Executive Compensation and Investor Clientele

Executive Compensation and Investor Clientele Executive compensation has increased dramatically in recent times, but so has trading volume and individual investor access to financial markets. We provide a model where some managers may understate asset values through misleading statements in order to have enough of a cushion to compensate themselves. Owing to a lack of sophistication or näıveté, possibly arising from high opportunity costs of learning about accounting conventions and financial markets, small investors are unable to ascertain the extent of this behavior. Expected compensation is therefore higher when small investors form a more significant clientele in the market for a firm’s stock. Increased precision of private information deters the entry of small investors and may keep executive compensation in check. Technologies that lower the cost of trading facilitate entry of small investors and raise expected compensation. Such compensation can in general be reduced through appropriate regulation and transparent disclosures. Empirical tests provide support to the key implication of the model that indirect executive compensation is higher in stocks with more retail investor participation.