Does CEO inside debt compensation benefit both shareholders and debtholders?

Although our findings are similar to those in Caliskan and Doukas (2015), we differ with respect to the positioning of the result. Their view on inside debt is that CEO inside debt reflects the degree of risk aversion, consistent with Wei and Yermack (2011). Thus, CEOs with high inside debt are motivated to lower firm risk by investing in fewer projects. However, we argue that inside debt is employed, as suggested by Jensen (1986), to reduce the agency costs between management and shareholders, and it eventually alleviates the agency costs of debt. As such, the increased dividend, induced by CEO inside debt, represents the reduced total agency costs, rather than just risk aversion. Overall, our results complement Caliskan and Doukas’ (2015) by demonstrating further evidence that inside debt encourages dividends and higher dividends increase firm value.

A CNN article (October 28, 2015) reports that the former CEO of Yum Brands, David Novak, has a cumulative balance of $233 million in his deferred compensation and pension. Yum Brands’ dividends per share were $0.53, $0.525, $0.78, $0.88, $1.035, $1.19, and $1.375 in our sample years. In 2014 alone, Comcast CEO, Brian Roberts, invested $23.5 million in his deferred account. Firms’ dividend per share in our sample years displays a similar upward trend. An article on the New York Times (April 3, 2005) notes that Vance Coffman, CEO of Lockheed Martin, received a lump sum payment of $31.5 million upon retirement. The dividends of his firm again show an increasing trend in our sample.

Deferred compensation is the “defined” compensation plan, where CEOs voluntarily delay e compensation and invest in their retirement plans. In most cases, firms offer CEOs fixed returns. Thus, it is viewed as CEOs’ lending money to firms. As reported in a CNBC article (December 16, 2013), firms tend to offer their executives higher “fixed” returns. This type of compensation can be accrued if CEOs agree to have part of their current compensation withheld by the firm. Firms generally match CEOs’ contributions to their deferred compensation account after setting a match rate. This deferred compensation will be paid to CEOs at a pre-selected date in the future (usually at retirement). However, some firms allow earlier withdrawals. For CEO inside debt, which consists of pension and deferred compensation, the amounts due to CEOs are generally left unfunded and unsecured. Thus, the benefits from this compensation are at risk as other creditors if the firm becomes financially distressed. Similarly, Ki and Mukherjee (2016) argue that deferred compensation is a fixed obligation of the company to make future payments to the CEO. Furthermore, deferred compensation accrues when CEOs lend the compensation back to the company by foregoing the cash and bonus compensation, and is invested either at the fixed rate of return or in the form of mutual funds chosen by the company.

In studies of cross-country data, La Porta et al. (2000) and Bartram et al. (2012) find that shareholders can exercise their legal rights to force firms to pay dividends, reducing the agency costs of equity.

Our results are quantitatively similar when dividend yield is used as a proxy for dividend level. Dividend yield is defined as the cash dividends on common stock scaled by the market value of equity (Fenn and Liang 2001).

We note that our hypothesis may raise questions regarding the effect of managerial stock incentives and borrowing cost as managers receive a significant amount of their pay in the form of stock and options. Studies linking managerial ownership with the cost of borrowing find a positive relation between managerial ownership and borrowing costs (Ortiz-Molina 2006). Our main explanatory variable is the CEO to firm debt/equity ratio (CEO’s debt-to-equity ratio scaled by a firm’s debt-to-equity ratio). Thus, managerial stock incentives are in the denominator of this measure of CEO inside debt holdings. This indicates a negative relation between borrowing costs and our measure of CEO inside debt.

KMV–Merton model is widely used by many researchers. Vassalou and Xing (2004) use this model to examine whether the distance-to-default is priced in equity returns. Kealhofer and Kurbat (2001) propose that KMV–Merton model captures all of the information in traditional agency ratings.

In untabulated tests, we conduct Pearson correlations for our variables of interest and find a positive and significant relation between the measures of CEO inside debt holdings and the dividend payout variables. We also determine that the relation between CEO inside debt and the market-to-book value of assets is significantly positive, consistent with our predictions.

Observations in the Candy and Soda and Tobacco products industries based on the Fama and French 49 industry classifications are dropped from the logistic regressions as all of the firms in those two industries are paying dividends.

We are grateful to an anonymous referee for designing this 2SLS model with regard to the endogenous relationship.