The Choice of Different Types of Subjectivity in CEO Annual Bonus Contracts

ABSTRACT: In assessing the performance of the CEO, subjectivity by the board of directors is often present in one form or another. We specifically focus on: (1) the ex ante option to ex post override a formula-based contract (“discretionary bonus”), and (2) the ex ante absence of any formula in a contract (“subjective weights”). We argue that the two types of deviations are driven by different contracting problems, which relate to whether post-contract information does or does not affect the agent's optimal action choice. We refer to these different contracting problems as problems of risk and problems of noncongruity, respectively, and hypothesize that discretionary bonuses are used for risk-reduction purposes, while subjective weights on different performance dimensions are used for congruity-improvement purposes. Our results are consistent with our expectations, showing that the use of the different types of subjectivity is consistent with optimal contracting considerations. Data Availability: All data...

[1]  Rachel M. Hayes,et al.  Implicit Contracts and the Explanatory Power of Top Executive Compensation for Future Performance , 1997 .

[2]  D. Larcker,et al.  Corporate governance, chief executive officer compensation, and firm performance 1 The financial sup , 1999 .

[3]  Canice Prendergast,et al.  Favoritism in Organizations , 1993, Journal of Political Economy.

[4]  Jay W. Lorsch,et al.  A Modest Proposal for Improved Corporate Governance , 1992 .

[5]  Madhav V. Rajan,et al.  The choice of performance measures in annual bonus contracts , 1997 .

[6]  Bengt Holmstrom,et al.  Moral Hazard and Observability , 1979 .

[7]  Shivaram Rajgopal,et al.  CEOS' Outside Employment Opportunities and the Lack of Relative Performance Evaluation in Compensation Contracts , 2005 .

[8]  John E. Core,et al.  The Use of Equity Grants to Manage Optimal Equity Incentive Levels , 1999 .

[9]  M. Ederhof.  Discretion in bonus plans , 2007 .

[10]  Raffi J. Indjejikian,et al.  CEO compensation: The role of individual performance evaluation , 1996 .

[11]  C. Karuna,et al.  Industry product market competition and managerial incentives , 2007 .

[12]  H. Demsetz,et al.  The Structure of Corporate Ownership: Causes and Consequences , 1985, Journal of Political Economy.

[13]  Rajiv D. Banker,et al.  Sensitivity, Precision, and Linear Aggregation of Signals for Performance Evaluation , 1989 .

[14]  Marshall W. Meyer,et al.  Subjectivity and the Weighting of Performance Measures: Evidence from a Balanced Scorecard , 2003 .

[15]  George P. Baker,et al.  Subjective Performance Measures in Optimal Incentive Contracts , 1993 .

[16]  John E. Core,et al.  Estimating the Value of Employee Stock Option Portfolios and Their Sensitivities to Price and Volatility , 2002 .

[17]  Jeffrey M. Woodbridge.  Econometric Analysis of Cross Section and Panel Data , 2002 .

[18]  J. Heckman.  Sample selection bias as a specification error , 1979 .

[19]  Michael Gibbs,et al.  Determinants and Effects of Subjectivity in Incentives , 2004 .

[20]  Paul Oyer,et al.  Why Do Firms Use Incentives that Have No Incentive Effects? , 2000 .

[21]  Gerald A. Feltham,et al.  Performance Measure Congruity and Diversity in Multi-Task Principal/Agent Relations , 2007 .

[22]  M. Petersen,et al.  Does Distance Still Matter? The Information Revolution in Small Business Lending , 2000 .

[23]  L. Bebchuk,et al.  Managerial Power and Rent Extraction in the Design of Executive Compensation , 2002 .

[24]  Frank Moers,et al.  The Issue of Endogeneity within Theory-Based, Quantitative Management Accounting Research , 2007 .

[25]  Jeffrey L. Coles,et al.  Boards: Does One Size Fit All? , 2005 .

[26]  Edward I. Altman,et al.  FINANCIAL RATIOS, DISCRIMINANT ANALYSIS AND THE PREDICTION OF CORPORATE BANKRUPTCY , 1968 .

[27]  Eliezer M. Fich,et al.  Are Some Outside Directors Better than Others? Evidence from Director Appointments by Fortune 1000 Firms , 2005 .

[28]  Alma Cohen,et al.  What Matters in Corporate Governance? , 2004 .

[29]  M. C. Jensen,et al.  The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems , 1993, A Theory of the Firm.

[30]  C. Ai,et al.  Interaction terms in logit and probit models , 2003 .

[31]  Frank Moers,et al.  Discretion and Bias in Performance Evaluation: The Impact of Diversity and Subjectivity , 2001 .

[32]  D. Rubin,et al.  The central role of the propensity score in observational studies for causal effects , 1983 .

[33]  Christopher D. Ittner,et al.  Subjectivity and the Weighting of Performance Measures: Evidence from a Balanced Scorecard , 2003 .

[34]  Ronald G. Ehrenberg,et al.  Compensation and Firm Performance , 1987 .

[35]  Richard G. Sloan.  Accounting earnings and top executive compensation , 1993 .

[36]  Vidhi Chhaochharia,et al.  CEO Compensation and Board Structure , 2008 .