Are Incentive Contracts Rigged by Powerful CEOs?
49 Pages Posted: 22 Mar 2005 Last revised: 12 Nov 2008
Date Written: November 2008
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: Suggested Citation