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Wednesday, February 23, 2005

Contracts for CEOs

Ssrn_logo_3 One area of real-world contracting that gets little attention from contracts scholars is that of CEO compensation. Contracts between companies and CEOs are, for example, classic relational contracts, yet most of the debate on the subject assumes a model of arms’ length bargaining and is done by corporate law types, not contracts profs.

Nevertheless, there’s a good deal of interesting work being done by our corporate colleagues and economists. An interesting new paper on SSRN is The Good, the Bad and the Lucky: CEO Pay and Skill, by Robert Daines, Vinay B. Nair, and Lewis A. Kornhauser. The paper tries to model CEO pay and skill, and concludes that in some (but not all) situations, there is a strong correlation between the CEO’s ability and his or her pay.  The abstract:

CEO compensation varies widely, even within industries. In this paper, we investigate whether differences in skill explain these differences in CEO pay. Using the notion that skilled CEOs are more likely to continue prior good performance and to reverse prior poor performance, we develop a new methodology to detect if skill is related to pay. We find that highly paid CEOs are more skilled than their industry counterparts when firms are small, especially when there is a large shareholder and the CEO has high incentives, or when firms face few environmental constraints on managerial discretion. By contrast, pay is negatively related to skill in firms constrained by environmental conditions, especially when there is no large shareholder to monitor management or the firm is large. We also examine CEO turnovers and show that the firm's post-turnover performance is related to differences between the two CEO's pay levels. Finally, we find that a portfolio that invests in firms managed by highly paid CEOs and sells firms managed by poorly paid CEOs generates an annualized abnormal return of 8% between 1994 and 2001, but only in conditions when pay and skill are related.

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