Equity-based Compensation Research Articles

Better safe than sorry? CEO inside debt and risk-taking in bank acquisitions

Widespread bank losses during the financial crisis have raised concerns that equity-based compensation for bank CEOs causes excessive risk-taking. Debt-based compensation, so-called inside debt, aligns the interests of CEOs with those of external creditors. We examine whether inside debt induces CEOs to pursue less risky acquisitions. Consistent with this, we show that acquisitions announced by CEOs with high inside debt incentives are associated with a wealth transfer from equity to debt holders. After the completion of a deal, banks where acquiring CEOs have high inside debt incentives display lower market measures of risk and lower loss exposures for taxpayers.

The compensation of busy directors: An international analysis

Using international data from 49 countries, we examine how director busyness affects global compensation. Prior literature reports conflicting evidence regarding the effect that multiple directorships has on firm value and performance. Some studies find that busy directors have skills and connections that benefit the firm while other research concludes that busy directors are too distracted to provide adequate monitoring. We determine that busy directors receive higher total compensation which is consistent with their greater skills and extensive networks. Busy directors, however, receive a significantly higher percentage of equity-based compensation which is consistent with their limited time for monitoring. This compensation structure is associated with improved market-to-book ratios, ROA, and profit margins. Finally, we discover that compensation committee members do not receive higher total compensation, but a lower percentage is equity linked.

Misvaluation, CEO Equity-Based Compensation, and Corporate Governance

We investigate empirically whether misvaluation of the firm’s stock price affects CEO equity-based compensation, controlling for industry and year effects, economic determinants, board governance characteristics, and institutional ownership. Among firms that award stock options, we find that CEOs of overvalued firms receive higher stock option compensation, lower cash compensation and higher overall total compensation. The findings are robust using alternative regression methods, including rank variable regressions, Tobit analysis, and the Heckman 2SLS procedure to control for the endogenous decision of whether to award grants. We find that misvaluation does not influence the probability that grants are awarded. The results suggest that an overvalued firm awards higher grants to meet the manager’s reservation utility from another job, to maintain performance incentives, to acquiesce to greater rent extraction, and to reduce the likelihood of paying for luck. Furthermore, we find that the firm subsequently underperforms more when it awards higher option grants because the board is weak, the CEO is able to extract rents, and the firm is overvalued. However, the firm over-performs when it awards more option grants because the firm has high growth prospects or a high fraction of institutional shareholders.

Executive compensation in banks: insights from CEO equity incentives and securitization transactions

This paper investigates whether CEO equity incentives promote risk-taking activities in the financial industry. Prior research shows that, during the recent credit crisis, banks whose CEOs had high equity incentives performed significantly worse than banks whose CEOs had low equity incentives. A possible explanation for this result is that the incentive to boost stock price induced CEOs to take risks that turned out to be extremely costly. Focusing on securitization transactions that were among the fundamental causes of the financial crisis and using a sample of US financial institutions, the paper provides evidence that banks whose CEOs had high equity incentives engaged in securitization transactions to a greater extent than did financial institutions guided by CEOs with low equity incentives. Moreover, the paper shows that CEOs with high equity incentives securitized riskier loans than did CEOs with low incentives. This study helps to clarify the role of equity-based compensation in promoting risk-taking behaviors in banks.

The Impact of Shareholder Litigation Risk on Equity Incentives: Evidence from a Natural Experiment

While prior studies generally support that equity-based compensation induces CEOs to manipulate financial reporting, there is little direct empirical evidence on how concerns regarding financial misreporting affect compensation design. Exploiting the exogenous reduction in litigation threat brought about by a 1999 ruling of the U.S. Ninth Circuit Court of Appeals, we examine how the weakened litigation environment affected CEOs’ compensation design. Consistent with the theoretical prediction that concerns regarding misreporting prevent companies from providing more powerful incentive pay that is otherwise optimal, we find that firms headquartered in Ninth Circuit Court states decreased CEOs’ equity portfolio vega after the ruling. We also show that the reduction was more pronounced for firms with higher litigation risk and for firms with lower institutional ownership.

Director Compensation and Related Party Transactions

This paper examines whether independent directors’ compensation is associated with related party transactions (RPTs). We focus both on directors’ total compensation and on their equity-based compensation. Employing hand-collected data for S&P 1500 firms, we find that independent directors’ compensation is significantly associated with RPTs. Specifically, we predict and find that level of compensation is positively related to RPTs, but we do not find equity-based compensation to be associated with RPTs. Next, we decompose the compensation measures into “market” (i.e., predicted) level and “excessive” components and find that the results are driven by the excessive components. This association between RPTs and director compensation is moderated by corporate governance mechanisms, suggesting that the association between director compensation and RPTs reflects a conflict of interest between insiders and shareholders. We also find some evidence that the effects of director compensation on RPTs are stronger for RPTs with directors compared with RPTs with non-directors, for non-business RPTs compared with business RPTs, and for ex post RPTs compared to ex ante RPTs.

Stock Liquidity and CEO Compensation in the US Hospitality Industry

This paper examines the effect of stock liquidity on CEO compensation in the US hospitality industry. By using a panel data sample of 50 US publicly traded hospitality companies from 1993 to 2014, the study finds that US hospitality companies with a high stock liquidity tend to have a higher proportion of equity-based CEO compensation schemes and a lower proportion of cash-based compensation. This study provides the board of directors with useful insights to alleviate agency problem and improve corporate governance efficiency.

Corporate social responsibility and CEO compensation structure

We examine how firms' corporate social responsibility (CSR) performance affects CEO compensation structure. Traditional agency theory suggests that CEOs engage in CSR for their own interests at the expense of shareholders. A competing argument is that CEOs consider firms' social performance as a business strategy to increase firm value and align their interests with those of shareholders. Our results support the latter prediction. We find that a firm's social performance is negatively associated with the proportion of cash-based compensation, while it is positively associated with the proportion of equity-based compensation. These results are robust to the degree of corporate governance, and they are more pronounced for firms with high levels of inside director ownership and long director tenure. Overall, our findings highlight the positive impact of CSR performance on CEO compensation packages, implying that CEOs' fiduciary behavior of engaging in CSR leads to mitigating agency problems and maximizing firm value.

The impact of dividend-protected CEO equity incentives on firm value and risk

Stock options and restricted stock are the two main vehicles of equity-based compensation. In this paper, we analyze how different dividend treatment of stock options and restricted stock grants impacts stock price and the riskiness of the firm. We find that if a firm's manager's utility function includes contemporaneous dividends (as in the case of restricted stock grants), the manager increases the risk level of equity in order to maintain the preferred risk level of her utility function. Increased risk level negatively impacts stock price, ceteris paribus. However, the calibrated model reveals that the impacts are rather trivial, specifically, equity value is lower by 1.5% and leverage is greater by 4%.

An International Analysis of Director Equity Incentives and Earnings Management

Using data from 29 countries, I examine how directors’ equity incentives affect earnings management internationally. I find that firms whose directors awarded higher percentage equity-based compensation are associated with greater use of earnings management. Such positive relation between equity incentives and earnings management persists regardless whether a director serves on the audit committee, or whether a director is classified as an independent or inside director. However, this association is reversed at firms with greater board or audit committee independence. Finally, using a matched sample of American Depository Receipts (ADRs) and non-ADRs, I provide evidence that although ADRs exhibit less earnings management relative to non-ADRs, having an ADR does not deter the attempt of directors with high equity incentives to manipulate earnings.

Does Dilution Due to Option Exercises Cause Share Repurchases?

Equity-based compensation causes increases in firms' share count and dilutes Earnings Per Share (EPS), which provides firms with an incentive to raise EPS using either share buybacks or earnings management. We employ a regression discontinuity framework to provide evidence of a causal link between equity-based pay and EPS management. Our tests compare firms experiencing dilution from ``just-in-the-money'' option exercises with firms whose options end up narrowly out-of-the-money. We find that firms engage in real- and accruals-based earnings management, but not buybacks, to boost EPS around these plausibly exogenous dilutive events. These effects are stronger when executives' bonuses depend directly on EPS.

Initial compensation contracts for new executives and financial distress risk: An empirical investigation of UK firms

This paper analyses the effect of financial distress risk on the initial compensation contracts of new executives in the UK, where credit markets are more concentrated than in the US. We find that financial distress risk has a negative and statistically significant impact on the level of cash-based compensation and total compensation of executives, who are newly hired from either outside or inside the firm. This negative impact is accentuated in firms with a high fraction of bank debt, suggesting that banks, as creditors, provide monitoring and influence initial executive compensation packages in firms with high financial distress risk. Additionally, we find that financial distress risk has a negative and significant impact on the fraction of equity-based compensation for both externally and internally appointed executives.

Managerial conservatism, board independence and corporate innovation

Using panel data on U.S. public firms, we document a positive effect of board independence on corporate innovation. This effect is concentrated in firms that are larger in size, in the non-technical industries, facing less product market competition, and using more debt, where managers are more likely to be excessively risk averse. We establish causality of board independence on innovation using a difference-in-difference approach that exploits an exogenous shock to board composition, namely, the mandate of a majority of outside directors on company boards by NYSE and NASDAQ in response to the passage of Sarbanes-Oxley Act in 2002. We further examine incentive compensation as a possible mechanism. We show that firms with more independent boards use more equity-based compensation, especially stock options, to promote managerial risk-taking.

Do Executive Compensation Contracts Maximize Firm Value? Evidence from a Quasi-Natural Experiment

We find significant positive abnormal returns surrounding a surprising and quick enactment of a law that restricts executive pay to a binding upper limit in a few industries. We find that the effect is concentrated only for firms in which the restriction is binding. We also find that the increase in value is greater for firms with weaker corporate governance and smaller for firms that grant a greater portion of equity-based compensation to their executives. These results provide indications that, on average, compensation contracts can be set in a way that does not maximize firm value.

How do companies react to restatements? – Evidence from audit committee compensation,

This study examines whether firms react to restatements by adjusting equity-based compensation paid to their audit committees and whether such adjustment is effective in improving the quality of firms’ financial reporting. Three major findings are documented. First, larger equity-based compensation aligns the interests between audit committees and shareholders in S&P 1500 firms, leading to lower restatement likelihood. In contrast, larger equity-based compensation induces audit committees to compromise independence in non-S&P 1500 firms, leading to higher restatement likelihood. Second, S&P 1500 firms increase equity-based compensation to both AC chairs and other AC members following restatements to enhance the alignment effect. Differently, non-S&P 1500 firms reduce equity-based compensation paid to audit committee chairs rather than other members following restatements to mitigate the entrenchment effect. Importantly, restating firms adjust equity compensation only to audit committee members but not to CEOs or other board committee members. Finally, reducing (increasing) audit committees’ equity-based compensation is effective in improving non-S&P 1500’s (S&P 1500’s) quality of financial statements after restatements. These findings are robust to controlling for endogeneity, including corporate governance variables, dropping firms who discharge auditors and CEOs, and considering nonlinearity. Our empirical results bear important implications for regulators and investors.

An Ill Wind? Terrorist Attacks and CEO Compensation

Using multiple measures of attack proximity, we show that CEOs employed at firms located near terrorist attacks earn an average pay increase of 12% after the attack relative to CEOs at firms located far from attacks. CEOs at terrorist attack-proximate firms prefer cash-based compensation increases (e.g., salary and bonus) over equity-based compensation (e.g., options and stocks granted). The effect is causal and it is larger when the bargaining power of the CEO is high. Other executives and workers do not receive a terrorist attack premium.

Managerial Ability, Financial Distress, and Audit Fees

SYNOPSIS This study examines whether the relationship between managerial ability and audit fees is conditional on financial distress. We find that higher managerial ability increases audit fees in financially distressed firms and decreases audit fees in non-distressed firms. We also observe that financially distressed firms with higher-ability managers display lower accrual quality and a higher likelihood of restatement. Moreover, higher-ability managers in distressed firms engage more in opportunistic financial reporting to concurrently maximize equity-based compensation and cope with debt refinancing pressures, which increases audit risks and results in greater audit fees. We confirm our results using a battery of sensitivity and additional analyses.

What lies beneath the implementation of expensing equity-based compensation?

This study explores whether SFAS 39, which mandated expensing of equity-based compensation (EBC) causes an unexpected wealth reallocation between debtholders and shareholders. Through a structural framework under the economic measure, we theorize that mandatory EBC expensing affects the priority of free cash flow payment mechanisms and thereby transfers firm value to equity at the expense of debt. Based on 582 Taiwan listed firms over the period 2005–2010, we empirically find that a significant increase in equity value as a percentage of firm value for firms that were affected by EBC expensing rule, compared to firms that were not affected. The wealth transfer from debtholders to shareholders is more salient for heavy EBC users. We also document that firms with more intensive debtholder-shareholder conflicts experience a larger wealth transfer than their counterparts do. Overall, our analyses suggest that mandated expensing of EBC leads to a value transfer from debt to equity.

Does Allowing Publicly Listed Firms to Adopt Equity-Based Compensation Increase Shareholder Value? Evidence from China

We examine whether allowing publicly listed firms to adopt equity-based compensation increases shareholder value for firms domiciled in weak institutional environments. We test our idea using a series of regulations in China that allowed publicly listed Chinese firms to adopt equity-based compensation for the first time. Consistent with prior research, we find that shareholder value did increase for the firms that adopted equity-based compensation schemes. However, we find that only 16% of the publicly listed Chinese firms adopted equity-based compensation schemes seven years following the passage of the first regulation. We find little evidence that the stock market reactions to the events associated with the passage of the regulations were significant for the entire stock market portfolio or the sub-portfolios of SOEs and non-SOEs. Overall, our results support Core et al.’s (2003) conjecture that the efficacy of equity-based compensation hinges on a country’s institutional environment quality.

Takeovers and (Excess) CEO Compensation

We study if a CEO’s equity-based compensation affects the expected value generation in takeovers. When the objectives of management and shareholders are more aligned, as proxied by the use of equity-based compensation, more value-maximizing acquisitions are expected. Whereas in widely-held firms the decision power is with the management, in firms with concentrated ownership the decision power may be with major blockholders. This may entail that ownership concentration and equity-based pay are substitutes. We find a strongly positive relation between equity-based compensation and cumulative abnormal announcement returns at take-overs, but this relation is eroded when dominant share blocks are held by corporations, which confirms the substitution effect. Powerful CEOs in companies with weak boards and without actively monitoring shareholders may set their own pay which could lead to excesses. We relate excess pay to how takeover decisions are received by the market, and demonstrate that excess compensation negatively affects the acquirer’s stock valuation at a takeover announcement. The market is thus able to identify firms with agency problems and is cautious in its expectations about potential value creation by means of acquisitions.