Bonus Season

Kevin Lewis

December 23, 2010

CEO Compensation

Carola Frydman & Dirk Jenter
Annual Review of Financial Economics, 2010

This paper surveys the recent literature on CEO compensation. The rapid rise in CEO pay over the past 30 years has sparked an intense debate about the nature of the pay-setting process. Many view the high level of CEO compensation as the result of powerful managers setting their own pay. Others interpret high pay as the result of optimal contracting in a competitive market for managerial talent. We describe and discuss the empirical evidence on the evolution of CEO pay and on the relationship between pay and firm performance since the 1930s. Our review suggests that both managerial power and competitive market forces are important determinants of CEO pay, but that neither approach is fully consistent with the available evidence. We briefly discuss promising directions for future research.


Size Anomalies in U.S. Bank Stock Returns: A Fiscal Explanation

Priyank Gandhi & Hanno Lustig
NBER Working Paper, November 2010

We use bank stock returns to develop an ex-ante measure of the distortion created by the implicit collective guarantee extended to large U.S. financial institutions. The average return on a stock portfolio that goes long in the largest U.S. commercial banks and short in the smallest banks is nearly minus 8% compared to a portfolio of non-bank stocks and bonds with the same exposure to standard risk factors. We provide evidence that 6.35 % of this spread is a subsidy that reflects the government's implicit guarantee of large banks, but not of small banks, when a financial disaster occurs. As predicted by theory, this long-short portfolio of bank stocks rallies during recessions, when the probability of a financial disaster increases, while the benchmark portfolio of non-banks stocks and bonds does not. This 6.35% spread can be decomposed into a 3.1% implicit subsidy to the largest commercial banks and a 3.25% tax on the smallest banks. The annual subsidy to the largest commercial banks is $4.71 billion per bank in 2005 dollars.


Stock-Based Compensation and CEO (Dis)Incentives

Efraim Benmelech, Eugene Kandel & Pietro Veronesi
Quarterly Journal of Economics, November 2010, Pages 1769-1820

The use of stock-based compensation as a solution to agency problems between shareholders and managers has increased dramatically since the early 1990s. We show that in a dynamic rational expectations model with asymmetric information, stock-based compensation not only induces managers to exert costly effort, but also induces them to conceal bad news about future growth options and to choose suboptimal investment policies to support the pretense. This leads to a severe overvaluation and a subsequent crash in the stock price. Our model produces many predictions that are consistent with the empirical evidence and are relevant to understanding the current crisis.


Pareto-improving inefficiency

Arup Bose, Debashis Pal & David Sappington
Oxford Economic Papers, January 2011, Pages 94-110

This paper considers a simple moral hazard setting in which a project owner (or, more generally, a principal) hires a contractor (or, more generally, an agent) to operate her project. We show that a systematic increase in the agent's operating costs can increase either the principal's profit or the agent's profit. The combined profit of the two parties also can increase. Perhaps most surprisingly, the principal's profit and the agent's profit can both increase simultaneously as the agent's costs rise. In this sense, increased inefficiency can be Pareto-improving under plausible conditions.


Imperfect Competition in Financial Markets: An Empirical Study of Island and Nasdaq

Bruno Biais, Christophe Bisière & Chester Spatt
Management Science, December 2010, Pages 2237-2250

The competition between Island and Nasdaq at the beginning of the century offers a natural laboratory to study competition between and within trading platforms and its consequences for liquidity supply. Our empirical strategy takes advantage of the difference between the pricing grids used on Island and Nasdaq, as well as of the decline in the Nasdaq tick. Using the finer grid prevailing on their market, Island limit order traders undercut Nasdaq quotes, much more than they undercut one another. The drop in the Nasdaq tick size triggered a drop in Island spreads, despite the Island tick already being very thin before Nasdaq decimalization. We also estimate a structural model of liquidity supply and find that Island limit order traders earned rents before Nasdaq decimalization. Our results suggest that perfect competition cannot be taken for granted, even on transparent open limit order books with a very thin pricing grid.


Earnings fraud: Board control vs CEO control and corporate performance - 1992-2004

Don Warren, Mary Zey, Tanya Granston & Joseph Roy
Managerial and Decision Economics, January 2011, Pages 17-34

The turn of the millennium is associated with increased corporate fraud, largely attributed to the failure of corporate governance. The compensation committee is expected to minimize fraud by rewarding only appropriate CEO behavior. A causal modeling approach, the Directed Acyclic Graph, was used to estimate the structure of corporate fraud. Corporate fraud was measured as illegal earnings statement(s), not all restatements but only those found illegal. A major finding is that the CEO's stock-option compensation motivates the CEO to commit corporate earnings fraud, while cash salaries and bonuses are only indirectly related to earnings fraud through those stock options.


Are U.S. CEOs Paid More Than U.K. CEOs? Inferences from Risk-adjusted Pay

Martin Conyon, John Core & Wayne Guay
Review of Financial Studies, forthcoming

We compute and compare risk-adjusted CEO pay in the United States and United Kingdom, where the risk adjustment is based on estimated risk premiums stemming from the equity incentives borne by CEOs. Controlling for firm and industry characteristics, we find that U.S. CEOs have higher pay, but also bear much higher stock and option incentives than U.K. CEOs. Using reasonable estimates of risk premiums, we find that risk-adjusted U.S. CEO pay does not appear to be large compared to that of U.K. CEOs. We also examine differences in pay and equity incentives between a sample of non-U.K. European CEOs and a matched sample of U.S. CEOs, and find that risk-adjusting pay may explain about half of the apparent higher pay for U.S. CEOs.


Making the Numbers? "Short Termism" & The Puzzle of Only Occasional Disaster

Nelson Repenning & Rebecca Henderson
MIT Working Paper, August 2010

Much recent work in strategy and popular discussion suggests that an excessive focus on "managing the numbers" -- delivering quarterly earnings at the expense of longer term investments -- makes it difficult for firms to make the investments necessary to build competitive advantage. "Short termism" has been blamed for everything from the decline of the US automobile industry to the low penetration of techniques such as TQM and continuous improvement. Yet a vigorous tradition in the accounting literature establishes that firms routinely sacrifice long-term investment to manage earnings and are rewarded for doing so. This paper presents a model that can reconcile these apparently contradictory perspectives. We show that if the source of long-term advantage is modeled as a stock of capability that accumulates gradually over time, a firm's proclivity to manage short-term earnings at the expense of long-term investment can have very different consequences depending on whether the firm's capability is close to a critical "tipping threshold". When the firm operates above this threshold, managing earnings smoothes revenue with few long-term consequences. Below it, managing earnings can tip the firm into a vicious cycle of accelerating decline. Our results have important implications for understanding managerial incentives and the internal processes that lead to sustained advantage.


Do Sell-Side Stock Analysts Exhibit Escalation of Commitment?

John Beshears & Katherine Milkman
Journal of Economic Behavior & Organization, forthcoming

This paper presents evidence that when an analyst makes an out-of-consensus forecast of a company's quarterly earnings that turns out to be incorrect, she escalates her commitment to maintaining an out-of-consensus view on the company. Relative to an analyst who was close to the consensus, the out-of-consensus analyst adjusts her forecasts for the current fiscal year's earnings less in the direction of the quarterly earnings surprise. On average, this type of updating behavior reduces forecasting accuracy, so it does not seem to reflect superior private information. Further empirical results suggest that analysts do not have financial incentives to stand by extreme stock calls in the face of contradictory evidence. Managerial and financial market implications are discussed.


Competition and Bias

Harrison Hong & Marcin Kacperczyk
Quarterly Journal of Economics, November 2010, Pages 1683-1725

We attempt to measure the effect of competition on bias in the context of analyst earnings forecasts, which are known to be excessively optimistic because of conflicts of interest. Our natural experiment for competition is mergers of brokerage houses, which result in the firing of analysts because of redundancy (e.g., one of the two oil stock analysts is let go) and other reasons such as culture clash. We use this decrease in analyst coverage for stocks covered by both merging houses before the merger (the treatment sample) to measure the causal effect of competition on bias. We find that the treatment sample simultaneously experiences a decrease in analyst coverage and an increase in optimism bias the year after the merger relative to a control group of stocks, consistent with competition reducing bias. The implied economic effect from our natural experiment is significantly larger than estimates from OLS regressions that do not correct for the endogeneity of coverage. This effect is much more significant for stocks with little initial analyst coverage or competition.


Shareholder Activism and CEO Pay

Yonca Ertimur, Fabrizio Ferri & Volkan Muslu
Review of Financial Studies, forthcoming

We study 134 vote-no campaigns and 1,198 shareholder proposals related to executive pay between 1997 and 2007. Union pension funds sponsor most of these initiatives, yet their targeting criteria do not appear to reflect labor-related motives. Shareholders favor proposals related to the pay-setting process (e.g., subject severance pay to shareholder approval) over proposals that micromanage pay level or structure. While activists target firms with high CEO pay (whether excessive or not), voting support is higher only at firms with excess CEO pay. Firms with excess CEO pay targeted by vote-no campaigns experience a significant reduction in CEO pay ($7.3 million). Our findings contribute to the debate on "say on pay" and other reforms empowering shareholders.


The Vote is Cast: The Effect of Corporate Governance on Shareholder Value

Vicente Cuñat, Mireia Gine & Maria Guadalupe
NBER Working Paper, December 2010

This paper estimates the effect of corporate governance provisions on
shareholder value and long-term outcomes in S&P1500 firms. We apply a
regression discontinuity design to shareholder votes on governance proposals
in annual meetings. A close-call vote around the majority threshold is akin
to a random outcome, allowing us to deal with prior expectations and the
endogeneity of internal governance rules. Passing a corporate governance
provision generates a 1.3% abnormal return on the day of the vote with an
implied market value per provision of 2.8%. We also find evidence of changes
in investment behavior and long-term performance improvements.


Can Mutual Fund Managers Pick Stocks? Evidence from Their Trades Prior to Earnings Announcements

Malcolm Baker, Lubomir Litov, Jessica Wachter & Jeffrey Wurgler
Journal of Financial and Quantitative Analysis, October 2010, Pages 1111-1131

Recent research finds that the stocks that mutual fund managers buy outperform the stocks that they sell (e.g., Chen, Jegadeesh, and Wermers (2000)). We study the nature of this stock-picking ability. We construct measures of trading skill based on how the stocks held and traded by fund managers perform at subsequent corporate earnings announcements. This approach increases the power to detect skilled trading and sheds light on its source. We find that the average fund's recent buys significantly outperform its recent sells around the next earnings announcement, and that this accounts for a disproportionate fraction of the total abnormal returns to fund trades estimated in prior work. We find that mutual fund trades also forecast earnings surprises. We conclude that mutual fund managers are able to trade profitably in part because they are able to forecast earnings-related fundamentals.


Real Effects of Accounting Rules: Evidence from Multinational Firms' Investment Location and Profit Repatriation Decisions

John Graham, Michelle Hanlon & Terry Shevlin
Journal of Accounting Research, forthcoming

We analyze survey responses from nearly 600 tax executives to better understand corporate decisions about real investment location and profit repatriation. Our evidence indicates that avoiding financial accounting income tax expense is as important as avoiding cash income taxes when corporations decide where to locate operations and whether to repatriate foreign earnings. This result is important in light of the recent research about whether financial accounting affects investment and in light of the decades of research on foreign investment that examines the role of cash income taxes but heretofore has not investigated the importance of financial reporting effects. Our analysis suggests that financial reporting is an important factor to be considered in the policy debates focused on bringing investment to the U.S.


The accounting art of war: Bounded rationality, earnings management and insider trading

Ramy Elitzur
Journal of Accounting and Public Policy, forthcoming

The study uses the idea of a multi-faceted managerial strategy and examines the effects of bounded rationality and ethical compass on insider trading, earnings management, and managerial effort. The analysis establishes that bounded rationality and the ethical compass play an important role in the managers' decisions. As such, the study provides an insight into why managers would engage in schemes that could potentially ruin their lives. The analysis also demonstrates that earnings management has multi-period dynamic properties, while the effort and insider trading decisions are made independently each period. Another interesting finding is that that earnings manipulation can only occur in a world with ethically diverse managers. Contrary to common wisdom, the study shows that shareholders have a vested interest in eliciting income management because it boosts their wealth. Consequently, expected market losses to shareholders' value, in response to detected accounting manipulations, are necessary to mitigate shareholders' preferences for earnings management. It is interesting to note that shareholders' preferences for earnings management (balanced by the expected market losses) imply that they would not necessarily prefer to hire the most ethical and least ‘bounded rationality' decision-making managers. Finally, the study examines the public policy implications of the topic in light of the recent US Senate Financial Regulation Overhaul bill.


The Causes and Consequences of Securities Class Action Litigation

Brian McTier & John Wald
Journal of Corporate Finance, forthcoming

We examine the impact of securities class action lawsuits on firms' investment and financing choices. Firms which overinvest are more likely to be sued. After a lawsuit, firms on average decrease overinvestment activity, and they decrease payouts while increasing leverage, cash holdings, and firm-specific risk. Additionally, we find some evidence that firms decrease diversification post-suit. Overall, these changes are consistent with a post-suit decrease in agency problems which lead to significant changes in real investment policies. The evidence is consistent with the notion that security class action lawsuits draw attention to agency problems which are then at least partly resolved.

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