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Determinants of Explicit CEO Contracts

By Harvard Law School Program on Corporate Governance

(Editor?s Note: This post comes from Stuart L. Gillan of Texas Tech University, and Jay C. Hartzell and Robert Parrino of The University of Texas at Austin.)

In Explicit vs. Implicit Contracts: Evidence from CEO Employment Agreements, which was recently accepted for publication in the Journal of Finance, we report evidence on the determinants of whether the relationship between a firm and its CEO is contractually defined in an explicit agreement. Our sample consists of the 494 U.S.-based firms in the S&P 500 on January 1, 2000 and their CEOs as of that date. We construct the sample by combining a set of explicit CEO EAs provided to us by The Corporate Library with agreements identified by searching the SEC filings of all remaining S&P 500 firms for any mention of an explicit EA. We define explicit EAs to include only comprehensive written agreements that specify the relationship between a firm and its CEO. We find that fewer than half of the CEOs of S&P 500 firms have comprehensive explicit employment agreements.

We find that comprehensive explicit EAs are used more frequently at firms operating in more uncertain business environments and at firms that are likely to face lower costs from altering the agreement with the CEO. This is consistent with the idea that firms facing greater uncertainty are more likely to encounter situations in which the benefits from altering an EA outweigh the costs. CEOs that have been hired from another firm (outside CEOs) are also more likely to have explicit EAs. These CEOs tend to face greater uncertainty about the sustainability of their relationships with their firms than CEOs who have been promoted from within. We find strong evidence that CEOs who can expect to earn greater abnormal compensation at their firms, both in the near future and over the estimated remainder of their career, are more likely to have an explicit EA. In addition, CEOs who receive a larger fraction of their pay as incentive-based compensation, which tends to be at greater risk if their employment agreement is altered, are more likely to have an explicit EA. Lastly, we find that the factors that explain the presence of an explicit EA also explain contract duration.

On balance, the evidence supports theoretical literature on the choice between explicit and implicit agreements and is consistent with optimal contracting.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on January 19, 2009 (boomark / email).