Abstract:
We introduce the possibility to disclose evidence about performance in a dynamic agency model with non-verifiable cash flows. Evidence reduces the use of high powered cash incentives, and optimal compensation includes “pay for verifiable bad luck” options. The effect of evidence on optimal policies is non-monotonic in performance, with the largest impact occurring for intermediate performance histories. Perhaps counterintuitively, more frequent expected disclosure might reduce efficiency ex ante. Two forces drive this effect. First, the substitutability between evidence and cash incentives might enable investors to substantially lower the initial level of managerial pay. Second, even is shocks are iid and evidence reveals only current performance, its disclosure introduces (i) persistency, and (ii) a downward drift in managerial compensation paths. For low profitability firms, such as utilities, as well as in moderate interest rate environments, these two forces more than compensate investors for a higher probability of termination ex post, and so the availability of evidence exacerbates the conflict between rent and effciency.