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E-MailM. Todd Henderson is an Assistant Professor of Law at University of Chicago Law School.
Each year, CEOs sell billions of dollars of stock in their firms. Previous empirical work demonstrates that CEOs earn abnormal returns on these trades, suggesting some trading based on material non-public information. Critics of CEO compensation practices offer this fact as evidence of a manager-dominated process. According to their story, CEOs earn “extra” compensation from these profits that is not disclosed or taken into account by the board when setting CEO pay. CEOs are therefore systematically overpaid.
A new paper, available here, presents evidence boards of directors bargain with executives about the profits they expect to make from trades in firm stock. In general, the evidence suggests executives whose trading freedom is increased experience reductions in other forms of pay to offset the potential gains from trading. This “implicit compensation” is a significant component of pay (about 20 percent). This result is consistent with (and the flipside of) a study by Darren Roulstone, finding firms that restrict trading increase compensation to offset the lost opportunities from trading. While Roulstone finds that firms restricting trading pay more, this Paper finds that firms liberalizing trading pay less.
Roulstone does not distinguish, however, between the gains expected from being able to trade (liquidity benefits) and being able to trade on inside information (information benefits). Using a new dataset of firms permitting so-called Rule 10b5-1 trading plans, this Paper tries to isolate the informed-trade component. Firm disclosure choice about Rule 10b5-1 plans provides two groups of firms that sort by expected trading profits based on informed trades, and this allows us to test whether boards anticipate these profits and deduct them from executive compensation. The evidence suggests they do, which speaks to not only theories about how boards set pay but also to issues of insider trading policy.
For instance, the data presented in the Paper seriously undercuts criticisms of the laissez-faire view of insider trading most closely associated with Henry Manne. At least with respect to classic insider trading (that is, a manager of a firm trading on the basis of information about the firm where she works), if boards are taking potential trading profits into consideration when setting pay, it is difficult to locate potential victims of this trading. Current shareholders should be happy with a deal that pays managers in part out of the hide of future shareholders, and the firm should internalize any costs arising from this payment scheme, since future shareholders should take this into account when deciding whether and what price to buy shares. While there still may be good reasons to prohibit some individuals from trading on material, non-public information, the case for classic insider trading liability may be made weaker by this data.
The paper is available here.
