David Fragoso Gonzalez

Department of Economics, University of North Carolina at Chapel Hill



A Theory of Disclosed Executive Compensation as a Signal of Inside Information

Abstract: This paper develops a theoretical model that illustrates how a board with positive inside information about its company's prospects can use disclosed executive compensation to credibly signal its optimism to the less informed outsiders pricing the company's stock. To do so, the board uses the fact that performance based pay is more valuable to the executive (who has access to the same private information) when prospects are good to give her a compensation package that she would not accept if the inside information were bad. In the model, disclosed compensation is available to be used as a signal because regulations on inside trading and compensation disclosure prevent boards from privately undoing the connection established by disclosed compensation between the executive's pay and the company's performance, and the market for the executive's labor is well understood by outsiders. When available, disclosed compensation is used as a signal because the board is short-termist. The signaling motive does not always distort compensation packages away from optimal incentive provision; when it does, the distortion is magnified if the moral hazard in the agency relation between board and executive is large, the executive's contribution to company performance is relatively unimportant, the company's operations are relatively risky, and the enforcement of disclosure rules is weak. By outlining some conditions in which compensation is likely to be used as a signal and characterizing the distortions that such use induces in different circumstances, this paper proposes new explanations for the observed heterogeneity in compensation practices.