Optimal Contracting with Limited Monitoring: CEO Entrenchment and Pay-For-Luck

Abstract:     
This paper proposes a principal-agent model of efficient contracting with endogenous matching and limited monitoring in which firms compete for CEOs. The model provides a new explanation for empirical regularities usually associated with the skimming or "managerial power" hypothesis. Most notably, CEOs are not punished for either bad performance or bad luck, they are partially entrenched, and they are paid for luck. Furthermore, endogenous matching between CEOs and firms can explain why pay-for-luck is stronger and CEO pay is higher in firms with a more limited monitoring capacity, which can be interpreted as an indicator of bad governance. The model also predicts that an improvement in the monitoring capacity of the worst firms has a spillover effect that increases CEO pay in all firms.

Number of Pages in PDF File: 38

Keywords: CEO pay, corporate governance, entrenchment, monitoring

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