Does Missing Performance Goals Prompt More Opportunistic Insider Trading?

Tying executive pay to corporate performance has become increasingly important in creating incentives for corporate managers.  Theoretical models argue that compensation contracts that reward managers contingent on performance, especially performance relative to peer firms, can increase managerial effort (e.g., Holmstrom, 1979, 1982). The effectiveness of performance-based pay in motivating managers, however, could be limited, especially if self-interested managers can negate its incentive effect. In a new paper, I investigate one such action, insider trading.

Theoretical models suggest that insider trading may be a suboptimal way to compensate management. For instance, Fischer (1992) argues that allowing insider trading can exacerbate existing agency problems, because it expands the set of unobservable actions that managers can take. In the context of performance-based pay, the ability of managers to earn abnormal profits from insider trading may weaken their ex ante incentive to improve performance. In other words, if managers are able to recoup much of the loss in compensation due to missing performance goals through abnormal profits from insider trading, their ex ante incentive to beat performance goals may be limited.

In my paper, I use a regression discontinuity design (RDD) to examine whether managers use insider trading to undermine the incentive effect of performance-based pay. I exploit discontinuity in compensation induced by missing relative performance goals in executive incentive contracts. Managers whose performance is right around a relative performance goal presumably have strong incentives to improve performance because of the convexity in the pay-for-performance structure, i.e., compensation jumps if performance is just above the goal. Yet, if managers are able to generate abnormal profits from insider trading when they miss the performance goal, they can effectively flatten the pay-for-performance relation and hence mitigate the incentive effect. I hypothesize that missing a relative performance goal prompts managers to generate abnormal trading profits from insider trading to make up for the loss in performance-based compensation.

There are at least two reasons why missing relative performance goals could lead to opportunistic insider trading. First, because of the large negative shock to their compensation, CEOs who narrowly miss a relative performance goal would, relative to those who narrowly beat one, derive a higher marginal utility from an additional dollar of abnormal profits from insider trading. The cost of exploiting private information in insider trading, on the other hand, is arguably the same between the two groups of CEOs because they are equally likely to get caught and face the same penalties, including the present value of future compensation and benefits forfeited. Therefore, missing relative performance goals may encourage CEOs to earn abnormal profits from insider trading. Second, CEOs whose actual performance is close to a relative performance goal may treat the compensation associated with meeting the goal as a reference point and exhibit loss aversion when they narrowly miss the goal. In other words, CEOs derive utility from gains and losses relative to an expected level of compensation, and the negative effect of losses in compensation on utility is larger in magnitude than the positive effect of gains (Kahneman and Tversky, 1979). Therefore, CEOs who narrowly miss a performance goal and hence suffer a loss in compensation would derive a higher marginal utility from an additional dollar of insider trading profits than otherwise similar CEOs who narrowly beat the goal.

Using a sample of 1,317 relative performance grants for which the payout schedule exhibits jumps around performance goals, I first show that there is no bunching on either side of the performance goals and the density function is smooth around the goals. This pattern contrasts with that for grants based on absolute performance goals, which are subject to manipulation by managers (Bennett, Bettis, Gopalan, and Milbourn, 2017). Because the performance goals are based on the performance of a group of peer companies, which is not evident until the performance period ends, this makes it difficult for managers to perfectly control whether their performance is above or below a relative goal in a narrow range around the goals. I also show that firms that just beat and those that just miss the relative performance goals exhibit similar firm and CEO characteristics. These results allow me to use missing performance goals right around the cutoff to identify the effect of compensation shocks on insider trading.

The main results of the paper can be summarized as follows. First, relative to managers that narrowly beat a relative performance goal, those that narrowly miss one suffer a loss of about 11 percent to 13 percent of their total compensation. This suggests that missing relative performance goals has a large negative effect on CEO compensation, which might induce managers to engage in opportunistic insider trading.

Second, relative to managers that just beat a relative performance goal, those that just miss one earn abnormal profits from insider trading that amount to about 8 percent of their total compensation. Combined with the above estimate on the effect of missing relative performance goals on abnormal incentive pay, this estimate suggests that managers use insider trading to make up for over half of the loss in compensation due to missing performance goals.

Finally, to mitigate the concern that the observed effect on insider trading profits is driven by CEOs who receive equity (as opposed to cash) awards and hence have a diversification motive in their insider trades, I repeat the reduced-form regression on the subsample of equity awards and cash awards separately. I find that the effect of missing relative performance goals on insider trading profits holds for both subsamples, suggesting that the diversification story is not a main driver of the observed results.

As the first to identify the effect of missing relative performance goals on managerial actions, this paper contributes to our understanding of the efficacy of performance-based compensation. The results suggest that performance-based incentive awards may be limited in generating incentives for managers. Closer scrutiny of managerial actions, such as insider trades, may be necessary to improve the effectiveness of performance-based pay.


Bennett, Benjamin, J. Carr Bettis, Radhakrishnan Gopalan, and Todd Milbourn, 2017, Compensation goals and firm performance, Journal of Financial Economics 124, 307-330.

Fischer, Paul E., 1992, Optimal contracting and insider trading restrictions, Journal of Finance 47, 673-694.

Holmstrom, Bengt, 1979, Moral hazard and observability. Bell Journal of Economics 10, 74-91.

Holmstrom, Bengt, 1982, Moral hazard in teams, Bell Journal of Economics 13, 324-340.

This post comes to us from Meng Gao, a PhD candidate at the University of Illinois at Urbana-Champaign. It is based on her recent paper, “Get the Money Somehow: The Effect of Missing Performance Goals on Insider Trading,” available here.