A rule designed to protect investors may encourage managerial short-termism, to the detriment of firms. This sobering finding comes from a study led by HKUST’s Yan Xiong. According to Xiong and a U.S. colleague, the American government is tying firms’ hands with the requirement to disclose managers’ pay offers. The paper shows how managers become more myopic in their investment decisions when rival firms know their contract details.
Investment in new projects is how firms chase long-term profit. Firms delegate investment decisions to managers, whom they retain by offering them contracts. Since 2006, the SEC has required firms to declare details of executives’ compensation. This rule, which mandates that a Compensation Discussion and Analysis (CD&A) section be included in every annual report, was designed to protect investors by facilitating oversight of firms. As the authors explain, it “can be viewed as a mandatory disclosure of explicit incentives that firms provide to their executives.”
The public nature of the CD&A inevitably makes managers’ contractual terms accessible to rival firms. The paper’s key insight is that this information spillover may have unintended consequences, as contractual details—the link between pay and stock performance—offer clues to a firm’s likely investment strategy. This fills an important research gap. Previous studies focus solely on “how disclosure affects compensation contract design,” say the authors, “without considering its effects on rival firms’ strategic interactions.”
To explore how the CD&A alters firms’ behavior, Xiong and colleague model a market in which two publicly traded firms compete for an investment opportunity. Each firm’s board offers its investment manager a contract. Next, each manager decides whether to invest—based on their private assessment of the cost to the firm—and the stock market reacts accordingly. Eventually, the firms receive their profit on investment and pay their managers according to the contract. In this general model, the opportunity could be, for instance, “to build a new product line, enter a new regional market, or engage in a race to innovate.”
When setting terms, each firm knows that the other can see its offer. Firm A reasons as follows. If it weights the contract toward short-term performance, its rival—Firm B—will know that Firm A’s manager is motivated to overinvest to gain market credibility and boost short-term stock prices. This would force Firm B to invest conservatively and forsake immediate profit to avoid competition. “A short-term compensation contract is a strategic tool that commits a manager to an aggressive investment strategy,” the researchers note.
However, because each firm assumes that its rival thinks in the same way, both firms pre-empt the others’ attack, offering contracts skewed toward short-termism. This is confirmed by the model’s results: when contract disclosure is mandatory, managers invest more aggressively. The intensified competition hurts each firm’s long-term performance, directly contradicting their boards’ goals. This “prisoner’s dilemma” ties in with the literature on managerial myopia, a widespread problem that can harm consumers as well as firms.
The paper therefore offers a stark warning for regulators. Mandatory pay disclosures intended to safeguard investors may be exploited by firms to strategize against rivals, putting all firms’ profits in jeopardy. There is good news, though. For one thing, interfirm competition can, under certain circumstances, benefit consumers by driving down profits. Furthermore, the authors propose that managerial myopia can be curbed by setting longer-term managerial pay horizons.