–compensation relationship. In addition, when managerial effort incentives are high and corporate governance costs are low, managers may prefer insider-trading restrictions because such restrictions force shareholders to offer them a larger fraction of output through the employment relationship.     

Industry product market competition and managerial incentives

While some studies suggest that industry product market competition can substitute for managerial incentives, other studies suggest a complementary relation. The underlying assumption behind these studies is that competition can be uni-dimensionally proxied for by industry concentration. However, recent studies suggest that competition can reflect several dimensions: product substitutability, market size, and entry costs, given the level of industry concentration. Using these determinants of competition, this study contributes to the literature by showing that (a) firms provide stronger incentives when industry competition is greater, (b) competition is multi-dimensional in its relation to incentives; and (c) industry characteristics play a major role in influencing incentives.     

Uncertainty,investment, and managerial incentives

This study provides evidence that managerial incentives, shaped by compensation contracts, help to explain the empirical relationship between uncertainty and investment. We develop a model in which the manager, compensated with an equity-based contract, makes investment decisions for a firm that faces time-varying volatility. The contract creates incentives that affect both the sign and magnitude of a manager׳s optimal response to volatility shocks. The model is calibrated using compensation data to quantify this predicted investment response for a large panel of firms. Our estimates help explain the variation in firm-level investment responses to volatility shocks observed in the data.     

Capital structure and the control of managerial incentives

We present a theory of capital structure based on the power of shareholders, bondholders and managers to control the incentive conflicts in large corporations. The manager–owner conflict produces a trade-off between inefficiency in the low state and rents in the high state, and the shareholder–bondholder conflict produces under-investment as in Myers [Journal of Financial Economics 19 (1997) 147]. Since managers and bondholders both prefer more efficient actions in the low state, the two conflicts are interdependent. With risk-less levels of debt, there are no shareholder–bondholder agency costs, but managerial control over the incentive-setting process produces excessive rents. With risky debt, shareholders focus more on returns in the high state so that shareholder–bondholder agency costs increase but managerial rents decrease. Efficient levels of debt holder protection facilitate a reduction in manager–owner agency costs that outweighs shareholder–bondholder agency costs, and are decreasing in firm performance. The results are consistent with the separate empirical results relating control to both compensation and leverage, and suggest how future studies can be integrated.     

Internal managerial promotions: Insider incentives and CEO succession

We identify and compare firms that promote a single executive (successor-incentive) and companies that conduct tournaments (tournament-incentive) among inside managers to succeed the CEO. Successor-incentive firms give more pay-for-performance compensation to the designated successor, are more likely in firms or industries where firm-specific human capital is more important to the CEO position and where the supply of potential outside CEO replacements is limited. In addition, these firms are associated with lower CEO turnover sensitivity to firm performance. Restricting firms that are suited for a successor-incentive promotion to a tournament-incentive promotion is associated with lower firm valuation.     

Nonprofit boards: Size,performance and managerial incentives

We examine relations between board size, managerial incentives and enterprise performance in nonprofit organizations. We posit that a nonprofit's demand for directors increases in the number of programs it pursues, resulting in a positive association between program diversity and board size. Consequently, we predict that board size is inversely related to managerial pay-performance incentives and positively with overall organization performance. We find empirical evidence consistent with our hypotheses. The number of programs is positively related to board size. Board size is associated negatively with managerial incentives, positively with program spending and fundraising performance, and negatively with commercial revenue, in levels and changes.     

Integrated ownership and managerial incentives with endogenous project risk

Review of Accounting Studies - Integrated ownership is often seen as a way to foster specific investments. However, even in integrated firms, managers invest to maximize their compensation, which...     

Derivative activities and managerial incentives in the banking industry

Using a sample of 175 publicly traded bank holding companies (BHCs), we find that managerial incentives and external monitoring affect the decision to use derivatives in the banking industry. Managers with incentives that are more closely aligned with the interests of shareholders, as reflected in a high percentage of CEO shareholdings, are less likely to use derivatives when insider holdings exceed 10%. Similarly, when outside directors own substantial equity, the firm is less likely to use derivatives. These results suggest that managers with large equity stakes take advantage of the risk-shifting opportunities of deposit insurance by not hedging. For BHCs with insider holdings below 10%, however, monitoring by outside directors is associated with a greater likelihood of derivative usage. This suggests that monitoring by outside directors may lead to more risk-averse behavior on the part of managers with small equity stakes.     

The role of managerial incentives in bank acquisitions

This paper examines the effect of variables related to management incentives, corporate governance, and performance on the likelihood a bank is acquired. We find that banks with higher levels of management ownership are less likely to be acquired, particularly in acquisitions where target managers depart from their jobs following the acquisition. We document high rates of management turnover following bank acquisitions. This evidence is consistent with an entrenchment hypothesis, where management teams block attempts to be acquired. We find little evidence that any other incentive, governance, or performance variables are systematically related to the probability a bank is acquired.     

Bankruptcy law and financial structure: The impact of managerial incentives

Abstract

Providing the manager of a firm with suitable incentives to act in the investors’ interest may be socially efficient, but not individually rational for the investors themselves. This paper specifies a second-best arrangement and shows how investors can be induced to implement it by means of an optimal bankruptcy code in the case where only standard financial contracts are available. It explains why bankruptcy law should, in some states of nature, let shareholders and senior creditors decide jointly, and provides a rationale for the existence of junior debt, which never enjoys any power of decision.     

Leading indicator variables and managerial incentives in a dynamic agency setting

This paper studies, in a dynamic agency setting, how incentives and contractual efficiency are affected by leading indicators of firms’ future financial performance. In our two-period model, a leading indicator variable provides a noisy forecast of the uncertain return from the manager’s long-term effort, and both contracting parties cannot refrain from renegotiating contract terms based on updated information. We find that the leading indicator can reduce the manager’s long-term effort incentive, as it allows the firm owner to capture more of the resulting return through renegotiated wages (i.e., the manager is held up). By reducing the uncertainty about future aggregate cash flows, the leading indicator also exacerbates the “ratchet” effect and discourages the manager’s short-term effort. In equilibrium, as the leading indicator becomes more accurate in forecasting future cash flows, the first-period contract attaches higher explicit weights to both the forward-looking leading indicator and backward-looking cash flow, and yet the manager may find it optimal to reduce both the short- and long-term efforts. We further show that with a more accurate leading indicator variable, the explicit incentive on the lagging cash flow may increase more than that on the leading indicator, and the equilibrium firm profit may decrease and diverge from the manager’s equilibrium efforts.     

Stakeholder orientation and managerial incentives: Evidence from a natural experiment

This paper examines the influence of stakeholder orientation on the design of managerial incentives. Our tests exploit the quasi-natural experiment provided by the staggered adoption of directors' duties laws (i.e., state-level laws that explicitly expand board members' duties to act in the best interests of all stakeholders). We find that the enactment of these laws results in a significant decrease in the sensitivity of CEO wealth to the stock price. This decrease is mostly driven by firms most exposed to pressures to maximize short-term stock price. Our results suggest that the decrease in the sensitivity of CEO compensation to the stock price is an important channel boards use to internalize stakeholder orientation.     

West meets east: Understanding managerial incentives in Chinese SOEs

State-owned enterprises (SOE) are essentially extensions of the government and are therefore responsible for multi-task objectives. The incentive system for SOE managers consists of both monetary compensation and promotion within the bureaucratic system. Political promotion is key to understanding the incentives of SOE managers. In the reform and opening up era, SOEs have been reformed and exposed to political and market forces. The design of incentive systems for SOE managers has thus become complicated and challenging. Our study provides important implications for this key issue of SOE reform.     

Empire-builders and shirkers: Investment,firm performance,and managerial incentives

We consider the equilibrium relationships between incentives from compensation, investment, and firm performance. In an optimal contracting model, we show that the relationship between firm performance and managerial incentives, in isolation, is insufficient to identify whether managers have private benefits of investment, as in theories of managerial entrenchment. We estimate the joint relationships between incentives and firm performance and between incentives and investment. We provide new results showing that investment is increasing in incentives. Further, in contrast to previous studies, we find that firm performance is increasing in incentives at all levels of incentives. Taken together, these results are inconsistent with theories of overinvestment based on managers having private benefits of investment. These results are consistent with managers having private costs of investment and, more generally, models of underinvestment.     

Information-based stock trading and managerial incentives: evidence from China's stock market

This paper uses stock price informativeness, or information-based stock trading, to help explain the pay–performance sensitivity (PPS) of chief executive officer (CEO) compensation in China's listed firms. We argue that higher stock price informativeness, which we measure by the probability of informed trading, helps and encourages shareholders to incentivize the top management team based on stock market performance. The regression results support our argument and show that a higher level of stock price informativeness is associated with higher CEO PPSs. Moreover, the impact of stock price informativeness on CEO incentives is stronger for privately controlled listed firms than it is for state-controlled listed firms. The results also hold when information asymmetry is approximated by the accuracy and dispersion of the earnings forecasts made by financial analysts.     

The influence of managerial incentives on the resolution of financial distress

This study investigates the influence of managerial incentives on the resolution of financial distress. Our model predicts that when creditors and equityholders prefer different resolution methods, the likelihood of choosing Chapter 11 over private renegotiation is related to the ownership structure of the distressed firm. Empirical test results using a sample of 81 voluntary Chapter 11 firms and 65 private workout firms support the model’s prediction. We show that managerial ownership is positively related to the incidence of Chapter 11 filing when there is conflict between equityholders and creditors over the choice between Chapter 11 and a private renegotiation. Consistent with prior literature, we also find that the choice of resolution methods depends on the extent of creditor holdout problems and the level of economic distress. We also performed the analysis of a subsequent 5 years of post-distress performance for all sample firms. The majorities of firms that file for Chapter 11 lose their independence and are either acquired or liquidated. However, more than half of firms in private workouts survived as independent firms.

Monitoring mechanisms,managerial incentives,investment distortion costs,and derivatives usage

We relate derivatives usage to the level of corporate governance/monitoring mechanisms, managerial incentives and investment decisions of UK firms. We find evidence to suggest that the monitoring environment, e.g., board size, influences both currency and interest rate derivatives usage. Managerial compensation plans also influence derivatives usage. Investment decisions are affected by the governance and managerial compensation plans of firms, which in turn impact on derivatives usage. We find a strong tendency for UK firms to reduce derivatives usage in situations where derivatives usage should be increased. There is limited evidence that firms use hedging substitutes to avoid monitoring from external capital markets.