Firms generate profits through investments in physical and human capital. In legal regimes that recognize property rights, the firm generally has full ownership over its physical capital, as well as the right to future cash flows generated by these assets. However, human capital is inherently different from other forms of capital because firms cannot “own” employees or the investments made in these employees. Common law, however, sometimes makes an exception for certain restrictive covenants like non-compete agreements – covenants signed by an employee not to compete with her employer for some specified period after employment ends. Non-compete agreements limit employees’ mobility by restricting them from joining the firm’s competitors, thereby imposing significant costs on these employees. From the firm’s perspective, such agreements can be beneficial, because they bind the employee to the firm for a fixed period of time and start to make human capital look more like physical investments.
Our paper focuses on restrictions to CEO mobility through non-compete agreements. We first examine the determinants of CEO non-compete agreements. We then study the implications of CEO non-compete agreements for how CEOs are monitored by their boards of directors. Finally, we examine the consequences of CEO non-compete agreements on the level and structure of the CEO’s compensation. Our sample consists of all firms included in the S&P 1500 index that have headquarters in the United States. For these firms, we manually collect data on their CEOs’ employment contracts and non-compete agreements from their filings with the U.S. Securities and Exchange Commission. Notably, we find an increase in CEO non-compete agreements over time, reflecting the evolution of the U.S. into more of a knowledge-based economy.
Unlike rank-and-file employees, CEOs can negotiate their employment contracts, because they not only have greater bargaining power relative to rank-and-file employees, but also are likely to have legal representation in their negotiations with firms. From the firm’s perspective, losing a CEO to a competitor in any capacity can cause severe economic harm, because she knows its trade secrets, key suppliers and customers, strategic plans, and strengths and weaknesses vis-à-vis its competitors. Thus, the presence of a CEO non-compete agreement will likely be the outcome of a bargaining game between the CEO and the firm. Specifically, the CEO is less likely to have a non-compete agreement if her job is less secure and more likely to have such an agreement if her working for a competitor in either an executive or non-executive role would cause the firm greater economic harm. We find evidence consistent with this hypothesis. Further, given the limited geographical enforceability of non-compete agreements, we document a strong relation between the existence of CEO non-compete agreements and their enforceability under state law.
The presence of a non-compete agreement also influences how strongly the board of directors disciplines the CEO for poor performance. In the absence of a non-compete agreement, the firm may be reluctant to fire the CEO for poor performance, because she can do significant economic damage to the firm by working for a competitor. However, in the presence of a non-compete agreement, the firm is more likely to fire the CEO for poor performance, because the CEO is broadly restricted from working for a competitor for some period of time. Consistent with this argument, we find that the sensitivity of CEO turnover to the firm’s performance is significantly stronger when the CEO has a non-compete agreement. Further, these results are amplified when the state-level enforcement of non-compete agreements is more stringent as well as when there are no state-level wrongful discharge laws that can in increase the cost of firing a CEO.
Finally, the CEO recognizes that non-compete agreements impose costs on her through decreased mobility and an increased risk of being fired for poor performance. A rational CEO accordingly demands higher compensation for her increased job risk and decreased mobility. Consistent with this view, we show that CEOs with non-compete agreements have higher compensation. Further, once the CEO signs the non-compete agreement, she has incentives to take actions that can potentially reduce her job risk. For example, she may make financial reporting more opaque or take less risky projects, even if such behavior is detrimental to shareholders. Recognizing these potential agency problems, the firm will structure her increased compensation in a manner that aligns her interests with those of shareholders. We find that in the presence of a non-compete clause in her employment contract, the CEO’s equity-based compensation constitutes a larger percentage of her total compensation and that she receives higher risk-taking incentives to offset her increased motivation to take less risky projects in the face of greater personal job risk. We exploit exogenous staggered changes in the state-level enforceability of non-compete agreements to make causal inferences.
Our paper illustrates that restrictions on CEO mobility have important implications for how the board monitors and sets the compensation of the CEO. In the process, it provides a partial solution to a long-standing puzzle in financial economics of a weak relation between firm performance and CEO turnover. Specifically, firms without CEO non-compete agreements are more hesitant to fire their CEOs for poor performance, because these CEOs can do greater economic damage to the firm by joining competitors. Drawing a distinction between restrictions on CEO mobility and restrictions on rank-and-file employee mobility is particularly important, because the departure of a CEO (among all employees) for a competitor can cause the greatest economic damage to the firm.
 We also build an index of state-level non-compete enforceability based on the classifications in Garmaise (2011) and data provided by Russell Beck at Beck Reed Riden LLP.
 The departing CEO does not need to work for a competitor in a CEO/senior manager role to cause economic harm to her former employer. This point is clearly illustrated in DIRECTV’s non-compete agreement with its CEO, which states that the CEO cannot “in any manner directly or indirectly, own, manage, operate, join, control or participate in the ownership, management, operation or control of, or be employed by, or connected in any manner with, in any capacity (including, without limitation, as an employee, consultant, officer, director, partner, advisor or joint venturer), or provide services to or on behalf of, any corporation, firm or business, or any affiliate of any corporation, firm or business, that directly or indirectly engages in any business which competes with the Company.”
This post comes to us from professors Omesh Kini at Georgia State University, Ryan Williams at the University of Arizona, and Sirui Yin at Miami University. It is based on their recent paper, “Restrictions on CEO Mobility, Performance-Turnover Sensitivity, and Compensation: Evidence from Non-compete Agreements,” available here.