Are Incentive Contracts Rigged by Powerful CEOs?
Introduction (via Harvard Law)
In our paper Are Incentive Contracts Rigged By Powerful CEOs?, which is forthcoming in the Journal of Finance, we argue that powerful CEOs induce their boards to shift the weight on performance measures towards the better performing measures, thereby rigging the incentive part of their pay. The intuition is developed in a simple model in which some powerful CEOs exploit superior information and lack of transparency in compensation contracts to extract rents. The model delivers an explicit form for the rigging of CEO incentive pay along with testable implications that rigging is expected to (1) increase with CEO power; (2) increase with CEO human capital intensity and uncertainty about a firm’s future prospects; and (3) negatively impact firm performance.
Findings (via Harvard Law)
The findings have important policy implications. A direct solution to rigging would be to require more explicit disclosure of ex ante incentive pay contracts. The argument that poor disclosure is justifiable given firm concerns about leaking competitive information and difficulty in recruiting executives strikes us as overstated and self serving. It is, therefore, reassuring to note regulatory efforts in this regard, with the SEC sending letters to 350 companies in 2007 critiquing the way they described the pay of their top executives. Even in the absence of better disclosure, the good news from our paper is that contract rigging might be reduced in other ways as well. Our results suggest that policies that increase the independence of boards may be effective in reducing contract rigging by powerful CEOs. In addition, rigging may be moderated in firms with stronger governance along other dimensions.