Essays on corporate governance and managerial incentives

Contrary to a commonly-held view in the corporate governance literature, in Chapter 1, I argue theoretically that the optimal pay-performance sensitivity (PPS) should be smaller in the presence of board monitoring for a risk-averse CEO. My model is based on a simple adaptation of Holmstrom and Milgrom (Econometrica 1987). I show that board monitoring and PPS should be substitutes and the relative weights placed on board monitoring and PPS should depend on firm transparency (ease of monitoring). It is a prediction of my model that if firms that were relying on incentives (PPS) are mandated to strengthen monitoring, their constrained optimal PPS would be smaller.Firms use a mix of cash and equity compensation to provide monetary incentives to align the interest of their managers with the interest of their shareholders and debt holders. Because each manager has different expectations, non-monetary incentives, and management style, the same compensation mix results in different incentives for different managers. Chapter 2 investigates to what extent the unobservable manager heterogeneity determines compensation mix and whether there are good or bad manager effects. Using a panel of executives from 1992 to 2005, I find significant time-invariant manager effects on compensation mix controlling for firm fixed effects and other observable firm and manager characteristics. There is a significant negative correlation between the manager fixed effects and the firm fixed effects, the level of compensation, and firm size, but the manager fixed effects show no relation with performance. Larger deviations of either direction from the expected compensation mix are related to higher probability of CEO turnover after controlling for performance and retirement. The findings of this study support the view that there is no optimal compensation mix applicable to all managers.Using the percentage of outside directors as a proxy for board monitoring, I find empirical evidences consistent with these predictions. In 2002, following the adoption of the Sarbanes-Oxley Act of 2002, major U.S. exchanges began to require the boards of listed firms to have more than 50% of outside directors. In the case of firms affected by this requirement, their CEO pay-performance sensitivity decreased significantly relative to the control group, especially in the case of large firms which are more transparent and thus easier to monitor than small firms. The decrease was a result of the CEOs aggressively selling their stock while the boards allowed the option sensitivity to remain the same.