Passive shareholders and active managers: an empirical test of Admati and Pfleiderer's hypothesis

Abstract

Admati and Pfleiderer (2006) demonstrate that under some conditions, linking CEO pay to share price performance may aggravate agency conflicts. Two fundamental conflicts are considered: the manager may take value-destroying, privately beneficial (‘bad’) actions, or value-enhancing, privately costly (‘good’) actions. Applying a structural equation model to a global data set, we find that when institutions encouraging ‘good’ (‘bad’) managerial conduct are lacking, CEO pay is more (less) strongly associated with share price performance. Our analysis suggests that the Wall Street Rule as a governance mechanism varies in its effectiveness to cope with different categories of agency conflict.

Notes

¹The panel is not balanced since some countries enter or leave the sample, and because data for 2002 and 2004 are not reported.

² Contrastingly, Noe (1997) shows that when the pay policy is determined endogenously, insider trading restrictions may even increase managerial effort. This results from the fact that when insider trading is permitted, the optimal pay structure relies less heavily on incentive-based pay, and the increased incentives to exert effort by taking chance of profitable insider deals does not offset the loss of incentives by decreased managerial incentive compensation. Similar arguments were made by Bagnoli and Khanna (1992), Fischer (1992) and Khanna et al. (1994).

³ Empirical evidence for this effect exists for the US (Bettis et al., 2000).