Executive Compensation Contracts in the Presence of Adverse Selection

48 Pages Posted: 17 Mar 2021

See all articles by Chris Armstrong

Chris Armstrong

University of Pennsylvania - Accounting Department

Luzi Hail

University of Pennsylvania - The Wharton School; European Corporate Governance Institute (ECGI)

Rachel Xi Zhang

University of Pennsylvania, The Wharton School, Students; University of Pennsylvania - The Wharton School

Date Written: March 15, 2021

Abstract

We develop three complementary tests to examine how adverse selection affects the design of executive compensation contracts: First, we show that externally-hired CEOs receive higher total pay and have fewer equity incentives relative to internally-promoted CEOs, consistent with their ability to extract larger information rents due to greater private information. These differences are more pronounced when less is known about the prospective CEO, but quickly dissipate over time. Second, we show that external CEOs’ initial contracts differ more from those of their firm’s incumbent senior managers than do those of internal CEOs—particularly in terms of accounting performance metrics and equity-based pay, in line with the use of these features to elicit private information. Third, we find that following an unanticipated change in option vesting schedules prompted by SFAS 123R, newly appointed executives do not increase their option exercises and share sales—despite their newfound ability to do so—while longer-tenured executives do, consistent with contracts initially being designed to screen for certain types of managers before shifting to encourage certain behaviors. Combined, our evidence supports the distinct role of adverse selection in the design of executive compensation contracts.

Keywords: executive compensation, CEO turnover, contract design, adverse selection, equity incentives, SFAS 123R

JEL Classification: G32, J33, J41, M41

Suggested Citation

Armstrong, Chris S. and Hail, Luzi and Zhang, Rachel Xi, Executive Compensation Contracts in the Presence of Adverse Selection (March 15, 2021). Available at SSRN: https://ssrn.com/abstract=3805082 or http://dx.doi.org/10.2139/ssrn.3805082

Chris S. Armstrong (Contact Author)

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Luzi Hail

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States
215-898-8205 (Phone)
215-573-2054 (Fax)

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Rachel Xi Zhang

University of Pennsylvania, The Wharton School, Students ( email )

3641 Locust Walk
Philadelphia, PA 19104
United States

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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