How Corporate Insiders Perceive CEO Inside Debt

The media often highlights hefty CEO compensation packages featuring lucrative stock grants, restricted shares, and stock options. The rationale for offering such equity-type compensation to top executives is to align the interests of managers and shareholders to mitigate agency conflicts between them. Otherwise, managers might deviate from optimal corporate strategies that maximize shareholder value.

In addition to the agency conflict between shareholders and managers, firms face a conflict stemming from the divergent attitudes between shareholders and debtholders toward risk. Debtholders tend to be more risk averse due to concerns about a firm’s ability to fulfill its financial obligations, while shareholders often prefer riskier capital investments that maximize shareholder wealth. One method of mitigating this conflict is to supplement a manager’s compensation with debt-type compensation such as deferred compensation and pension benefits, collectively referred to as “inside debt.” Both pensions and deferred compensation are unsecured, rendering them fundamentally similar to the firm’s externally-financed debt. This sort of compensation would give managers an incentive to take debtholders’ interests into account.

Theoretically, if a manager’s compensation package includes both debt and equity in proportions equal to the firm’s debt-to-equity ratio, the manager will consider the interests of both shareholders and debtholders. By alleviating conflicts of interest between the two constituencies, the firm’s market valuation may rise.

The incorporation of inside debt in CEO compensation remains an underdeveloped area of inquiry about which many questions remain. Given corporate insiders’ privileged access to private information regarding the CEO’s corporate policy decisions, insider trading offers one way to tell how knowledgeable shareholders react to increases in inside debt within the CEO’s compensation package. Using the trading activities of insiders to examine their perceptions of inside debt, we contribute to an emerging literature on the effects of this recent practice.

In our study, we empirically investigate the extent to which the trades of corporate insiders are influenced by CEO inside debt compensation. Inside debt is defined as the sum of the present value of accumulated pension and deferred compensation benefits. We concentrate on trading by insiders for several reasons. First, insiders not only possess informational advantages, but also devote greater attention to the firm than casual shareholders do. Additionally, it is reasonable to expect that the opinions of insiders will be reflected in their personal trades. Finally, investors who are unaffiliated with the firm can benefit from a better understanding of insider trades. In fact, several studies have found that both firm financial performance and stock price movements can be predicted to some extent based on changes in insider transactions.

We document a positive and highly significant relation between CEO inside debt compensation and insider purchasing. Consistent with existing theoretical predictions, which hypothesize that corporate insiders should react positively to CEO inside debt, we find that insiders tend to increase their levels of purchasing when the CEO is compensated with higher levels of inside debt relative to equity-based pay. Moreover, the positive association between CEO inside debt and insider trading persists when we control for a host of alternative factors that have been shown to affect investors’ trading decisions. We also execute additional tests to alleviate econometric endogeneity concerns and find that our results are qualitatively similar. In every analysis, we continue to observe a highly significant positive relationship between CEO inside debt and insider trading.

In an attempt to explore the dynamics of this relationship in greater detail, we examine the extent to which our results depend on the trading motivations of the insiders as well as their specific role within the firm. We find that the positive impact of inside debt is statistically significant solely within the subset of trades that are considered opportunistically motivated in that they likely reflect information about the firm. On the other hand, the relationship is insignificant within the subsample of routine trades initiated for portfolio rebalancing purposes. These contrasting results suggest that only opportunistic trades contain incremental information about insiders’ knowledge and expectations pertaining to inside debt compensation. Additionally, we find that the results are stronger within the subset of trades by directors and officers, implying that this group of well-informed insiders recognizes the potential for CEO inside debt compensation to enhance shareholder value.

We also conduct a subsample analysis based on the degree of a firm’s financial health. We examine the strength of the relationship between insider trading and CEO inside debt within the subset of firms that are in financial distress. Existing theory in the executive compensation literature predicts that inside debt gives managers a greater incentive to not only avoid bankruptcy, but also enhance the firm’s liquidation value. Thus, we anticipate that insiders of firms experiencing financial distress will react even more positively to higher levels of CEO inside debt, leading to greater insider purchasing. Our findings support this hypothesis, as the baseline results are stronger within the subsample of financially distressed firms.

Consistent with theoretical predictions from the academic literature on executive compensation, our findings support the notion that corporate insiders perceive CEO inside debt favorably. Debt-type compensation for corporate executives is thought to reduce agency costs associated with debt and encourage managers to increase the firm’s liquidation value. Perhaps these benefits outweigh the costs, such as any incentive to adopt excessively risk-averse corporate strategies.

Our findings contribute to a more comprehensive understanding about the important role of inside debt within a manager’s compensation package. This guidance offers value to practitioners who must consider the role of potential agency conflicts when determining the optimal compensation structure for corporate executives. The professional insight afforded by our results may foster better-informed decisions by compensation committees regarding optimal contracting for upper-level management. With more knowledge about how insiders react to the use of pensions and deferred compensation in executive compensation packages, compensation committees may be more likely to adopt debt-type compensation as an effective strategy to maximize shareholder wealth.

This post comes to us from Eric R. Brisker at The University of Akron, Dominique Outlaw at Hofstra University, and Aimee Hoffmann Smith at Boston College. It is based on their recent article, “CEO Inside Debt and Insider Trading,” available here.

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