Are Incentive Contracts Rigged by Powerful CEOs?

In our paper Are Incentive Contracts Rigged By Powerful CEOs?, which is forthcoming in the Journal of Finance, 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 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 a large panel of U.S. firms from 1992-2003, we find support for all our predictions. We find that rigging explains 10% to 30% of the incentive pay sensitivity to performance. Rigging increases with CEO human capital and with the uncertainty of a firm’s prospects, and stronger governance along other dimensions moderates contract rigging by powerful CEOs. Finally, rigging of incentive pay is shown to be associated with a decrease in future firm performance and value.

Our analysis raises doubts about whether observed equity based compensation fully serves as an incentive mechanism and offers a potential explanation for the lack of pay sensitivity to negative performance. The findings are of particular importance in the agency-substitution versus rent skimming debate: if setting high incentive contracts for powerful CEOs in firms is rendered ineffective by rigging, then the agency problem inherent in separation of ownership and control may be more severe than previously realized. Overall our evidence is more consistent with powerful CEOs skimming rents in the form of camouflaged incentive pay and advocate for requiring greater ex ante disclosure of incentive contract terms.

An issue we do not directly address in the paper is why shareholders appear to stick with powerful CEOs who might leak firm value over time. We suspect that there are at least two reasons: The first reason is that, by its nature, rigging is hard to detect. Much like the recent backdating literature, while our empirical results show that powerful CEOs are, on average, engaging in this behavior, it would be difficult to pin down precisely which CEOs are actually doing this. In addition, with some CEOs and boards having every incentive to camouflage excessive compensation, shareholders might learn only gradually about the existence and scale of rigging that might be present in the firm. A second reason is that there are significant frictions (e.g., related to CEO labor market), for instance the cost of launching a proxy fight, that can discourage collective action from shareholders towards replacing powerful CEOs.

The findings have important policy implications. A direct solution to rigging would be to require more explicit disclosure of ex ante incentive pay contracts. The argument that poor disclosure is justifiable given firm concerns about leaking competitive information and difficulty in recruiting executives strikes us as overstated and self serving. It is, therefore, reassuring to note regulatory efforts in this regard, with the SEC sending letters to 350 companies in 2007 critiquing the way they described the pay of their top executives. Even in the absence of better disclosure, the good news from our paper is that contract rigging might be reduced in other ways as well. Our results suggest that policies that increase the independence of boards may be effective in reducing contract rigging by powerful CEOs. In addition, rigging may be moderated in firms with stronger governance along other dimensions.

The full paper is available for download here.