Market Reactions to CEO Inside Debt Holdings

Editor’s Note: This post comes to us from David Yermack, the Albert Fingerhut Professor of Finance and Business Transformation at New York University, and Chenyang Wei, economist at the Federal Reserve Bank of New York.

In our recently updated working paper Stockholder and Bondholder Reactions to Revelations of Large CEO Inside Debt Holdings: An Empirical Analysis, we investigate investor reactions to the first disclosures of the values of CEOs’ pensions and deferred compensation. These two items together comprise managers’ “inside debt” claims against their firms, since each represents a fixed liability owed by the companies to their executives at a future date.

We identify 231 companies whose CEOs have positive inside debt holdings and whose proxy statements with 2006 compensation data are filed in early 2007 during the first wave of disclosures under the SEC’s new executive compensation disclosure regulations. About 45% of these CEOs have excessive inside debt, as their personal inside debt-equity ratios exceed the external debt-equity ratios of their firms. As expected, we find evidence of transfers of value away from equity and toward debt upon revelations that top managers hold large pension and deferred compensation claims. Our results show that bond prices rise, equity prices fall, and the volatility of both securities drops at the time of disclosures by firms whose CEOs have large inside debt.

We conduct a series of ordinary least squares regressions 911 publicly traded bonds issued by our sample of 231 companies to estimate the influence of the CEO’s relative debt-equity ratio on the yield spread for each bond. We define the CEO’s relative debt-equity ratio as the ratio of the CEO’s inside debt-equity ratio over the firm’s external debt-equity ratio, with the CEO’s inside debt-equity ratio equal to the present value of the CEO’s pension and deferred compensation holdings divided by the value of his stock and option holdings. We estimate the monthly regressions in a piecewise specification. The CEO’s debt-equity ratio, which was unknown to investors prior to March 2007, had no significant impact on corporate bond yields up to that time. After the initial wave of CEOs’ inside debt disclosures in March 2007, our cross-sectional estimates of the influence of the CEO’s relative debt-equity ratio upon bond prices become consistently negative, with increasing strength and statistical significance month-by-month, for those observations in which the CEO’s inside debt equity ratio exceeds the firm’s external debt-equity ratio.

By showing that investors take close account of managers’ large inside debt positions when pricing a firm’s external claims, our results extend a nascent literature that illuminates the importance of inside debt as an incentive mechanism.

The full paper is available for download here.

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