Performance-Based Incentives for Internal Monitors

by  David Larcker, for The Harvard Law School Forum at Harvard Law School, March 12, 2010.

In the paper, Performance-Based Incentives for Internal Monitors, which was recently published on SSRN, my co-authors (Christopher Armstrong and Alan Jagolinzer) and I investigate the choice of performance-based incentives for the general counsel (GC) and chief internal auditor (IA) and assess whether these incentives enhance or impair monitoring.

We use proprietary and public data that provide details about the incentive-compensation contracts of the GC and the IA to identify the determinants of performance-based incentives of internal monitors. More importantly, we also examine the impact these incentives have on either alleviating or exacerbating agency problems within the firm. We draw inferences regarding the implications of compensating internal monitors with performance-based incentives using a propensity score matched-pair research design, which helps address econometric concerns related to the endogenous design of compensation contracts.

We find that internal monitors receive greater incentives when their job duties contribute more to the firm’s production function. Internal monitors also receive greater incentives when they are more highly ranked within the firm and when the firm’s CEO receives greater incentives, consistent with standardization in compensation contracts within the executive suite. In addition, monitors receive lower incentives at firms with greater ex ante litigation risk, consistent with risk-averse monitors demanding less risky compensation when their human capital is more at risk. Finally, we find some evidence that incentive levels are greater when there is more demand for internal monitoring…(continue reading)

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