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Are Incentive Contracts Rigged by Powerful CEOs?

49 Pages Posted: 22 Mar 2005 Last revised: 12 Nov 2008

Adair Morse

University of California, Berkeley - Haas School of Business; National Bureau of Economic Research (NBER)

Vikram K. Nanda

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics

Amit Seru

Stanford University

Date Written: November 2008

Abstract

We argue that powerful CEOs induce their boards to shift the weight on performance measures towards the better performing measures, thereby rigging the incentive part of their pay. The intuition is developed in a simple model in which some powerful CEOs exploit superior information and lack of transparency in compensation contracts to extract rents. The model delivers an explicit structural form for the rigging of CEO incentive pay along with testable implications that rigging is expected to (1) increase with CEO power; (2) increase with CEO human capital intensity and uncertainty about a firm's future prospects; and (3) negatively impact firm performance. Using measures of CEO power and board independence on a large panel of firms in the U.S., we find support for these predictions. Rigging accounts for 10%-30% of the sensitivity of compensation to performance measures and is increasing in CEO human capital and volatility of a firm's future prospects. Moreover, the portion of incentive pay that is predicted by power is associated with negative subsequent future stock performance of the order of 1% and operating performance of 5% per year. Overall, the results provide evidence against the agency substitution theory and support instead the entrenchment skimming theory.

Keywords: CEO Power, Incentive Contracts, CEO Compensation, Board of Directors, Governance, Rent Extraction

JEL Classification: J33, J31, G34

Suggested Citation

Morse, Adair and Nanda, Vikram K. and Seru, Amit, Are Incentive Contracts Rigged by Powerful CEOs? (November 2008). AFA 2006 Boston Meetings Paper; EFA 2006 Zurich Meetings Paper. Available at SSRN: https://ssrn.com/abstract=687504 or http://dx.doi.org/10.2139/ssrn.687504

Adair Morse

University of California, Berkeley - Haas School of Business ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Vikram K. Nanda (Contact Author)

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics ( email )

2601 North Floyd Road
P.O. Box 830688
Richardson, TX 75083
United States

Amit Seru

Stanford University ( email )

650 Knight Management
Stanford, CA 94305
United States

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