The Paradox of Insider Information and Performance Pay

This article investigates the paradox of insider information and performance pay as it pertains to managerial compensation. The paradox is that managers are permitted to exploit their role as insiders for personal \u85nancial gain when simple directives issued by their board of directors could eliminate this practice. Our empirical evidence shows that managers signi\u85cantly bene\u85t from their \u85rms good fortune through their choice of compensation package and trading \u85rm securities. We prove in our theoretical framework that the manager should not pro\u85t from changes in the value of the \u85rm if he signs an optimal contract, if there is only private information but not moral hazard. Therein lies an explanation for the paradox. Shareholders permit managers to personally exploit hidden information about the \u85rms pro\u85tability because it helps incentivize their work activities as well. Our structural estimates of a pure moral hazard model show that the bene\u85ts to the \u85rm from letting managerial compensation depend on abnormal returns to solve the moral hazard problem far outweigh the savings in reduced compensation that would be realized if managers were paid \u85xed wages.