Three essays on the impact of exogenous and persistent changes on the provision of incentives.

Summary In the presence of agency friction, incentive contracts are designed to align the manager's goals with those of the firm's owner. However, the contractual environment is subject to shocks beyond the manager's control that impact the firm's future profitability. These shocks may be due, for example, to increased regulation, changes in the market or the emergence of a new alternative to the manager. The question then arises as to how contracts are designed when such shocks are anticipated at the time the contract is signed. To understand this effect, we conduct three studies. In the first paper, we explore how an incentive contract evolves upon the emergence of automation technologies that can replace the manager in the asset management context. We study a continuous-time principal-agent problem where the performance of an asset is determined by the unobserved effort of the manager, and the automation technology emerges in an uncertain future. Our model suggests that the empirically observed layoffs that accompany the emergence of automation technology may have a contractual basis. In the second study, we explore how changes in the agent's ability to divert cash flows impact the design of an optimal contract. We construct a continuous-time principal-agent model where the agent can divert cash flows out of the owner's view. While it is clear that mitigating agency friction is valuable to the business owner, its effect on incentive provision throughout the contractual relationship is unclear. First, our result suggests that bonus compression at the time of the shock: the reduction (respectively, increase) in bonuses expected by good (respectively, bad) managers. Second, our analysis also predicts that this type of regulation leads to retention of bad managers, defined as keeping a manager in place when his or her poor performance would have induced his or her dismissal in the absence of the cash flow detour profit shock. In the third study, we continue the previous study with an empirical approach. We analyze the Compensation Discussion and Analysis (CD&A) introduced in the US starting in 2007. We focus on the impact of this reform on the decision to lay off employees in non-financial companies of the S&P 500. We find that the introduction of the CD&A law significantly reduced the probability of CEO layoffs in non-financial firms. While the literature has shown that exogenous industry-level shocks have an impact on the layoff decision, we document that changes in the regulatory environment also matter.