CEO Compensation and Strategy Inertia∗

This paper considers the joint optimal design of CEOs’ on-the-job compensation and severance pay in a general optimal contracting framework. We obtain a novel argument for high-powered, non-linear CEO compensation such as bonus schemes and option grants that is different from existing arguments based on moral hazard and risk taking. Based on this argument, the CEO’s optimal on-the-job compensation scheme is designed to minimize the use of costly severance pay to reduce CEO entrenchment, thus minimizing the CEO’s informational rents. Our model generates novel empirical predictions concerning the interrelation of CEOs’ on-the-job compensation and severance pay as well as CEO turnover which, to the extent that they have been tested, are consistent with the empirical evidence. ∗We thank Andres Almazan, James Dow, Dirk Jenter, Wei Jiang, Lasse Pedersen, Thomas Phillipon, Javier Suarez, Jeff Wurgler, David Yermack, and seminar participants at Stanford, Berkeley, Wharton, New York University, University of Southern California, London Business School, London School of Economics, CEMFI, HEC, the European Summer Symposium in Financial Markets in Gerzensee (2005), and the NBER Corporate Finance Meeting in Cambridge (2005) for helpful comments and suggestions. This is a substantially revised version of an earlier draft entitled “Keeping the Board in the Dark: CEO Compensation and Entrenchment.” †London School of Economics and CEPR. Address: Department of Economics and Department of Finance, London School of Economics, Houghton Street, London WC2A 2AE. Email: [email protected]. ‡New York University and CEPR. Address: Department of Finance, Stern School of Business, New York University, 44 West Fourth Street, Suite 9-190, New York, NY 10012. Email: [email protected].