Do Higher Paid CEOs Weather the Storm Better Do Higher Paid CEOs Weather the Storm Better? Evidence from the Great Recession Wei-Ling Song E.J. Ourso College of Business Louisiana State University Hsiangping Tsai College of Management Yuan Ze University

Motivation & Background The collapse of Lehman Brothers The say-on-pay rules in the Dodd-Frank legislation Shareholder’s reaction Kaplan (2011): Shareholders support More than 98% of S&P 500 firms Some academic view (empirical evidence) Agency problem → CEOs are overpaid Bebchuk et al. (2011): CPS (CEO pay slice) is negatively correlated with firm value (Tobin’s Q), accounting profitability, acquisition announcement returns, and performance sensitivity of CEO turnover.

Bebchuk et al. (2011) CEO Pay Slice (CPS) Definition The fraction of the aggregate compensation of the firm’s top-five executive team captured by the CEO. CPS negatively correlated with Tobin’s q Optimal selection explanation: The optimal level of CPS or the relative importance of the CEO could be higher for lower value firms Agency problem explanation: High excess CPS reflects agency problems, which bring about the identified pattern between lower firm value and higher CPS.

Our Main Idea CPS (Excessive CEO pay) may proxy for Agency problem Tournament effect Unobserved CEO ability CEOs with better capacity to navigate through a difficult environment are likely to be paid higher even though firm value and profitability appear to be similar to other type of firms during normal times. During tough times, high CPS firms perform better

Main Results High CPS firms experienced A significantly lower increases in CDS spread around the Lehman Crisis Lower declines in firm value (Tobin’s Q) during the Great Recession Better outside financing opportunities: Better public debt access/Less deterioration in credit ratings Our results are consistent with the CEO ability hypothesis

CEO Compensation & CEO ability Two views Managerial rent extraction (agency problem) Bebchuk and Grinstein (2005), Bebchuk et al. (2011), Liu and Jiraporn (2010) Market-based (efficient contracting) Frydman and Saks (2010) Rosen (1981), Rossi-Hansberg (2006), Gabaix and Landier (2008) Murphy and Zabojnik (2007): managerial ability vs. firm-specific human capital Kapalan and Rauh (2010)

Credit Default Swaps (CDS) Credit Default Swap (CDS) Allows for one party transfers the default risk of a reference entity (or a firm) to another by paying an annual premium during the term of the contract. CDS spread quoted in basis points Information about the market perception of credit condition for a firm

Why examine CDS spreads The benefit of CEO high ability (to weather storm during crisis) is more likely to be captured by creditors CDS contracts are actively traded Price info more reliable than thinly traded bonds or loans CDSs are traded by large sophisticated institutions Information-efficiency (CDS spreads vs. stock prices) Acharya and Johnson (2006): a information flow from CDS market to the equity market

The value implication during crisis CDS: wealth effect of creditors If higher ability CEO can manage the exogenous shock better, creditors may benefit. Tobin’s Q: wealth effect of equity holders Residual claimants: the value implication is unclear CEO ability hypothesis High CPS firms → lower CDS spread increases High CPS firms → lower declines in Tobin’s q Agency problem hypothesis High CPS firms → higher CDS spread increases High CPS firms → higher declines in Tobin’s q

Alternative explanation (1) Agency problem: High CPS CEO take low risk Value implication of agency problems to creditors and shareholders Agency cost of debt: lower value for creditors Manager actions benefit shareholders at the expense of debt holders Conflict of interests between managers and shareholders Value destruction/high CPS firms taking more risk → harmful for both creditors and shareholders Bebchuk et al (2011) Lower risk taking: managers choose lower risk projects → enhance creditor’s value inconsistent with Liu and Jiraporn (2010)

Alternation explanation (1) Agency problem: High CPS CEO take low risk CEO’s low risk taking agency problem Control for CEO risk taking incentive Wei and Yermack (2011): inside debt variables Examine Tobin’s Q How shareholder view firms with different levels of CPS throughout the crisis? High → rule out the low risk taking

Alternation explanation (2) Tournament effect Tournament Effects Kale et al. (2012): positive competition among VPs contributes to higher values. Based on Murphy (1999), the level and structure of managerial compensation are driven by size and industry. Tournament size is likely to be similar within an industry. To net out the tournament effect Use Industry-adjusted CPS

Sample selection CDS spread ExecuComp & IRRC (CG data) Senior 5-year term CDS quotes ExecuComp & IRRC (CG data) Final sample: 407 firms Following Bebchuk et al.(2011) CEO tenure>=1 year Firms reporting top 5 executive compensation 332 industrial firms and 75 financial firms

Sample distribution

Variables CPS (CEO pay slice) High vs. low CPS firms the fraction of the total top five executives’ compensation that goes to CEO. Total Compensation (TDC1) High vs. low CPS firms High: Firms with above median ind-adj CPS during the fiscal year prior to the Lehman Crisis Governance variables Bebchuk et al. (2011)

Variables (continued) Risk characteristics CEO inside debt variables (Wei and Yermack 2011) Delta and vega (Core and Guay 2002) Delta: $ change in the value of equity related holdings/grants for a 1% change in the stock price Vega: $ change in the value of option holdings/grants for a 0.01 change in the annualized standard deviation of stock returns Asset risk characteristics: Ind-adj cash flow volatility (Parrino and Weisbach 1999) Stock return risk: market beta Spillover effects from the financial industry: Stock return co-movements of firms and financial industry

Median CDS spread by CPS

Time-line for event windows

CDS spreads by CPS type and by event window

Summary statistics by CPS types -fiscal year prior to the Lehman Crisis

Summary statistics by CPS types -fiscal year prior to the Lehman Crisis

Summary statistics by CPS types -fiscal year prior to the Lehman Crisis

Summary statistics by CPS types -fiscal year prior to the Lehman Crisis

Change in CDS spread surrounding the Crises

Change in CDS spread: Lehman Crisis (control for CEO risk-taking)

Change in Tobin’s q surrounding the Lehman Crisis

Change in Tobin’s q surrounding the Lehman Crises (control for CEO risk-taking)

Other selective variables: Pre-crisis level and changes

Debt Financing by CEO Pay Slice (CPS) % of firms accessing the debt market

Bond analysis by CPS type

Loan analysis by CPS type

Changes in Credit Rating All firms

Changes in Credit Rating weighted by bond or loan issue amounts

Conclusion High CPS firms performed better than low CPS firms during the Great Recession CDS spreads/ Tobin’s q / better public debt access / less deterioration in credit rating Consistent with the CEO ability hypothesis Higher paid CEOs can navigate through tough times better than lower paid CEOs CPS captures elements of both CEO ability and the agency problem The common managerial rent extraction proxies used in the literature are also likely to capture managerial ability.