Inducement grants, hiring announcements, and adverse selection for new CEOs

Only the equity portion of the inducement grant can be sensitive to the announcement return.

We discuss explanations for the lack of a relation in Section 4.4.3.

This hypothesis does not require the market to be more informed than the board about the CEO.

We search the reported title in the Form 3 for terms similar to “Chief Executive” and “CEO” to identify filings linked to new CEOs. We exclude division CEOs.

Because inducement equity grants do not require shareholder approval, there are concerns that inducement grants, which increase dilution, may be used by companies to bypass corporate governance. These concerns are mitigated by the fact that advisory firms consider the dilutive effects of inducement equity grants when making recommendations for equity plans in the future (ISS, 2016).

We require at least 50 quotes per day and use linear interpolation between the two most recent quotes when the price for a five-minute interval is not available. We also require at least 60 data points for every event day to calculate the intra-day return volatility and the stock to have quotes for at least half of the trading day.

It is possible that IOS captures the potential for overinvestment in risky projects, where firms with high IOS prefer a CEO that is more averse to risk. This predicts a negative relation between inducement grant sensitivity and IOS. Baber et al. (1996) and Guay (1999) find results that are not consistent with IOS capturing the potential for overinvestment in risky projects.

We compare our sample to firms in ExecuComp over our sample period in untabulated results. We find that our sample firms operate in less homogeneous industries with greater investment opportunity sets than ExecuComp firms. Also, as expected, our sample firms are significantly smaller with greater leverage than ExecuComp firms. Focusing on performance, as expected, our sample firms perform significantly worse than firms in the ExecuComp sample on both ROA andReturn. At the same time, the return volatility is higher for our sample firms. Finally, the grant date fair value of annual equity grants and the delta of the annual equity grants are significantly smaller in our sample than firms in ExecuComp, where annual equity grants include those granted after the inducement grants but before the end of the first year of employment. t-tests of the differences are all significant at p-value < 0.01. We also find that our sample spans a broader set of smaller firms than that of Fee and Hadlock (2003), who focus on the largest 1,000 firms in their sample period.

Fifty-nine percent of the sample report a positive three-day abnormal announcement return.

This three-day return is greater than the average 2% 30-day return and $30,000 increase in wealth following stock options granted in advance of “good news” documented by Yermack (1997). It is also greater than the 3% 30-day abnormal return and $92,500 change in wealth following unscheduled equity grants in advance of voluntary disclosure documented by Aboody and Kasznik (2000). Heron and Lie (2007) find a similar 30-day abnormal return for suspected back-dated option grants.

In untabulated results, we find that each year in the sample period is well represented, with a slightly larger number of observations occurring during the years 2005-2008.

Daily idiosyncratic return is the residual return from the Fama-French three-factor model. We also use market adjusted return and total raw return in untabulated results to measure daily return, and the results are similar.

In untabulated results, we find consistent results using the market adjusted return and the cumulative raw return.

Bonnier and Bruner (1989) show that stock returns to the announcement of new external CEOs are negatively associated with size and performance prior to the CEO turnover.

We are able to measure industry adjusted ROA and Return over the year following the new CEO appointment for 485 firms.

We find no evidence of significant relation when we estimate the change in the industry adjusted ROA and market return over the year prior to and the year following the new CEO appointment.

We searched for the terms “search” and “firm” within 50 characters of one another, which nearly always matched “search firm.” For each resulting match, we then searched the surrounding 200 characters for verbs in the past tense that were commonly used to describe either the retention of a search firm or the hiring recommendations of a search firm (e.g., engaged, retained, utilized, hired, recommended, proposed, identified). Occasionally, the resulting matches identified the use of a search firm to identify directors. We assume that, if a search firm is used to identify a director, then it is also used to identify a new CEO, and we therefore do not distinguish director from CEO matches.

Dutta (2008) suggests that the portfolio of CEO equity ownership may help resolve adverse selection problems related to CEO skill when both effort and skill affect the value of the equity holdings.

We find, in untabulated results, that the grant date fair value and delta of equity granted in the first year are $1,651,980 and $21,330, which are significantly less than the inducement grant magnitude and inducement grant sensitivity of $3,206,030 and $33,450, respectively.