RFS Advance Access published online on March 4, 2009
Review of Financial Studies, doi:10.1093/rfs/hhp002
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Tunnel-Proofing the Executive Suite: Transparency, Temptation, and the Design of Executive Compensation
University of Oxford and Tulane University
Send correspondance to Thomas H. Noe, Saïd Business School, Park End Street, Oxford, OX1 IHP, UK; telephone: 44(0)1865288933. E-mail: thomas.noe{at}sbs.ox.ac.uk.
JEL Classification: G3, J3
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Abstract |
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This paper considers optimal compensation for a CEO who is entrusted with administering corporate assets honestly. Optimal compensation designs maximize integrity at minimum cost. These designs are very "low powered," i.e., while specifying a lower bound for performance and increasing pay with performance, they increase compensation at a rapidly decreasing rate. Thus, integrity considerations engender optimal compensation packages that closely resemble the very pervasive 80/120 bonus plans, exactly the sort of compensation that Jensen (2003) argues should compromise integrity. Under optimal designs, expected compensation increases linearly with firm size, and increases in the market/book ratio. Moreover, given optimal compensation, CEO asset diversion is limited to high market-to-book firms that have received negative productivity shocks.
Support from the Center for Corporate Reputation, University of Oxford, is gratefully acknowledged. I would also like to thank an anonymous reviewer and the Editor, Robert McDonald, for a very careful reading of this manuscript. This paper has greatly benefited from comments by seminar participants at the University of Houston, Vanderbilt University, the Atlanta Finance Forum, Duke University, Georgetown University, the Financial Intermediation Research Society Meetings, and the Western Finance Association. Special thanks are extended to An Yan, Naveen Khanna, and Larry Wall for their detailed comments on the previous draft. Finally, I would also like to thank Debrah Noe and Susan Bergman for helpful comments on a very early draft of this paper. I would like to acknowledge refuge provided by Stewart Myers and Sloan School at MIT after Hurricane Katrina, during which period much of the work on this paper was completed. All remaining errors are mine.