Liquidity and Manipulation of Executive Compensation Schemes

Abstract

Several standard components of managerial compensation contracts have been criticized for encouraging managers to manipulate short-term information about the firm, thereby reducing transparency. This includes bonus schemes that encourage earnings smoothing, and option packages that allow managers to cash out early when the firm is overvalued. We show in an optimal contracting framework that these components are critical for giving long-term incentives to managers. The lack of transparency induced by the features of the contract makes it harder for the principal to engage in ex post optimal but ex ante inefficient liquidity provision to the manager.Executive compensation; earnings management; transparency