Managerial Compensation Contracts Research Articles

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.

Earnings vs. stock-price based incentives in managerial compensation contracts

We develop a theory of stock-price-based incentives even when the stock price does not contain information unknown to the firm. In our model, a manager must search for and decide on new investment projects when the market may have a difference of opinion about the quality of the firm’s investment opportunities. The firm optimally provides incentives based solely on realized earnings, leading to an efficient investment policy, when the market has congruent or pessimistic beliefs; however, the firm optimally introduces stock-price-based incentives, leading to an inefficient investment policy, when the market has optimistic beliefs. If the firm can raise equity capital on favorable terms, negative NPV projects from the perspective of the firm may be positive NPV projects from the perspective of current shareholders. The firm motivates the manager to take such projects by basing some compensation on the current stock price.

Equilibrium earnings management and managerial compensation in a multiperiod agency setting

To investigate how the possibility of earnings manipulation affects managerial compensation contracts, we study a two period agency setting in which a firm's manager can engage in "window dressing" activities to manipulate reported accounting earnings. Earnings manipulation boosts the reported earnings in one period at the expense of the reported earnings in the other period. We find that the optimal pay-performance sensitivity may increase and expected managerial compensation may decrease as the manager's cost of earnings management decreases. When the manager is privately informed about the payoff of an investment project to the firm, we identify plausible conditions under which prohibiting earnings management can result in a less efficient investment decision for the firm and more rents for the manager.

Equilibrium Earnings Management and Managerial Compensation in a Multiperiod Agency Setting

To investigate how the possibility of earnings manipulation affects managerial compensation contracts, we study a two period agency setting in which a firm's manager can engage in window dressing activities to manipulate reported accounting earnings. Earnings manipulation boosts the reported earnings in one period at the expense of the reported earnings in the other period. We find that the optimal pay-performance sensitivity may increase and expected managerial compensation may decrease as the manager's cost of earnings management decreases. When the manager is privately informed about the payoff of an investment project to the firm, we identify plausible conditions under which prohibiting earnings management can result in a less efficient investment decision for the firm and more rents for the manager.

Investment timing decisions of managers under endogenous contracts

This paper considers what kind of managerial compensation contract is optimal for mitigating the moral hazard decision regarding investment timing. We examine the situation where the personal objectives of managers do not align with those of shareholders and where there is the possibility of project liquidation but where managerial compensation is endogenously determined. Using a real options approach, we show that restricted stock is optimal relative to stock options under various circumstances. However, we also suggest that stock options are more likely to be used instead of, or in addition to, restricted stock in firms with new debt financing and more impatient managers, diversified firms involving more complicated business activities, and firms with weaker corporate governance. In addition, we find that project start-up is more likely to be deterred by the greater likelihood of project liquidation and larger managerial effort cost, whereas the amount of stock-based managerial compensation is independent of the probability of liquidation but is increasing in managerial effort cost.

Common vs. Firm-Specific Risks in Relative Performance Evaluation

This paper examines the trade-off between common and peers’ specific risks in relative performance evaluation (RPE). We establish that in order to remove common risk completely from management compensation contracts, it is sufficient and necessary that peers’ weighted specific risks are lower. Nonetheless, common risk needs not to be removed completely; the optimal use of RPE therefore entails a partial substitution of common for peers’ specific risks unless firms can hedge against peers’ specific risks. These results contribute to our understanding of factors affecting a firm’s peer choices and provide specific implications for the weak- vs. strong-form RPE tests.

Venture Capital, Property Rights, and Managerial Compensation Contracts1

Abstract This paper investigates the impact of venture capital on managers’ compensation contracts. The results show that pay-performance sensitivity (PPS) is higher in venture-capital-backed companies than in non-venture-capital-backed companies. A higher PPS may bring managers of venture-capital-backed companies a higher extra emolument compared with that offered by other companies in the same industry. A further test shows that the positive effect of venture capital on PPS and extra emolument exists in (1) private enterprises rather than state-owned enterprises (SOEs) and (2) in firms backed by highly reputable venture capitalists (VCs) rather than in firms backed by VCs with a low reputation. The findings indicate that even after initial public offerings (IPOs), venture capital still has a positive impact on corporate governance and affects managerial compensation contracts.

Risk Aversion or Downside Risk Aversion, Which Explains the Convexity of Optimal Compensation Contracts?

When is it appropriate to add a convex component such as stock options to an optimal, managerial compensation contract? We show that, contrary to what is said in the literature, it is not risk aversion but cautiousness, a downside risk aversion measure, which gives the answer. When stockholders are risk neutral, convexity is introduced when managers have moderate levels of cautiousness; when stockholders are considered to be risk averse, convexity is introduced when stockholders' and managers' cautiousness measures satisfy certain conditions.

Manajemen Laba Pada Saat Pergantian CEO (Dirut) Di Indonesia

This study investigates earnings management of CEO changes in Indonesia. CEO change is classified either as routine or non-routine based on RUPS (General Shareholders Meeting) and RUPSLB (Extraordinary General Shareholders Meeting) information. The samples are listed company undergoing CEO changes in the Indonesian Stock Market observed from 2000 to 2009. To identify the earnings management practice, modified Jones model of discretionary accruals and Rowchordory’ of real earnings management are employed. The study provides evidence of non-routine incoming CEO undertaking earnings management by minimizing the earnings in the year of CEO change. The evidence shows that reporting minimum earnings is consistent with the notion of new CEO’s engagement in an ‘earnings bath’. However, this study does not support the theory of management compensation contracts during routine CEO changes. In addition, the incumbent CEO in the non-routine changes does not practice earnings management in the final year before the change. Therefore, manipulating earnings is not the argument to a non routine change of CEO.

Good Value from Shared Values: A fraud and risk perspective

Corporate scandals in the last decade have led to renewed focus by auditors and regulators on fraud, risk assessments, and governance reforms. Hernandez (2007) documents auditor perceived associations between risk indications or concerns on dimensions of management ethics and compensation, performance, governance and fraud across auditor risk assessments performed during the continuance stage of an audit at a ‘Big Four’ firm (from 2002 to 2004). Running three separate sets of ordinal regressions, this study notes that assessed risk of fraud, perceived corporate performance risks, and corporate governance risks are independently associated with each other, as well as positively affected by management ethics and integrity concerns perceived by auditors and the pressure and balance of financial and non-financial goal-setting targets in management compensation contracts. This suggests that managers and entities focused by ethics, values, and sustainable goals (lower integrity concerns, less profits pressure) may present themselves with lower audit risk and benefit investors, reducing contracting and agency risks, which may be by simultaneously associated with fraud, governance, and overall entity performance risks. I extend this result into a theoretical model where the entity and its customers, suppliers, regulators, and other stakeholders (‘Five Forces’) share corporate values, lowering audit (and entity contracting) risks, resulting in higher entity value

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.

Determination Of The Performance Measure Of Executive Compensation

<p class="MsoNormal" style="text-align: justify; margin: 0in 0.5in 0pt; mso-pagination: none;"><span style="color: black; font-size: 10pt; mso-themecolor: text1;"><span style="font-family: Times New Roman;">This paper investigates the principal-agent model of executive compensation through an empirical study of the interaction between CEO compensation and firm performance. As a multi level regression analysis that specifically shows the weight of the variance of the main independent variable, above and over the other independent variables, the stepwise multiple regression is employed to induce a statistical model of the pay-performance sensitivity. The stepwise multiple regression offers insights into the different weight assigned to the performance measure. In this respect, variances of the variables related to the change in the market value of firms are specifically weighted against each other in order to determine specific characteristics of the pay-performance relationship. The analysis is consistent with the agency theory that firm’ executives take advantage of the lack of control by firms’ owners to pursuit their personal interests. As the United States’ economy tumbles, the change in CEO total compensation does not seem to follow the accounting criteria of performance measures typically specified in management compensation contracts. The study reveals a lack of relationship between CEO compensation and firm performance. The link running from the change in the market value of firms and the change in CEO total compensation is flawed. The incentives faced by shareholders to discipline executives would be able to increase the performance of firms. It would be absurd for the compensation committee to rely on the single firms’ total assets value as the performance measure of CEO compensation. Other performance vehicles, such as returns, earnings, and cash flows should be considered in the determination of executive compensation. </span></span></p>

Internal Capital Markets, Non-Cash Divestitures and Managerial Incentives

Management compensation contracts are postulated to alleviate the principal-agent conflict in widely-held firms. This paper studies the efficiency of managerial incentives in internal capital markets. The incentives, measured as stock option delta and stock option vega, are estimated based on the entire holdings of manager’s stock and stock options including all the new and previously made grants. Consistent with the finance theory, I find that in internal capital markets the incentives are designed and administered in a sub-optimal way. Moreover, I find that a break-up does not constitute a solution to the agency conflicts that arise inside a complex firm. To the contrary, the evidence suggests that a break-up may be used as a vehicle to derive private benefits of control. This last result contradicts the theoretical predictions found in Scharfstein and Stein (2000).

Technological change and the growing inequality in managerial compensation

Three of the most fundamental changes in US corporations since the early 1970s have been (1) the increased importance of organizational capital in production, (2) the increase in managerial income inequality and pay-performance sensitivity, and (3) the secular decrease in labor market reallocation. Our paper develops a simple explanation for these changes: a shift in the composition of productivity growth away from vintage-specific to general growth. This shift has stimulated the accumulation of organizational capital in existing firms and reduced the need for reallocating workers to new firms. We characterize the optimal managerial compensation contract when firms accumulate organizational capital but risk-averse managers cannot commit to staying with the firm. A calibrated version of the model reproduces the increase in managerial compensation inequality and the increased sensitivity of pay to performance in the data over the last three decades. This increased sensitivity of compensation to performance provides large, successful firms with the glue to retain their managers and the organizational capital embedded in them.

Does firm heterogeneity lead to differences in relative executive compensation?

Cost heterogeneity is an important source of performance disparity among firms. This heterogeneity conditions the strategic decisions that firms make in the product market and can lead to heterogeneity in the design of managerial compensation contracts. I investigate the effect of cost heterogeneity in a strategic product market environment where firms compete à la Cournot. The paper offers new predictions on how executive compensation contracts that account for relative performance must be adjusted for cost differences.

Main Street versus Wall Street: Efficiency and Wealth Redistribution Effects of Insider Trading

By addressing the interaction between security market microstructure and the generalized agency conflict between managers and shareholders, we study the effects of informed insider trading on productive efficiency, price discovery, and wealth redistribution. Insider trading can lead simultaneously to production distortions and higher ex ante shareholder value because there is a redistribution of wealth from uninformed liquidity traders to uninformed outside shareholders through the optimal design of managerial compensation contracts; this is in contrast to the literature that considers insider trading to either unambiguously worsen the managerial agency problem or improve managerial incentives. Security market characteristics, such as the trading noise in the firm's stock, affect productive efficiency by influencing the manager's equity-based compensation and, in turn, equilibrium market liquidity is influenced by firm-specific characteristics. Insider trading can therefore have conflicting effects on productive efficiency and the informational efficiency of stock prices; it also generates wealth redistribution not only between uninformed and informed traders but between uninformed traders and uninformed shareholders as well. We identify the firm and market characteristics that determine the net welfare impact of insider trading.

Pay Me Right: Reference Values and Executive Compensation

This paper studies the impact of external reference values on managerial compensation contracts. We consider the effect of adoption of non-binding pay norms on actal remuneration behavior using a unique country example. We find that introduction of pay norms changed the reference values for CEOs and led to adjustment of executive compensation towards new equilibrium. These pay norms affected pay in firms with actual compensation below and above reference values. Further we find that reference values changed compensation in all types of firms, although executive compensation increased more in firms with more dispersed ownership and control. These results confirm the importance of reference values in bargaining process between owners and managers.

Human Capital, Bankruptcy and Capital Structure

We derive a firm's optimal capital structure and managerial compensation contract when employees are averse to bearing their own human capital risk, while equity holders can diversify this risk away. In the presence of corporate taxes, our model delivers optimal debt levels consistent with those observed in practice. It also makes a number of predictions for the cross-sectional distribution of firm leverage. Consistent with existing empirical evidence, it implies persistent idiosyncratic differences in leverage across firms. An important new empirical prediction of the model is that, ceteris paribus, firms with more leverage should pay higher wages.

Examination of Board Meeting Frequency and CEO Characteristics: A Comparison of Dividend Paying and No-Dividend Firms

This abstract was created post-production by the JFI Editorial Board. The monitoring role of corporate boards has been under close scrutiny by dissatisfied investors in recent years. The Institutional Shareholder Service, Inc., the Business Roundtable, and the National Association of Corporate Directors advocate many suggestions regarding how to improve corporate governance. In this research, we investigate the relation between board monitoring activities, measured by board meeting frequency, and various firm and CEO characteristics under differential dividend payout policies. The theoretical and empirical literature on corporate governance and managerial entrenchment makes a number of unambiguous predictions regarding corporate board activities. We examine these implications and differential characteristics between dividend-paying firms and non-dividend firms by considering firm attributes and managerial compensation contracts. While our results support the theoretical predictions, we also find significant difference between dividend-paying firms and non-dividend firms regarding the board meeting frequency. We also find that duality of CEOs can increase the likelihood of holding more board meetings and the weight of intangible assets do not significantly affect the likelihood of board meeting frequency.

The economics of earnings manipulation and managerial compensation

This article examines managerial compensation in an environment where managers may take a hidden action that affects the actual earnings of the firm. When realized, these earnings constitute hidden information that is privately observed by the manager, who may expend resources to generate an inflated earnings report. We characterize the optimal managerial compensation contract in this setting, and demonstrate that contracts contingent on reported earnings cannot provide managers with the incentive both to maximize profits and to report those profits honestly. As a result, some degree of earnings management must be tolerated as a necessary part of an efficient agreement.