Do Executive Compensation Contracts Maximize Firm Value? Evidence from a Quasi-Natural Experiment
40 Pages Posted: 3 Oct 2017
Date Written: September 13, 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 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
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