Abstract
Despite their theoretical value in tackling principal–agent problems at low cost to firms there is almost no empirical literature on the prevalence and correlates of performance bonds posted by corporate executives. We show that they are an important feature in today's CEO labour market in China: around one-tenth of corporations deploy performance bonds and they are equivalent to around 14% of CEO cash compensation. Consistent with principal–agent theory bonds are negatively associated with firm sales volatility. The complementarity between bonds and other incentive mechanisms such as bonuses and stock holding is consistent with optimal reward structures for multi-tasking agents. Those CEOs posting bonds are higher in the Communist Party ranks, were promoted via tournaments, and run larger firms, findings consistent with using bonds as an incentive to attract and retain the most able workers. Although state-owned enterprises are just as likely as privately owned ones to use bonds in CEO contracts, some of the theoretical predictions which assume profit-maximising firms do not hold where the state has an ownership stake.
Highlights
The prototypical solution to the principal–agent problem is a performance bond
Performance bonds are prominent in the theoretical literature where they are considered an efficient way of tackling principal–agent problems by ensuring that the threat of personal financial loss can align agent's interests with those of the principal, and can aid in the selection of the right managerial talent
For the first time this paper considers the role of performance bonds, or security deposits, using representative enterprise data for a whole economy
Summary
The prototypical solution to the principal–agent problem is a performance bond. This bond or security deposit is an “up front” payment by a CEO to the firm, which is recoverable, with interest, conditional on good behaviour. It discourages malfeasance because the CEO puts personal wealth in jeopardy, knowing that there is some probability that the bond will not be repaid if she engages in unwanted behaviour. In principle bonds should be attractive to firms because the diminishing marginal utility of money makes the monetary reward required to induce good behaviour larger than the monetary penalty needed to discourage bad behaviour
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