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CFGE-15: Contracts and Incentives
Payday before Mayday: CEO Compensation Contracting for Distressed Firms
1Boston College, United States of America; 2Texas A&M, United States of America
Using detailed information on features of CEO contracts for more than 1,400 US public firms in the period 1998-2016, we examine changes in the structure of CEO compensation contracts when firms become financially distressed. When performance declines, firms face significant changes in liquidity, the need to replace or to retain the incumbent CEO, and the need to align CEO interests with those of shareholders versus creditors, each of which impacts contracting and CEO incentives. We find that distressed firms have lower pay-performance sensitivity if performance is measured against stock or earnings based metrics, but not when measured by cash flow based metrics. Examining the ex-ante compensation contracts, we find that distressed firms increase their overall use of performance metrics, particularly those that are based on cash flows, and set performance targets farther above prior performance. These changes in contracting increase in frequency and magnitude in the years preceding default. Overall, the observed changes in contracts reflect the need to re-align incentives rather than rent extraction by CEOs of distressed firms.
Pay for Future Returns
1London School of Economics, United Kingdom; 2New York University Shanghai
We show that firms use inside information on future performance to determine executive compensation. Our research strategy - to focus on salary raises - is based on actual contract practice from 649 hand-collected CEO employment contracts. Provisions for compensation reviews are prevalent in 55% of contracts, and almost all provisions link reviews to fixed compensation. Firms with review provisions give 7.5% more salary raises and are 8.1% less likely to explain them with observable performance measures. These raises predict events and performance next year - 24% more product announcements with 0.3% higher announcement returns. A hypothetical long-short portfolio investing in salary-raising firms could earn annual abnormal returns of 6%. Our paper underscores the importance of \pay for future returns" in motivating long-term performance.
Relative Performance Evaluation and Strategic Competition
1Rotterdam School of Management, Erasmus University Rotterdam; 2Ross School of Business and the NBER, University of Michigan; 3Lancaster University Management
This paper examines how the use of relative performance evaluation (RPE) affects industry competition. Using data from the U.S. airline industry, we estimate a dynamic game of competition with heterogenous firms in an oligopolistic market with the presence of RPE contracts. As is standard, RPE makes CEO compensation less sensitive to market conditions. Therefore, the CEO’s propensity to operate in a given market is determined by a tradeoff arises between the reduction in compensation based on market conditions and the gain from being compared to competing agents. The estimation results show that the use of RPE decreases a firm’s tendency to be active under bad market conditions by 10.1%. Conversely, the tendency to be active rises in good market conditions by 12.4%. These effects are stronger for firms with lower fixed operating costs.
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