Competition for Managers, Corporate Governance and Incentive Compensation

We propose a model in which firms compete to attract better managers by using corporate governance as part of an optimal executive compensation scheme. Higher governance decreases the cost of taking disciplinary actions against managers, but when managerial talent is scarce, competition among firms to attract better managers implies that firms under-invest in governance. The reason is that managerial rents are determined by the managerial reservation value when employed elsewhere. Hence, if a firm chooses a high level of governance, the remuneration package and pay for performance must increase to meet the managerial reservation value. We show empirically that a firm’s executive compensation is not chosen in isolation but it also depends on other firms’ governance. We document that firms use (weak) corporate governance as a substitute for executive compensation to attract better managers. In particular, better managers are matched to firms with weaker corporate governance. JEL classification: D82, G21, G18.