39 Pages Posted: 29 Jun 2017
Date Written: June 27, 2017
There is considerable debate on whether executive compensation contracts are designed to maximize firm value or a result of rent extraction. The endogenous nature of executive pay contracts limits the ability of prior research to answer this question. In this study, we utilize the events surrounding a surprising and quick enactment of a new law that restricts executive pay to a binding upper limit in the insurance, investment and banking industries. This quasi-natural experiment enables clear identification. If compensation contracts are value maximizing, any outside restriction to the contract will diminish its optimality and hence should reduce firm value. In contrast to the predictions of the value maximization view of compensation contracts, we find significantly positive abnormal returns in these industries in a short-term event window around the passing of the law. We find that the effect is concentrated only for firms in which the restriction is binding. We find similar results using a regression discontinuity design, when we restrict our sample to firms with executive payouts that are just below and just above the law’s pay limit. We find that the correlation between the annual expected pay savings and the increase in firm value around the event date is 82%. We also find that the increase in firm value is greater for firms with weaker corporate governance and smaller for firms that grant a greater portion of their executive compensation in the form of equity. Lastly, in a series of placebo tests, we find no evidence of significant abnormal returns in the period just before the event window nor in the period just after the event window. These results provide causal evidence that, in equilibrium, compensation contracts can be set in a way that does not maximize firm value.
Keywords: Executive Compensation; Governance; Optimal Contracts
JEL Classification: G30; G38; M12; M48; M52
Suggested Citation: Suggested Citation
Abudy, Menachem (Meni) and Amiram, Dan and Rozenbaum, Oded and Shust, Efrat, Do Executive Compensation Contracts Maximize Firm Value? Evidence from a Quasi-Natural Experiment (June 27, 2017). Columbia Business School Research Paper No. 17-69. Available at SSRN: https://ssrn.com/abstract=2993052