Active Agents, Passive Principals: Does High-Powered CEO Compensation Really Improve Incentives?

45 Pages Posted: 9 May 2002

See all articles by James Dow

James Dow

London Business School - Institute of Finance and Accounting

Clara C. Raposo

ISEG Lisbon School of Economics & Management

Date Written: April 2002

Abstract

In this Paper we use agency theory to study the active role of the CEO in the formulation of corporate strategy. We allow the agent (CEO) to play a role in defining the parameters of the agency problem, in an incomplete contracting model in which the agent can be rewarded based only on financial performance. Contracts can be renegotiated depending on the proposed strategy. We argue that CEOs will have an incentive to propose difficult, ambitious strategies for change. The principal (the shareholders) can mitigate this by pre-committing to pay high compensation regardless of the manager's chosen strategy, and will prefer to do so in times of change. In a less changeable environment, they will prefer to wait and see what strategy is chosen before setting compensation. In some circumstances, they will also prefer, if possible, to pre-commit never to pay high compensation.

Keywords: Agency theory, executive compensation, free-cash-flow theory, strategic complexity

JEL Classification: D82, G30, G34, J33

Suggested Citation

Dow, James and Raposo, Clara C., Active Agents, Passive Principals: Does High-Powered CEO Compensation Really Improve Incentives? (April 2002). Available at SSRN: https://ssrn.com/abstract=311439

James Dow (Contact Author)

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
+44 20 7262 5050 (Phone)
+44 20 7724 3317 (Fax)

Clara C. Raposo

ISEG Lisbon School of Economics & Management ( email )

Rua do Quelhas 6
LISBOA, 1200-781
Portugal

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