DP5315 Keeping the Board in the Dark: CEO Compensation and Entrenchment

Author(s): Roman Inderst, Holger M Mueller
Publication Date: October 2005
Keyword(s): CEO compensation, entrenchment, severance pay, stock options
JEL(s): G3
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5315

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 the same period.