1. 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

2. 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.

3. 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.

4. 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

5. 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

6. 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)

7. 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

8. 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

9. 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

10. 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)

11. 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

12. 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

13. 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

14. Sample distribution

15. 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)

16. 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

17. Median CDS spread by CPS

18. Time-line for event windows

19. CDS spreads by CPS type and by event window

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

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

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

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

24. Change in CDS spread surrounding the Crises

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

26. Change in Tobin’s q surrounding the Lehman Crisis

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

28. Other selective variables: Pre-crisis level and changes

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

30. Bond analysis by CPS type

31. Loan analysis by CPS type

32. Changes in Credit Rating All firms

33. Changes in Credit Rating weighted by bond or loan issue amounts

34. 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.