M. 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.