CEO Incentives Research Articles

Editorial Policy

Editorial Policy

Incentivizing CEOs to build customer- and employee-firm relations for higher customer satisfaction and firm value

This research reveals customer- and employee-firm relations to be two routes by which firms can leverage executive incentive structures to create customer and firm value. Analyses of a unique dataset with multiple archival sources show that (1) increases in the proportion of CEOs’ long-term equity-based compensation positively influence actions that build customer- and employee-firm relations as measured by the Kinder, Lydenberg, Domini & Co. (KLD) data source, (2) such effects are stronger in unstable markets, and (3) customer and employee relationship-building actions affect firm value both directly and indirectly via the mediator of customer satisfaction as measured by the American Customer Satisfaction Index (ACSI) data source. The findings have implications for the improvement of customer satisfaction, the role of marketing in the organization, and the design of CEO incentive packages leading to higher customer satisfaction and firm value.

Are Incentive Contracts Rigged by Powerful CEOs?

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 structural 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. Using measures of CEO power and board independence on a large panel of firms in the U.S., we find support for these predictions. Rigging accounts for 10%-30% of the sensitivity of compensation to performance measures and is increasing in CEO human capital and volatility of a firm's future prospects. Moreover, the portion of incentive pay that is predicted by power is associated with negative subsequent future stock performance of the order of 1% and operating performance of 5% per year. Overall, the results provide evidence against the agency substitution theory and support instead the entrenchment skimming theory.

Marital Prenups? A Look at CEO Severance Agreements

Some theoretical literature on firm-specific human capital investment suggests that severance contracts generate strong incentives for CEOs to ensure firm profitability, while the agency problem theory argues severance agreements are a less effective executive compensation measure. Using a unique sample of S&P500 CEO severance agreements between 1993 and 2007, I examine whether and how the existence and structure of severance agreements influence subsequent firm performance, CEO investment behavior, as well as CEO turnover likelihood. I show that while firms with severance agreements tend to perform worse than firms without severance agreements, the structure of severance agreements also makes a significant difference in performance. In particular, I find that firms with cash-only severance contracts underperform other firms that also include equity elements in the agreement. In addition, I find that severance agreements affect CEOs’ risk-taking behavior in that they encourage CEOs to overinvest in R&D. The findings are robust to controls for possible endogeneity concerns. Consistent with these findings I show in event study analysis that shareholders react negatively when firms award CEOs severance contracts and positively when firms cease to do so. Moreover, executives with severance contracts are more likely to be forced out of their firms. Results indicate that severance agreements, rather than promoting incentive alignment between CEOs and shareholders, actually exacerbate agency problems which lead to overinvestment and poor subsequent firm performance.

Performance Pay and Credibility of Performance Measurement: Evidence from CEO Incentive Compensation

This paper investigates the credibility of performance measurement from the evidence of a link between CEO incentive compensation and CEOs` overstatement of their firms` earnings, measured by stock return sensitivities to firms` earnings announcements. It empirically analyzes whether the stock market response to announced earnings is positively related to the CEO`s performance pay. It appears that stock return sensitivities to firms` earnings announcements increased with CEO pay-performance ratio in all earnings categories. Using stock return sensitivities as indicators of a CEO`s overstatement of firm earnings, this suggests not only that such overstatements exist, but also that overstatements are more severe among CEOs with high incentive compensation. This suggests that performance measurements based on performance pay are not credible. In addition to tightening market monitoring, regulatory authorities should develop measures that can reduce overstatement, such as making CEO compensation better linked to long-term performance, which is more difficult to embellish.

Accounting for Net Performance in Managerial Compensation Contracts

Prior empirical compensation studies typically consider net performance (i.e., measured after deducting compensation) while related principal-agent theory is generally based on gross performance measures (i.e., before compensation). We analyze incentive rates in a principal-agent model based on net (and gross) performance. We analytically demonstrate that using gross performance in compensation regressions yields an unbiased estimate of total effort incentives irrespective of whether actual compensation is based on net or gross performance. In contrast, using net performance creates a bias in estimating total effort incentives and yields a non-zero benchmark in testing for the strong-form relative performance evaluation hypothesis. We provide empirical evidence of underestimated total effort incentives when using net performance in compensation regressions, suggesting a possible explanation for surprisingly weak CEO incentives interpreted in prior studies.

The influence of governance on investment: Evidence from a hazard model

Does corporate governance affect the timing of large investment projects? Hazard model estimates suggest strong shareholder governance may deter managers from pursuing large investments. Controlling for investment opportunities, firms with good governance experience longer spells between large investments. However, in the presence of financial constraints or strong CEO incentives (high delta ( δ)), we find no such timing differences. Finally, these higher investment hazard firms exhibit significantly negative long-run operating and stock performance. Overall, our findings are consistent with the notion that poor governance associates with overinvestment.

Tractability in Incentive Contracting: Table 1

This article develops a framework that delivers tractable (i.e., closed-form) optimal contracts, with few restrictions on the utility function, cost of effort, or noise distribution. By modeling the noise before the action in each period, we force the contract to provide correct incentives state-by-state, rather than merely on average. This tightly constrains the set of admissible contracts and allows for a simple solution to the contracting problem. Our results continue to hold in continuous time, where noise and actions are simultaneous. We illustrate the potential usefulness of our setup by a series of examples related to CEO incentives. In particular, the model derives predictions for the optimal measure of incentives and whether the contract should be convex, concave, or linear. (JEL D86, G34) The principal-agent problem is central to many settings in economics and finance, such as compensation, insurance, taxation, and regulation. A vast literature analyzing this problem has found that it is typically difficult to solve, even in simple settings. The first-order approach is often invalid, requiring the use of more intricate techniques. Even if an optimal contract can be derived, it is often not attainable in closed form, which reduces tractability—a particularly important feature in applied theory models. This article develops a broad framework that delivers tractable, closed-form contracts, with few restrictions on the utility function, cost of effort, or noise distribution. The framework requires two conditions: the analysis of a given path of effort levels, and either continuous time or a discrete-time model with a modified timing assumption. Grossman and Hart (1983) show that the Funding: This work was supported by National Science Foundation grants [numbers DMS-0938185 and SES

Hard debt, soft CEOs, and union rents

PurposeThis paper aims to derive insights about optimal managerial compensation and firm capital structure in unionized firms.Design/methodology/approachThis paper uses applied game theory to address problems of CEO motivation in companies with unionized workforces.FindingsManagers can use high levels of debt and costly bankruptcy to win wage concessions from workers. Alternatively, workers can obstruct management in the detection of poor work. CEO compensation that encourages rent sharing may reduce union hostility and associated deadweight losses. Shareholder value may be maximized by CEO incentive contracts with limited upsides, lower levels of pay, and some entrenchment protections.Originality/valueThis is the only study to use applied game theory to look at how CEO pay and capital structure affects the productivity of a unionized workforce.

Introduction of New CEO Incentive Structure and Effects on Firm Policies

We investigate the impact of the creation of a new incentive structure for CEOs resulting from firms initiating equity-based compensation (EBC) as a means of paying top executives on firm policy decisions. Contrasting firm stock and operating performance in the period the CEO is compensated with EBC (EBC period) and the period when EBC is not a component of the executive’s pay (No EBC period) leads us to conclude that awarding stock options and restricted shares to executives is not associated with higher firm value. However, firms have higher unsystematic and total risk levels in the EBC period suggesting that awarding equity-based compensation to CEOs influences their risk-taking behavior. While there is no change in R&D expenses and cash ratios there is a decrease in capital expenditures in the EBC period, which is consistent with reduced overinvestment agency costs. Finally, leverage and dividend payout ratios are similar in EBC and No EBC periods implying that EBC does not impact a firm’s financing policy.

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.

Executive compensation and corporate governance in China

We investigate executive compensation and corporate governance in China's publicly traded firms. We also compare executive pay in China to the USA. Consistent with agency theory, we find that executive compensation is positively correlated to firm performance. The study shows that executive pay and CEO incentives are lower in State controlled firms and firms with concentrated ownership structures. Boardroom governance is important. We find that firms with more independent directors on the board have a higher pay-for-performance link. Non-State (private) controlled firms and firms with more independent directors on the board are more likely to replace the CEO for poor performance. Finally, we document that US executive pay (salary and bonus) is about seventeen times higher than in China. Significant differences in US–China pay persist even after controlling for economic and governance factors.

Investor Reactions to CEOs' Inside Debt Incentives

Pensions and deferred compensation represent substantial components of CEO incentives. Limited disclosure requirements hindered research into these widely used “inside debt” compensation contracts until SEC reforms in 2007 greatly increased their transparency. We study stockholder and bondholder reactions to companies’ initial reports of their CEOs’ inside debt positions. We find that bond prices rise, equity prices fall, and the volatility of both securities drops upon disclosures by firms whose CEOs have sizeable defined benefit pensions or deferred compensation. Similar changes occur for credit default swap spreads and exchange traded options. The results indicate a reduction in firm risk, a transfer of value from equity toward debt, and an overall destruction of enterprise value when a CEO’s deferred compensation holdings are large.

CEO incentives and the cost of debt

Motivated by concerns that stock-based compensation might lead to excessive risk-taking, this paper’s main purpose is to examine the relations between CEO incentives and the cost of debt. Unlike prior research, this paper uses the sensitivities of CEO stock and option portfolios to stock price (delta) and stock return volatility (vega) to measure CEO incentives to invest in risky projects. Higher delta (vega) is predicted to be related to lower (higher) cost of debt. The results show that yield spreads on new debt issues are lower for firms with higher CEO delta and are unrelated to CEO vega. The results also show that yield spreads are higher for firms whose CEOs hold more shares and stock options. In sum, the results suggest that both percentage-ownership and option sensitivity variables are important in understanding relations between CEO incentives and the cost of debt.

The Effect of Risk on the CEO Market

This article presents a market equilibrium model of CEO assignment, pay, and incentives under risk aversion and moral hazard. Each of the three outcomes can be summarized by a single closed-form equation. In the presence of moral hazard, assignment is distorted from positive assortative matching on firm size as firms with higher risk or disutility choose less talented CEOs. Such firms also pay higher salaries in the cross-section, but economywide increases in risk or the disutility of being a CEO do not affect pay. The strength of incentives depends only on the disutility of effort and is independent of risk and risk aversion. If the CEO can affect firm risk, incentives rise and are increasing in risk and risk aversion. We calibrate the losses from various forms of poor corporate governance, such as failures in monitoring and inefficiencies in CEO assignment. ( JEL G34, J33) This article presents a market equilibrium model of CEO assignment, pay, and incentives. Risk-averse managers of different talents are hired in a competitive market by heterogeneous firms, which vary in their size, risk, and level of effort required. The level of pay drives the assignment of talent to firms. The strength of incentives induces the efficient effort level, and is determined by an optimal contracting approach. Our main contribution is to incorporate risk into a CEO market equilibrium in a tractable manner. A large empirical literature has shown that risk is a firstorder determinant of compensation contracts (Demsetz and Lehn 1985; Garen 1994; Core and Guay 1999; Oyer and Schaefer 2004; Peters 2009; Peters and Wagner 2009), but most theories assume risk-neutrality. This assumption is

What Drives CEOs to Take on More Risk? Some Evidence from the Laboratory of REITs

Many have pointed to excessive risk‐taking by the CEOs of financial firms as a contributor to the recent worldwide economic crisis. The same observers often blame questionable corporate governance structures and compensation practices for that risk‐taking. But is this perception correct? And what is the relationship between CEO incentives and risk‐taking outside of the financial industry, where the government guarantees provided by deposit insurance could have distorted incentives?In an attempt to answer these questions, the authors analyze the relationship between CEO incentives and corporate risk‐taking by 101 U.S. REITs during the period 2003 to 2007. Their main finding is that corporate risk‐taking, as measured by the growth rate in corporate debt (the only measure of risk that is completely under the control of the CEO), is inversely related to CEO stock ownership—that is, the larger the CEO's equity ownership stake, the slower the growth in debt financing and financial risk‐taking. At the same time, the authors find that financial risk‐taking is positively related to large cash bonuses for the CEOs and to situations in which the CEO is also chairman of the board of directors. Finally, the authors also report that CEOs who are relatively new to the job grow more slowly and borrow less, suggesting that boards of directors can temporarily contain risky expansion plans by the CEO. These results provide support for those corporate governance reformers who wish to cut cash bonus payments for CEOs in favor of long‐term stock ownership.

Why do Managers Divest Corporate Assets? New Perspectives from Equity Carve-Outs

We investigate the effect of corporate governance on equity carve-out decisions by 199 firms during the period of 1990 to 2009. Consistent with the notion that managerial incentives drive corporate decisions, we find that firms where the CEO and management have larger stock ownership are more likely to carve-out their subsidiaries. Larger firms with prior poor performance are also more likely to carve-out their divisions, while smaller firms with poor prior performance, lower leverage and lower managerial ownership and CEO incentive based compensation tend to sell larger portions of their subsidiaries. We finally demonstrate that for wealth-enhancing strategic decisions such as equity carve-outs outside directors are positively related to value, while CEO tenure and classified board are negatively related to the wealth effects associated with carve-outs.

New Evidence On The Structuring Of CEO Incentive Pay Ratios

<p class="MsoNormal" style="text-align: justify; margin: 0in 0.5in 0pt;"><span style="font-family: "CG Times","serif";"><span style="font-size: x-small;">The model examines both determinants of CEO incentive pay ratios that are controllable by the CEO, and those that are less controllable, based on a sample of 316 Fortune 500 firms in 1992. Firm diversity, firm growth opportunities, outside blockholdings, and the number of analysts following the firm were positively related to CEO incentive compensation ratios, while firm unsystematic risk, CEO stockholdings, and industry regulation had a negative impact. Finally, industry-specific influences were evident on incentive compensation ratios.</span></span></p>

Political Promotion, CEO Incentives, and the Relationship between Pay and Performance

We examine how incentives for political promotion affect compensation policy and firm performance in Chinese state-owned enterprises (SOEs). In contrast to the conventional wisdom that political incentives tend to be misaligned with value maximization, we find that the likelihood that the CEO receives a political promotion is positively related to firm performance. In addition, as predicted by models of career concerns (Baker, Gibbons, and Murphy (1987)) we find that CEOs with a higher likelihood of political promotion have lower pay levels and lower sensitivity of pay to performance. Overall, the evidence suggests that competition in the political job market helps mitigate weak monetary incentives for CEOs in China. Moreover, the Chinese example suggests that state control and political connections are not necessarily inconsistent with good economic incentives.

A dual agency view of board compensation: the joint effects of outside director and CEO stock options on firm risk

AbstractThis paper contributes to multiple agency theory by examining how the compensation schemes awarded to outside directors and the CEO jointly affect firm‐level risk taking. Using data of the S&P 1500 firms from 1997 to 2006, we find support for earlier arguments that providing the CEO, the outside directors, or both with stock options increases risk taking. More importantly, we find that compensating outside directors with stock options has significantly stronger effects than CEO stock options. Finally, contrary to what one would expect, we find that these effects are mutually substituting; that is, if both the outside directors and the CEO are provided with stock option compensation, outside directors' incentives weaken the effect of the CEO's incentives on firms' risk taking. Copyright © 2010 John Wiley & Sons, Ltd.