Subjectivity at Different Stages in the Contracting Process

Abstract

When considering the overall contracting process, subjectivity can be adopted in the contract design stage and/or the performance evaluation stage of the contracting process. By distinguishing between these two different contracting stages I shed light on the differential incentives for the inclusion of subjective performance measures at the different stages of the contracting process. My results show that in the contract design stage less subjective performance measures are included in the contract when the compensation committee is unlikely to formulate sufficient subjective assessments due to inadequate knowledge of the to-be-evaluated CEOs and when the level of trust between the compensation committee and the CEO is low. In the performance evaluation stage, after performance results based on objective measures are readily available, subjectivity tends to be used more as a potential tool to complement the predetermined contract. In particular, in cases where the predetermined contract did not assign high weights to objective performance measures that the CEO was able to significantly outperform, my analyses suggest that subjectivity was applied in order to account for such effects ex-post. My last set of hypotheses tries to investigate whether subjectivity is used as a potential tool for powerful CEOs to extract rent. Consistent with prior literature, the mere use of subjectivity in evaluating powerful CEOs does not lead to excess compensation. However, I find that powerful CEOs take advantage of performance evaluators outcome biases and spillover effects from the determined performance results based on objective measures to extract greater amounts of compensation.