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Journal of Business Economics

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18.04.2018 | Original Paper

Hedging and accounting-based RPE contracts for powerful CEOs

verfasst von: Viktoria Diser, Christian Hofmann

Erschienen in: Journal of Business Economics | Ausgabe 7-8/2018

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Abstract

Several firms prohibit their CEOs from trading in the stock of peer firms. This is puzzling since hedging by the CEO through private trading in the capital market can reduce the CEO’s exposure to systematic compensation risk. When the CEO’s incentive contract comprises relative performance evaluation, we find that the firm might want to disallow private hedging even though there are no technological interdependencies or strategic interactions to peer firms. In the analysis, we highlight two frequently observed characteristics of incentive contracts. First, the use of accounting benchmarks is widespread in compensation contracts for CEOs. Second, empirical and anecdotal evidence suggests that powerful CEOs have influence on the process of designing their own compensation. We find that in the presence of a powerful CEO, the firm can benefit from disallowing private hedging. In particular, the firm’s decision to allow or to disallow private hedging depends on the characteristics of the accounting benchmarks and the characteristics of the peer firms.

Vorheriger Artikel Self-enforcing capital tax coordination

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Journal of Business Economics

From January 2013, the Zeitschrift für Betriebswirtschaft (ZfB) is published in English under the title Journal of Business Economics (JBE). The Journal of Business Economics (JBE) aims at encouraging theoretical and applied research in the field of business economics and business administration, promoting the exchange of ideas between science and practice.

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The rigorous rules imposed by the SEC and the firms result from the incentive incompatibility of such transactions (e.g., Dye and Sridhar 2016; Gao 2010).

Trading in competitors’ stock might be undesirable from the firm’s perspective in the presence of strategic interactions between firms (as in Aggarwal and Samwick 1999; Asseburg and Hofmann 2009). In this analysis, we explore whether trading in other firms’ stock (including competitors) might be undesirable from the firm’s perspective even if there are no strategic interactions between firms.

More recent evidence by Gong et al. (2011) extracted from the 2006 proxy statements of S&P 500 firms shows that stock price based performance measures are increasingly used as RPE benchmarks. Still, about one fourth of RPE users in their sample employ accounting metrics. Implicit RPE tests yield mixed results. For instance, while Antle and Smith (1986) find evidence of RPE using accounting-based benchmarks, Albuquerque (2009), Gibbons and Murphy (1990), and Janakiraman et al. (1992) fail to find support for the RPE hypothesis using accounting metrics as benchmarks.

Hedging and RPE are perfect substitutes when the firm implements RPE by using stock price based performance as a benchmark, as the CEO can perfectly replicate the RPE contract (e.g., Antle and Smith 1986; Garvey and Milbourn 2003; Jin 2002; Maug 2000). In this case, implementing RPE in addition to private hedging by the CEO does not reduce compensation risk. In contrast, if accounting benchmarks are used in the RPE contract, the CEO cannot replicate the RPE contract by trading the shares of peer firms because accounting benchmarks are not tradeable in capital markets (Antle and Smith 1986; Maug 2000).

Evidence on the influence of powerful CEOs on compensation also follows from studies on backdating options (Collins et al. 2009), pension benefits (Gerakos 2010), and one-dollar salaries (Loureiro et al. 2011).

Other hedging costs discussed in the literature include transactions costs, e.g., due to the imperfect liquidity of the capital market; CEO wealth and short-selling constraints; and limited access to markets in which the CEO can hedge his exposure to systematic risks (Antle and Smith 1986; Gao 2010; Dye and Sridhar 2016; Ozerturk 2005).

Similarly, Wu (2014) differentiates between “correlated firm-specific risk” that affects all firms in an industry and market risk that reflects economy-wide shocks. Wu (2014) assumes that the CEO can hedge market risk on own account (e.g., by investing in a market index). However, in his model, the correlated specific risk can be filtered only at the firm level through RPE.

To simplify the analysis, we do not endogenize the capital market. Similar to Sloan (1993), we model the stock price as an exogenous variable.

In our main analysis, we focus on the trade-off between accounting-based RPE contracts and the benefits of private hedging by the CEO. In Appendix B: Additional Analysis, we consider the more general setting where the BoD uses the stock price of the own firm in addition to accounting earnings for contracting with the CEO. We illustrate the conditions under which the results from the main analysis remain qualitatively the same.

Similarly, Chiappori et al. (1994) considers a setting where the principal can monitor the agent’s saving and borrowing in the capital market.

The index “†” denotes the case when the BoD chooses all parameters of the incentive contract.

Previous research established several measures of CEO power such as CEO tenure, CEO duality, and percentage of insiders on the BoD (e.g., Adams et al. 2005; Grinstein and Hribar 2004; Morse et al. 2011).

The index “‡” denotes the case when a powerful CEO influences the design of the RPE contract.

The principal adjusts the fixed wage \( c_{0} \) to skim off any benefits to the CEO from distorting \( v_{p} \); the powerful CEO receives his reservation utility.

The results remain the same when the CEO sequentially chooses his hedging strategy, \( h \), and the incentive weight on the performance of the peer firm, \( v_{p} \).

When private hedging is personally costly for executives, e.g., due to wealth constraints, RPE and hedging might be used simultaneously to filter risk even though all performance metrics underlying the compensation contract are traded in the capital market (Garvey and Milbourn 2003).

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Titel: Hedging and accounting-based RPE contracts for powerful CEOs
verfasst von: Viktoria Diser
Christian Hofmann
Publikationsdatum: 18.04.2018
Verlag: Springer Berlin Heidelberg
Erschienen in: Journal of Business Economics / Ausgabe 7-8/2018
Print ISSN: 0044-2372
Elektronische ISSN: 1861-8928
DOI: https://doi.org/10.1007/s11573-018-0907-7

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