Do Higher Paid CEOs Weather the Storm Better? Evidence from the Great Recession

Abstract

The astonishing collapse of the largest financial institutions managed by repulsively high-paid Wall Street executives led to the Say-on-Pay rules in the Dodd-Frank legislation. However, the shareholders of S&P 500 firms do not seem to exercise their newly granted right as anticipated by the public (Kaplan (2011)). This paper provides empirical evidence to explain this phenomenon by testing the CEO ability hypothesis using the Great Recession as an exogenous shock. We examine whether “excessive” CEO pay – above median industry adjusted CEO pay slice (CPS) developed by Bebchuk et al. (2011) – can be a proxy for CEO ability.We find that high CPS firms experienced lower increases in credit default swap spreads and lower declines in firm value (measured by Tobin’s q) during the Great Recession than low CPS firms. These findings are consistent with the CEO ability hypothesis that higher paid CEOs appear to navigate through troubled times better than lower paid CEOs but contradict the notion that CPS proxies only for the CEO rent extracting agency problem. Our analysis does not refute the evidence of the agency problem depicted by Bebchuk et al. (2011), which analyze the issue during normal times. On the contrary, the paradigm of information asymmetry suggests that CPS captures elements of both CEO ability and the agency problem resulting in a pooling of both types of CEOs. Events such as financial crisis make it easier for CEO ability to prevail, thus allowing us to detect the presence of such a factor. Therefore, effective policies on CEO pay are difficult to craft. Our study contributes to the debates on CEO pay by providing empirical evidence to balance out the negative view of “seemingly excessive” CEO compensation in some cases.