Working Paper: CEPR ID: DP5315
Authors: Roman Inderst; Holger M. Mueller
Abstract: We study a model in which a CEO can entrench himself by hiding information from the board that would allow the board to conclude that he should be replaced. Assuming that even diligent monitoring by the board cannot fully overcome the information asymmetry vis-à-vis the CEO, we ask if there is a role for CEO compensation to mitigate the inefficiency. Our analysis points to a novel argument for high-powered, non-linear CEO compensation such as bonus pay or stock options. By shifting the CEO?s compensation into states where the firm?s value is highest, a high-powered compensation scheme makes it as unattractive as possible for the CEO to entrench himself when he expects that the firm?s future value under his management and strategy is low. This, in turn, minimizes the severance pay needed to induce the CEO not to entrench himself, thereby minimizing the CEO?s informational rents. Amongst other things, our model suggests how deregulation and technological changes in the 1980s and 1990s might have contributed to the rise in CEO pay and turnover over thesame period.
Keywords: CEO compensation; entrenchment; severance pay; stock options
JEL Codes: G3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| CEO compensation (M12) | inefficiencies caused by information asymmetry (D82) |
| high-powered nonlinear compensation schemes (C61) | likelihood of CEO entrenchment (G34) |
| CEO's expected on-the-job compensation tied to firm's performance (M12) | likelihood of CEO entrenchment (G34) |
| external economic conditions (E66) | structure of CEO compensation (M12) |
| CEO compensation structure (M12) | board effectiveness (G34) |
| CEO's ability to control information (D83) | effectiveness of compensation schemes (J33) |