Liquidity and Manipulation of Executive Compensation Schemes

Ulf Axelson, Sandeep Baliga
2008 The Review of financial studies  
We study optimal renegotiation-proof compensation contracts when long-term information is valuable, but managers have a preference for early consumption. After managerial action is sunk, the firm has an incentive to renegotiate any long-term compensation program to provide the manager with liquidity. We show that when firms are transparent so that early information about firm performance is publicly available, compensation contracts cannot be made contingent on long-term performance. However,
more » ... ormance. However, when the manager can engage in earnings management, the firm can credibly commit to long-term contracts because adverse selection at the renegotiation stage effectively eliminates recontracting. We show that optimal contracts allow earnings management, contain vesting clauses such that the manager can cash out early when the firm is over-valued, and have bonus packages that encourage earnings smoothing.
doi:10.1093/rfs/hhn095 fatcat:jvqxfpqywfhb5n2uao36qxamfe