Leadership Investigate

CEO Replacement Under Private Information

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Executive Summary

This paper examines the optimal CEO compensation and replacement policy when the CEO is privately informed about the firm's continuation value under his leadership. Ex ante moral hazard implies that the CEO must receive ex post quasi rents, which endogenously biases him toward continuation. The authors' model shows that to induce "Bad" CEOs to quit, it may be best to make continuation costly (through steep incentive pay) rather than simply rewarding quitting (through severance pay). Incentive pay makes continuation attractive for "Good" CEOs, who can expect high future on-the-job pay, but unattractive for "Bad" CEOs, who may instead prefer to take their outside option payoff.

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