CEO Compensation and Corporate Risk

The Harvard Law School Forum on Corporate Governance and Financial Regulation 2013-11-07

Summary:

Editor's Note: The following post comes to us from Todd Gormley of the Department of Finance at the University of Pennsylvania, David Matsa of the Department of Finance at Northwestern University, and Todd Milbourn, Professor of Finance at Washington University in St. Louis.

Every firm is exposed to business risks, including the possibilities of large, adverse shocks to cash flows. Potential sources for such shocks abound—examples include disruptive product innovations, the relaxation of international trade barriers, and changes in government regulations. In our paper, CEO Compensation and Corporate Risk: Evidence from a Natural Experiment, forthcoming in the Journal of Accounting and Economics, we examine (1) how boards adjust CEOs’ exposure to their firms’ risk after the risk of such shocks increase and (2) how incentives given by the CEOs’ pre-existing portfolios of stock and options affect their firms’ response to this risk. Specifically, we study what happens when a firm learns that it is exposing workers to carcinogens, which increase the risks of significant corporate legal liability and costly workplace regulations.

The results presented in this paper suggest that corporate boards respond quickly to changes in their firms’ business risk by adjusting the structure of CEOs’ compensation, but that the changes only slowly impact the overall portfolio incentives CEOs face. After the unexpected increase in left-tail risk, corporate boards reduce CEOs exposure to their firms’ risk; the sensitivities of the flow of managers’ annual compensation to stock price movements and to return volatility decrease. Various factors likely contribute to the board’s decision, including CEOs’ reduced willingness to accept a large exposure to their firms’ risk and the decline in shareholders’ desired investment after left-tail risk increases. Indeed, managers act to further reduce their exposure to the firm’s risk by exercising more options than do managers of unexposed firms. These changes, however, only slowly move CEOs’ overall exposure to their firm’s risk because the magnitude of their pre-existing portfolios continues to influence their financial exposure to the firm.

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Link:

http://blogs.law.harvard.edu/corpgov/2013/11/07/ceo-compensation-and-corporate-risk/

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Blogs.law Aggregation Hub » The Harvard Law School Forum on Corporate Governance and Financial Regulation

Tags:

academic research incentives executive compensation management risk stock options shocks todd milbourn corporate liability david matsa todd gormley

Authors:

R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation,

Date tagged:

11/07/2013, 15:30

Date published:

11/07/2013, 09:07