Do executive compensation contracts maximize firm value? Evidence from a quasi-natural experiment

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There is considerable debate on whether executive compensation contracts are a designed to
maximize firm value or a result of rent extraction. The endogenous nature of executive pay
contracts limits the ability of prior research to answer this question. In this study, we utilize the
events surrounding a surprising and quick enactment of a new law that restricts executive pay to a
binding upper limit in the insurance and banking industries. This quasi-natural experiment enables
clear identification. If compensation contracts are value maximizing, any outside restriction to the
contract will diminish its optimality and hence should reduce firm value. In contrast to the
predictions of the value maximization view of compensation contracts, we find significantly
positive abnormal returns in these industries in multiple short term event windows around the
passing of the law. We find that the effect is concentrated only for firms in which the restriction is
binding. We find similar results using a regression discontinuity design, when we restrict our
sample to firms with executive payouts that are just below and just above the law’s pay limit.

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