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Do Executive Compensation Contracts Maximize Firm Value? Evidence from a Quasi-Natural Experiment

40 Pages Posted: 3 Oct 2017  

Menachem (Meni) Abudy

Bar-Ilan University - Graduate School of Business Administration

Dan Amiram

Columbia Business School - Accounting, Business Law & Taxation

Oded Rozenbaum

George Washington University - School of Business

Efrat Shust

School of Business, College of Management Academic Studies

Date Written: September 13, 2017

Abstract

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 the contracts limits the ability of prior research to answer this question. In this study, we use events surrounding the surprising and quick enactment of a new law restricting executive pay to a binding upper limit in the insurance, investment and banking industries. This quasi-natural experiment enables clear identification. In contrast to the predictions of the value maximization view, we find significantly positive abnormal returns in these industries in a short-term event window around the passage of the law. This effect is concentrated among firms bound by the restriction. 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%. Ruling out possible alternative explanations, 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, on average, 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

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 (September 13, 2017). Columbia Business School Research Paper No. 17-69; 28th Annual Conference on Financial Economics and Accounting. Available at SSRN: https://ssrn.com/abstract=2993052

Menachem Abudy

Bar-Ilan University - Graduate School of Business Administration ( email )

Ramat Gan
Israel

Dan Amiram (Contact Author)

Columbia Business School - Accounting, Business Law & Taxation ( email )

3022 Broadway
New York, NY 10027
United States

Oded Rozenbaum

George Washington University - School of Business ( email )

Washington, DC 20052
United States
202-994-5992 (Phone)

Efrat Shust

School of Business, College of Management Academic Studies ( email )

Yitzhak Rabin Blvd.
Rishon LeZion, 75190
Israel

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