Executive Compensation Contracts in the Presence of Adverse Selection

We develop three complementary tests to examine how adverse selection affects the design of executive compensation contracts: First, we show that externally-hired CEOs receive higher total pay and have fewer equity incentives relative to internally-promoted CEOs, consistent with their ability to extract larger information rents due to greater private information. These differences are more pronounced when less is known about the prospective CEO, but quickly dissipate over time. Second, we show that external CEOs’ initial contracts differ more from those of their firm’s incumbent senior managers than do those of internal CEOs—particularly in terms of accounting performance metrics and equity-based pay, in line with the use of these features to elicit private information. Third, we find that following an unanticipated change in option vesting schedules prompted by SFAS 123R, newly appointed executives do not increase their option exercises and share sales—despite their newfound ability to do so—while longer-tenured executives do, consistent with contracts initially being designed to screen for certain types of managers before shifting to encourage certain behaviors. Combined, our evidence supports the distinct role of adverse selection in the design of executive compensation contracts.