STEVEN L. SCHWARCZ, Duke University - School of Law
Email: schwarcz@law.duke.edu

Corporate governance scholarship has long focused on conflicts of interest between firms and their top executive officers. This essay contends that increasing leverage and financial complexity make it important for scholars to also focus on conflicts of interest between firms and their secondary managers.

MATTEO TONELLO, The Conference Board, Inc.
Email: matteo.tonello@conference-board.org

What should the board of directors of a public company do in critical economic times like these? The paper highlights "pressure points" for boards to consider, including practical actions that can be followed to help ensure directors fully meet their fiduciary responsibilities toward shareholders.

RAGHAVENDRA RAU, Purdue University, Barclays Global Investors
Email: raghu@purdue.edu
JIN XU, Purdue University
Email: xu68@purdue.edu

We analyze a sample of over 2,000 severance pay agreements in place at 862 firms to examine whether severance agreements are designed to reduce managerial human capital risk or whether they merely reflect managerial power in setting their own pay. We find that severance pay increases with the riskiness of a firm's business. This relation is especially strong for firms with a high degree of idiosyncratic risk - small firms and firms in industries with a high risk of takeover. The CEO is also granted higher severance pay in firms with higher institutional ownership. Severance pay is significantly higher when termination results from a change of control and the change-in-control (CIC) clause is more likely to be used by firms with a high institutional ownership when the contracting executive is the CEO or Chairman. Our results are largely consistent with the risk compensation hypothesis, and inconsistent with the managerial rent extraction hypothesis.

JOSEPH GERAKOS, University of Chicago - Booth School of Business
Email: jgerakos@chicagogsb.edu
CHRISTOPHER D. ITTNER, University of Pennsylvania - Accounting Department
Email: ittner@wharton.upenn.edu
FRANK MOERS, Maastricht University - Department of Accounting and Information Management, European Centre for Corporate Engagement (ECCE)
Email: f.moers@aim.unimaas.nl

This study investigates the effects of attraction, retention, and incentive objectives on the organization-wide use of two non-cash pay elements: benefits and broad-based equity (stock and stock option) grants. Recent economic theories lead to conflicting implications for the use of various non-cash pay elements in achieving these objectives. Data from the European operations of 185 large firms indicate that benefits are primarily provided for retention purposes. Broad-based option grant eligibility is positively associated with incentive and attraction purposes, but negatively associated with retention objectives, despite claims that options' vesting provisions enhance their retention advantages. Stock grant eligibility is also positively associated with incentive objectives, but has little relation with either attraction or retention objectives. Further examination of overall compensation configurations (cash pay, benefits, and equity grants) indicates that different combinations of these elements are used to achieve compensation objectives. Finally, national labor market characteristics and differences in employee- and firm-level taxes on non-cash pay influence the use of benefits and broad-based equity plans, beyond the influence of stated attraction, retention, or incentive objectives.

FEI PAN, Purdue University - Krannert School of Management
Email: fpan@purdue.edu
HUI ZHAO, affiliation not provided to SSRN
Email: zhui@temple.edu
KWEI TANG, Purdue University - Krannert School of Management
Email: ktang@mgmt.purdue.edu

Hedge funds (HFs) have sharply grown in the last decade. Because HF managers are not required to report active information on their operations and performance, investors face a high risk in fund selection, gambling on HF managers' skills and performance. On the other hand, the growing number of funds has forced HF managers to compete for capital. We formulate a signaling game model to investigate the impact of the competition among HF managers on their compensation contracts under an information asymmetry structure. We show that competition causes HF managers to use a high-water mark (HWM) with an increased incentive fee to signal their skill levels in attracting investment. Our results explain why HF managers' incentive fees do not decrease when HF competition increases, as observed in the entire HF history. These theoretical findings are further validated by an empirical study, in which 6,417 funds over the period 1991 to 2006 are included. In particular, our analysis shows that the proportion of managers using HWM increases as the competition increases while the incentive fees also increase. Meanwhile, we also find that onshore funds are more willing to use HWM to compete with offshore funds. In addition, the fund size is not a significant factor in deciding whether to adopt a HWM in a compensation contract.

ILONA BABENKO, Hong Kong University of Science and Technology
Email: babenko@ust.hk
MICHAEL L. LEMMON, University of Utah - Department of Finance
Email: finmll@business.utah.edu
YURI TSERLUKEVICH, Hong Kong University of Science & Technology, University of California, Berkeley - Walter A. Haas School of Business
Email: yuri@ust.hk

Exercises of employee stock options generate substantial cash inflows to the firm. In our model, these cash inflows are correlated with improvements in the firm's investment opportunities and thus allow firms to relax financing constraints in those states of the world where the demand for investment is high. Using the fact that cash flows from stock option exercises exhibit a sharp nonlinearity at the point where options fall out of the money, we estimate that firms increase investment by between $0.25 and $0.36 for each dollar received from the exercise. The sensitivity of investment to these cash flows is higher in firms likely to face financing constraints. In contrast, financially unconstrained firms distribute the proceeds received from option exercises via stock repurchases.

MAHMOUD AGHA, University of Western Australia
Email: mahmoud.agha@uwa.edu.au

We develop a model, the "Tradeoff Model", to address the agency costs of free cash flows and the role of managerial incentives in mitigating these costs. Using US based data, we find empirical evidence that managers make a tradeoff when they allocate the cash flow of the firm between investment and dividends. Managers underinvest and overpay dividends when offered short-term incentives, like bonuses and vested stocks. Managers overinvest and underpay dividends when offered long-term incentives, like unvested stocks and options. An increase in these incentives would retract investment and dividends toward the optimal levels, thus firm performance would improve. Moreover, we find nonlinear concave relations between investment and both bonus and option incentives, and corresponding convex relations between dividends and these two incentive schemes, confirming the tradeoff made by the manager between investment and dividends. We also find concave relations between firm performance and all incentives, except option incentives where the relation is convex.

NEAL STOUGHTON, University of New South Wales
Email: nmstough@unsw.edu.au
KIT PONG WONG, affiliation not provided to SSRN

Compensation policy has become one of the most important ingredients of corporate governance. In this paper we take a new look at the issue, by contrasting the use of options with that of stock. We do this by integrating the repricing or resetting aspect of options with that of industrial structure. We show that industry competition may play an important role in dictating which form of compensation is optimal. When aggressive competition for key professional staff is an issue, the flexibility of options may actually become a disadvantage and therefore pure stock compensation may survive as an equilibrium. Thus compensation trends may be partly explained by trends in the nature of the competitive environment.

RÜDIGER FAHLENBRACH, affiliation not provided to SSRN

I analyze the role of executive compensation in corporate governance. As proxies for corporate governance, I use board size, board independence, CEO-chair duality, institutional ownership concentration, CEO tenure, and an index of shareholder rights. The results from a broad cross-section of large U.S. public firms are inconsistent with recent claims that entrenched managers design their own compensation contracts. The interactions of the corporate governance mechanisms with total pay-for-performance and excess compensation can be explained by governance substitution. If a firm has generally weaker governance, the compensation contract helps better align the interests of shareholders and the CEO.