The Boundary Conditions of Optimal Contracting and Managerial Entrenchment: A Simultaneous Two-Equation Vector Autoregression with Exogenous Variables Approach for Chief Executive Officer Compensation and Firm Performance

Abstract

We apply the vector autoregression with exogenous variables (VARX) approach to integrate the optimal contracting theory, the managerial entrenchment theory, the principal-agent theory, the contextual criteria theory, and the upper echelon theory. Based on this new approach, we discover two middle ground conditions between the boundary of managerial entrenchment and optimal contracting, where CEO non-entrenchment or entrenchment cannot be explained by the managerial entrenchment theory or optimal contracting theory alone. For example, some CEOs are not entrenched when the agency problem is not mitigated, while others are entrenched when the agency problem is mitigated. The results imply that merely mitigating the agency problem cannot prevent managerial entrenchment. However, not mitigating the agency problem at all leads to managerial entrenchment. We recommend the boards look at other non-financial means and social approaches (e.g., value- and culture-based trainings, performance recognition, goodwill and friendship building events, pay transparency increase, smooth flow of information among stakeholders, value-adding managerial investments, oversight committee) to minimize the impact of managerial entrenchment on both firm performance and CEO compensation. In addition, we recommend the boards take on the approaches unique to their own firms and their CEOs to address managerial entrenchment.

Keywords

• firm market value
• ceo pay
• simultaneous two-equation time series matrix system
• full information maximum likelihood estimation
• varx methodology