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 financial gain when simple directives issued by their board of directors could eliminate this practice. Our empirical evidence shows that managers significantly benefit from their firm's good fortune through their choice of compensation package and trading firm securities. We prove in our theoretical framework that the manager should not profit from changes in the value of the firm 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 firm's profitability because it helps incentivize their work activities as well. Our structural estimates of a pure moral hazard model show that the benefits to the firm 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 fixed wages.