What Can Market Microstructure Contribute to Explaining Executive Incentive Pay?: Liquidity and the Use of Stock-Based Compensation

Recent theoretical models derived from market microstructure have shown that liquid stock markets can improve the alignment of managers ’ and shareholders ’ interests, contrary to the traditional view of managers being monitored by a stable set of shareholders. Little evidence exists on the issue, because most of the key variables such as the precision of stock traders ’ information or their costs of influencing management are not observable. We show, however, that the model of Holmstrom and Tirole (1993) can yield the testable prediction that managers ’ compensation will be more closely tied to shareholder wealth when the firm’s shares trade more actively. We test this and related propositions on a sample of over 45,000 executive years. In virtually all specifications, the effect of liquidity is at least as great as that of size, risk, industry, year, the existence of growth options, leverage, the existence of cash constraints, firm focus, or the presence of government regulation, existing option holdings and stock holdings. In fact, based on 900 simulations across different sample sizes, three liquidity variables account for between 67 % and 79 % of the explained variation with the remainder accounted for by 17 traditional variables. By contrast, accounting-based bonus incentives are employed by more illiquid firms. We conclude that boards delegat