Abstract
This paper develops a new theory of CEO compensation based on the opacity of the internal workings of corporations to outsiders and the CEO's ability to divert or tunnel corporate resources to self-enriching uses. In this setting, neither high powered option compensation nor fixed salary compensation is optimal. Firm-value-maximizing compensation designs are low powered, featuring compensation that increases linearly in the book value of assets but is highly concave in performance. This optimal design can be implemented with a menu of capped bonus payments similar to the 80/120 bonus plans observed in practice. Given optimal compensation design, tunneling is concentrated in high market/book firms that are overvalued by outsiders. Eliminating the gap between inside and outside valuations eliminates the optimality of low powered compensation and renders high powered option compensation the best deterrent to tunneling.
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