Managerial Compensation Contracts Research Articles

The impact of top management team incentive dispersion on Non-GAAP reporting

We examine whether the dispersion of pay-performance sensitivity (PPS) amongst the top management team (TMT) impacts the likelihood of firms disclosing non-GAAP earnings and the quality of non-GAAP earnings. Management compensation contracts are designed to incentivize executive team members individually and in the aggregate. By structuring these contracts to have similar PPS, those charged with governance can increase collaboration amongst the TMT. However, this collaboration can turn into the TMT colluding to make firm decisions that result in the highest compensation for the TMT. Thus, a greater dispersion of PPS can lead to less collusion. We find that the likelihood of firms reporting non-GAAP earnings decreases and the quality of non-GAAP earnings disclosures increases when there is a higher dispersion of PPS. These findings are consistent with executives that are less incentivized by temporary stock price increases suppressing other executives from eliciting firm scrutiny by disclosing non-GAAP earnings and releasing low-quality non-GAAP earnings. Additionally, we find these effects on non-GAAP earnings are more likely to occur in firms with weaker governance and when the management team has a shorter tenure of working together. Overall, our research provides evidence of the association between the dispersion of TMT PPS and non-GAAP earnings decisions.

Environmental delegation versus sales delegation: a game-theoretic analysis

AbstractRecently, in their 2019 paper, Poyago-Theotoky and Yong consider a managerial Cournot duopoly with pollution externalities and emission taxes and propose an explicit environmental incentive in a managerial compensation contract. The authors compare several exogenous equilibria emerging in the symmetric sub-games in which the owner offers either the environmental delegation contract or the standard sales delegation contract: abatement and social welfare (resp. emission taxes) under environmental delegation are higher (resp. lower) than under sales delegation. The present work extends their model using a game-theoretic approach to analyse the asymmetric sub-games, in which only one firm adopts the environmental contract, and adds the contract decision stage. Results show that the environmental contract never emerges as the unique sub-game perfect Nash equilibrium of this non-cooperative managerial decision game. Indeed, if the green R&D technology is efficient, the sales contract emerges as the unique Pareto-inefficient Nash equilibrium. Otherwise, if the green R&D technology is inefficient, multiple Nash equilibria in pure strategies exist (coordination game). Our findings offer direct policy implications.

Economic consequences of managerial compensation contract disclosure

We analytically study the economic consequences of the disclosure of managerial compensation contracts in a setting where two firms, by designing compensation contracts for their respective managers, compete for a new investment opportunity. Each manager is privately informed about her firm's profitability from this investment. We find that the disclosure leads to firms' emphasizing short-term stock performance in their managers' contracts. This, in turn, induces managers to signal favorable private information via myopic overinvestment, which deters rival firms' investments and gains their own firms a competitive edge. Nonetheless, such strategic use of compensation contracts is absent when the contracts are not disclosed; under this regime, equilibrium contracts only focus on long-term outcomes. Moreover, while disclosure-mandate-induced managerial myopia erodes firm profits, it may benefit consumer and social welfare. Our theory illuminates the economic consequences of the Compensation Discussion and Analysis (CD&A) disclosure implemented in 2006.

Fair and Square: A Retention Model of Managerial Compensation

We propose a model of how the retention motive shapes managerial compensation contracts. Once employed, a risk-averse manager acquires imperfectly portable skills whose value is stochastic because of industry-wide demand shocks. The manager’s actions are uncontractible, and the perceived fairness of the compensation contract affects the manager’s motivation. If the volatility of profits is sufficiently large and outside offers are sufficiently likely, the equilibrium contract combines a salary with an own-firm stock option. The model’s predictions are consistent with empirical regularities concerning contractual shape, the magnitude of variable pay, the lack of indexation, and the prevalence of discretionary severance pay. This paper was accepted by Axel Ockenfels, behavioral economics and decision analysis.

Sharing managerial contract information in a vertically related market

Recent research shows that in duopolies with strategic delegation, firm owners have an incentive to always share information about managerial compensation contracts. We study how sharing of contract information is affected by the presence of a supplier. We find that under quantity competition, a partial information‐sharing equilibrium may occur. Firms that share contract information punish their managers for sales to soften supplier pricing. Mandating information sharing increases total welfare but decreases consumer surplus. Under price competition, firms always want to share managerial contract information. Finally, firm profits can be higher under price competition than under quantity competition.

A New Rationale for Not Picking Low-Hanging Fruits: the Separation of Ownership and Control

Recent attempts at explaining the energy-efficiency gap rely on considerations related to organizational and behavioral/cognitive failures. In this paper, we build on the strategic delegation literature to advance a complementary explanation. We show that strategic market interaction may encourage business owners to instill a bias against energy efficiency in managerial compensation contracts. Since managers respond to financial incentives, their decisions will reflect this bias, resulting in a lack of investment.

Multilevel optimal managerial incentives and audit fees to limit earnings management practices

The main objective of this study is to design an optimal managerial compensation scheme and optimal auditor fees to counter income-increasing earnings management behavior. This study draws on game theory with three players: the shareholders, managers and auditors. It considers the possibility of collusion between the manager and auditor and analyzes the different scenarios that may exist between the three players. The results of our study prove that it is possible to establish an optimal managerial compensation contract and optimal auditor fees which will limit earnings management manipulation and guarantee high audit quality. We found that the optimal managerial compensation scheme depends on the firm situation. Moreover, we illustrated how the auditor is motivated by improving audit effort in all possible scenarios. This paper can be considered a tentative effort to provide systematic evidence for designing optimal contracts that align divergent interests between managers and shareholders.

Voluntary Disclosure in a Cournot-Bertrand Duopoly

The literature on voluntary disclosure in oligopolies concentrates either on Cournot markets where firms compete in quantities or on Bertrand markets where firms compete in prices. In this paper we study voluntary disclosure of managerial contract information in a Cournot-Bertrand duopoly where one firm sets quantities while the other firm sets prices. Such a hybrid structure frequently captures firm behavior in real-world markets. Accordingly, this paper contributes to our understanding of how firms' choices of strategic market variables influences firms' voluntary disclosure incentives. In a setting where firm owners provide strategic incentives to their managers and can either disclose the details of the managerial compensation contract or keep them secret, we find that the Cournot firm punishes its manager for sales and the Bertrand firm induces more aggressive market choices by rewarding sales. Firms' disclosure choices in equilibrium depend on the level of product substitution. A full disclosure equilibrium where both firms reveal the details of their managerial contract information occurs if the firms' products are sufficiently differentiated. In this case, voluntary disclosure leads to lower consumer welfare, but higher total welfare than if contract information is kept secret by both firms. If product differentiation is low, then we find two partial disclosure equilibria where either the Cournot firm or the Bertrand firm keeps contract information private. In this case, we argue that mandating disclosure can lead to an increase consumer and social welfare, but might decrease firm profits.

Management compensation contracts and distribution policies in the US technology sector

This paper examines the impact of executive compensation practices on (a) the decision to distribute and (b) the distribution channel employed by companies from the US technology sector. We report that firms that compensate their managers using executive stock options (ESOs) tend to distribute less and firms that use stock awards make more distributions. When we simultaneously examine the distribution and the channel used, we find firms using ESOs restrict their dividend payments but their propensity for stock repurchases is unaffected. Firms using stock awards to compensate managers make greater distributions across all channels. We also provide strong evidence in favour of the agency and leverage explanations for distributions.

Impact of outside option on managerial compensation contract and environmental strategies in polluting industries

To unveil how a manager’s outside option affects managerial compensation contracts and environmental strategies in polluting industries, this article studies an agency problem in which a risk-averse manager has private information about his ability and type-dependent outside option. A compensation contract is designed to incentivise the manager to truthfully report. Meanwhile, the firm makes an optimal choice between end-of-pipe strategy and pollution prevention strategy to maximise its profit. Based on the principal-agent theory, we establish a managerial compensation contract model and derive the optimal contract mechanism by solving its equivalent optimal control problem. The results indicate that without an outside option, the manager receives a constant bonus share rate and no information rent under the end-of-pipe strategy, whereas he obtains a downward distorted incentive and high information rent under the pollution prevention strategy. Considering outside options, the manager may receive information rent under the end-of-pipe strategy while receiving a pooling distorted incentive under the pollution prevention strategy. In a certain circumstance, the managers are pooled with the same bonus share rate and information rent. However, due to the interaction between the countervailing incentives, it is difficult to identify the change in total information rent and the pollution prevention strategy decision.

Managerial Delegation Contracts, “Green” R&D and Emissions Taxation

AbstractWe introduce an explicit environmental incentive into a managerial compensation contract in the context of a Cournot duopoly with pollution externalities under an emissions tax regime. We show that, depending on the effectiveness of “green” R&D, compared to a standard sales compensation contract, the explicit environmental focused contract results in more abatement. As a consequence, the regulator sets a lower emissions tax, and social welfare is higher. Moreover, in general, firm owners earn higher profits when adopting the environmental delegation contract.

Motivating high‐impact innovation: Evidence from managerial compensation contracts

AbstractWe investigate the relationship between Chief Executive Officer (CEO) compensation and firm innovation and find that long‐term incentives in the form of options, especially unvested options, and protection from managerial termination in the form of golden parachutes are positively related to corporate innovation, and particularly to high‐impact, exploratory (new knowledge creation) invention. Conversely, non‐equity pay has a detrimental effect on the input, output and impact of innovation. Tests using the passage of an option expensing regulation (FAS 123R) as an exogenous shock to option compensation suggest a causal interpretation for the link between long‐term pay incentives, patents and citations. Furthermore, we find that the decline in option pay following the implementation of FAS 123R has led to a significant reduction in exploratory innovation and therefore had a detrimental effect on innovation output. Overall, our findings support the idea that compensation contracts that protect from early project failure and incentivize long‐term commitment are more suitable for inducing high‐impact corporate innovation.

Short Selling and Executive Pay-for-Performance Sensitivity

Based on the launch of short selling in our country as the background, using the data of the a-share listed company from 2007 to 2016 in China, we built the model and empirically proved the impact of short selling on the target company executive compensation contracts. And then we discussed how the different supervision mechanism and the management rights affected their relationship. This paper finds out that the implementation of short selling improved Executive Pay-for-performance Sensitivity of the target company. In the weak supervision mechanism of listed companies, short selling can significantly improve the Executive Pay-for-performance Sensitivity, while in strong supervision mechanism of listed companies, short selling can’t play a role; further from management right consideration, we found that in the higher management rights of listed companies, short selling can significantly improve its Executive Pay-for-performance Sensitivity, and in lower management rights of the listed company, short selling has no significant influence on management compensation contracts.

Funding Life Insurance Contracts with Guarantees: How Can We Optimally Respond to the Policyholder's Needs?

We study a problem of non-concave utility maximization under a fair pricing constraint. The framework finds many applications in, for example, the optimal design of managerial compensation or equity-linked life insurance contracts. Deriving closed-form solutions, we observe that the fair pricing constraint will reduce the riskiness of the optimal strategies substantially. In an extensive numerical section, we analyze innovative retirement products that adapt the investment strategy of the premium pool according to the policyholder's preferences, modeled as constant relative risk aversion (CRRA). Such products are a response to the loss of attractiveness of traditional life insurance contracts with guarantees that are negatively affected by increasing solvency requirements for return guarantees and a general decrease in interest rate levels. Taking into account that retirement products are usually tax-privileged, we find that fairly priced guarantee contracts that follow this optimal investment strategy lead to a higher expected utility level than asset investments.

Managerial Short-Termism, Turnover Policy, and the Dynamics of Incentives

I study managerial short-termism in a dynamic model of project development with hidden effort and imperfect observability of quality. The manager can complete the project faster by reducing quality. To preempt this behavior, the prin cipal makes payments contingent on long-term outcomes. I analyze the dynamics of the optimal contract and its implications for the level of managerial turnover. I show that optimal contracts might be stationary and entail no termination. In general, I show that the principal reduces the manager’s temptation to behave myopically by reducing the likelihood of termination and deferring compensation. The model predicts a negative relation between the rate of managerial turnover and the use of deferred compensation that is consistent with evidence of managerial compensation contracts. Received May 23, 2016; editorial decision May 27, 2017 by Editor Francesca Cornelli.

Can Clawback Provisions in Management Incentive Contracts Backfire and Lead to More Risk Taking?

Proposals after the last financial crisis in 2008 call for an extension of the scope of clawback provisions in compensation contracts beyond what is commonly legally required. Under such an extended scope, managers would be held accountable for losses. The reason for such an extended scope is to counter incentives for excessive risk-taking that are currently present in many bonus contracts. We argue that such a call for an extended scope of clawback provisions ignores implications from prospect theory and motivated reasoning. We propose that holding managers accountable under an extended clawback regime may backfire and lead to additional risk-taking if risk-taking is a means for avoiding personal liability. This is specifically the case when managers make an investment decision in a loss state, where an investment alters only the size of a loss. We argue that additional accountability in such a setting leads to a motivated reasoning process. Managers overweigh positive project success factors and underestimate risk. We further propose that this effect occurs despite a higher risk tolerance, as suggested by prospect theory. Using an experiment, we find empirical evidence that is consistent with our predictions. Our findings contribute to the debate of extending the scope of clawback provisions in management compensation contracts. We also expand the research on prospect theory by showing that motivated reasoning processes occur even when prospect theory implies a higher risk tolerance, which conceptually should negate the need for motivated reasoning.

The impact of clawback provisions on information processing and investment behaviour

Proposals after the last financial crisis in 2008 have called for an extension of the scope of clawback provisions in compensation contracts beyond what is commonly legally required. Under such an extended scope, managers would be held accountable for losses. The reason for such an extended scope is to counter incentives for excessive risk-taking that are currently present in many bonus contracts. We argue that such a call for an extended scope of clawback provisions ignores implications from prospect theory and motivated reasoning. We propose that if an investment decision can lead to either a gain or a loss for a company, then clawback provisions have a restraining effect on risk-taking compared to bonus-only contracts. In contrast, if the outcome of a decision affects only the potential size of a company’s loss, then clawback provisions lead to additional risk-taking compared to bonus-only contracts. In addition, we argue that additional accountability in a loss position leads to a motivated reasoning process. Managers overweigh positive project success factors and underestimate risk. We further propose that this effect occurs despite a higher risk tolerance, as suggested by prospect theory. Through an experiment, we find empirical evidence that is consistent with our predictions. Our findings contribute to the debate about extending the scope of clawback provisions in management compensation contracts. We also expand the research on prospect theory by showing that motivated reasoning processes occur even when prospect theory implies a higher risk tolerance, which conceptually should negate the need for motivated reasoning.

Executive pensions, risk-shifting, and foreign exchange exposure

Using a hand-collected executive compensation database of 272 large U.S. firms from 2000 to 2009, we present the first study of its kind to analyze the effects of executive pension-based compensation on foreign exchange exposure. We find evidence that higher executive pension compensation results in lower foreign exchange exposure among our sample firms, an effect that is strongest when sample firms are closest to bankruptcy. Our results have important implications for the structuring of managerial compensation contracts for multinational firms.

CLAWBACK PROVISIONS IN REAL ESTATE INVESTMENT TRUSTS

AbstractUsing a sample of 195 unique real estate investment trusts (REITs), we examine factors related to the adoption of clawback provisions within managerial compensation contracts. In general, we find strong and consistent empirical evidence that clawback provision are directly related to firm size, complexity, leverage, growth options, monitoring incentives, and CEO performance incentives. We also find that clawbacks are associated with enhanced market and accounting performance, with stronger performance relations observed for adoption decisions tied directly to regulatory mandates. In sum, we conclude compensation clawback provisions represent a value‐relevant, strategic governance mechanism for REITs.

Endogenous managerial compensation contracts in experimental quantity-setting duopolies

Given the ongoing debate on managerial compensation schemes, our paper offers empirical insights on the strategic choice of firms' owners over the terms of a managerial compensation contract, as a commitment device aiming at gaining competitive advantage in the product market. In a quantity setting duopoly we experimentally test whether firms' owners compensate their managers through contracts combining own profits either with revenues or with relative performance, and the resulting managerial behaviour in the product market. Prominent among our results is that firms' owners choose relative performance over profit revenue contracts more frequently. Further, firms' owners successfully induce a more aggressive behaviour by their managers in the market, by setting incentives which deviate from strict profit maximization.