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E-MailThe following post comes to us from Xia Chen and Qiang Cheng, both of the School of Accountancy at Singapore Management University; Alvis Lo of the Department of Accounting at Boston College; and Xin Wang of the Accounting Area at the University of Hong Kong.
In our paper, CEO Contractual Protection and Managerial Short-Termism, which was recently made publicly available on SSRN, we investigate whether CEO contractual protection, can address managerial short-termism by reducing managers’ incentives to engage in myopic behavior. Managers generally have incentives to boost short-term performance to increase their welfare, potentially at the expense of long-term firm value. However, CEOs with contractual protection are protected from short-term performance swings and downside risk, and consequently are likely to have weaker incentives to engage in myopic behavior.
In this paper, we examine two forms of CEO contractual protection: employment agreements and standalone severance pay agreements. CEO employment agreements are fixed-term comprehensive contracts between CEOs and firms; they generally specify termination payments and other terms such as non-competition and confidentiality. CEOs with employment agreements cannot be fired within the term without good cause. Standalone severance pay agreements stipulate the amount and terms of payments that executives can receive when their employment is terminated. CEO employment agreements and standalone severance pay agreements are the outcome of the negotiation between the firm and the CEO. From the firm’s perspective, such agreements increase the cost of firing the CEO, but they benefit the firm by incentivizing the CEO to undertake long-term risky projects and invest in firm-specific human capital. From the CEO’s perspective, such agreements offer protection by compensating the CEO for termination and downside risk. Thus, we expect CEOs with contractual protection to have weaker incentives to engage in myopic behavior.
To test this prediction, we hand collect information on CEO employment and severance pay agreements from firms’ proxy statements. Because the tradeoff between meeting current period’s earnings targets and increasing long-term firm performance is particularly salient in the case of cutting R&D, we use the likelihood of cutting R&D as our main proxy for managerial short-termism. The sample includes 2,027 firm-years from S&P 500 firms over the 1995-2008 period that have proxy statements and significant R&D expenditures. To increase the power of the test, we focus on firm-years in which a potential earnings decrease can be averted by cutting R&D, i.e., firm-years in which there is a decrease in the pre-tax, pre-R&D earnings compared to the previous year, but the decrease is smaller than the previous year’s R&D. The incentive to cut R&D to avoid earnings declines is most salient in this subset of firm-years, referred to as the SD group, and hence we predict that the effect of CEO contractual protection is greater in the SD group than in the other firm-years.
Given that the existence of CEO contractual protection varies with firm and CEO characteristics, we control for the endogeneity using both the instrument variable approach and the Heckman approach. We find that, consistent with our prediction, CEO contractual protection is associated with a lower likelihood of cutting R&D, and this effect is primarily driven by the SD group, in which the incentives to engage in myopic behavior are particularly strong. The effect of CEO contractual protection is both statistically and economically significant. For example, within the SD group, the difference in the likelihood of cutting R&D between firms without and with CEO contractual protection ranges from 21.1 to 24.3 percentage points, depending on the model specification.
We also predict and find that the effect of CEO contractual protection increases with the duration and monetary strength of the protection. For the cross-sectional tests, we predict and find that the effect of CEO protection is greater for firms in more homogenous industries where the threat of CEO dismissal is higher, firms with higher transient institutional ownership where CEOs are under greater pressure to deliver short-term performance, and firms with lower board independence. In general, these results indicate that the effect of CEO protection on managerial myopia is stronger when CEOs have stronger incentives to engage in myopic behavior (as in the first two cases) or when alternative mechanisms to curb myopic behavior are weaker (as in the last case).
We conduct additional analyses to provide further insights and to address alternative explanations. First, we use the extent of real earnings management to proxy for managerial myopia and the inferences are the same. Second, we conduct tests to rule out the alternative explanation that investment opportunities differ between firms with and without CEO protection. Third, we find that within the SD group, CEO protection is associated with better performance in the future. This speaks to the economic benefits of alleviating managerial short-termism.
Overall, our findings suggest that CEO contractual protection, in the form of employment agreements and standalone severance pay agreements, can reduce managers’ incentives to engage in myopic behavior. While the popular press often associates employment agreements and ex post severance pay with managerial power and entrenchment, our evidence suggests that ex ante, such contractual protection can expand managers’ horizons and address the agency problem of managerial short-termism.
The full paper is available for download here.
