Palace Coup, Inside Rival, Investment, and the Optimal CEO Compensation Scheme

Abstract

In this paper, I claim that threat of palace coup by an inside rival can be used as an effective disciplinary method on the Chief Executive Officer. I set up the moral hazard model with hidden information with respect to the idiosyncratic intrinsic risk associated with the CEO?s investment choice. Then, I analyze the relationship among the investment choice, the role of palace coup, the rent-seeking by the CEO, the optimal CEO compensation scheme, and the changing direction of reservation wage for the CEO position and the second position. I find that, under information asymmetry about the intrinsic risk of the investment between the board of directors and the CEO, the optimal compensation scheme is to retain a fixed risk-free compensation and a fixed risk-sharing compensation, rather than adjusting them according to the investment variation. With that consistent fixed wage policy, in equilibrium, a reckless investment can be deterred. By widening the gap in the reservation wage between CEO position and second position, board of directors gives a greater incentive to the inside rivals to launch a palace coup. Then, the board of directors can effectively prevent the CEO from rent-seeking with a reckless investment and from bribing rents to the inside rival within the management team. These results well explain the current phenomena of the soaring CEO compensation and the widening gap of the compensation between the CEO and the second man, which are explained by the extant theory with limit.