Bonus Contracts, Private Information and CEO Turnover

In this paper, we address the question whether performance measures that are specified in annual bonus contracts represent overall performance dimensions used by boards of directors in making governance decisions. Recent studies claim that managerial incentives are predominantly provided by equity holdings rather than short-term cash compensation. Given the dominance of equity compensation and the fact that firms invest resources in the design and use of bonus contracts, it is unclear why the vast majority of firms continue to use annual bonus contracts if these would create only minor, or no incentive benefits. We argue that boards of directors use bonus contracts as a channel to ex-ante communicate how performance will be evaluated annually and thus signal the measures relevant for CEO termination decisions, which provides significant incentives. Further, the resulting cash compensation communicates the board's actual performance evaluation of the CEO, which can disclose private information to the capital market. Our empirical results are consistent with these arguments and show that the incentive weight on privately observed performance measures in bonus contracts is systematically related to the importance of these measures for CEO turnover. We further show that the stock market reaction to a management change depends on bonus contract design. We specifically find a positive reaction when boards of directors have signaled to solely use public information in CEO performance evaluation (good news about the board) and a negative reaction when they (also) use private information (bad news about the CEO). Overall, we show that the care taken in designing annual bonus contracts can be explained by its link with governance decisions and indicate that performance measurement issues are an important part of the corporate governance process.