CEO Inside Debt Holdings and the Riskiness of Firm Investment and Financial Policies

In the paper, Seeking Safety: The Relation Between CEO Inside Debt Holdings and the Riskiness of Firm Investment and Financial Policies, forthcoming in the Journal of Financial Economics, we investigate whether CEOs with large inside debt holdings protect the value of their holdings by implementing less risky investment and financial policies. The recent near-collapse of global financial markets led to renewed scrutiny of executive compensation practices by journalists, academicians, politicians, and regulators.  Much of the scrutiny focused on alleged excesses in the compensation packages of the executives deemed (at least partially) responsible for the economic turmoil (e.g., Karaian, 2008; Rappeport, 2008; McCann, 2009). However, the financial crisis also highlighted the vulnerability of certain components of firm-specific executive wealth during times of financial distress as several prominent chief executive officers (CEOs) surrendered significant portions of their inside debt holdings (pension benefits and/or deferred compensation) when their firms failed during the crisis. Inside debt holdings are at risk because they generally represent unsecured and unfunded liabilities of the firm, rendering these executive holdings sensitive to default risk similar to that faced by other outside creditors (Sundaram and Yermack, 2007; Edmans and Liu, 2011).

Following the theoretical predictions of Jensen and Meckling (1976) and Edmans and Liu (2011), as well as recent empirical applications (Sundaram and Yermack, 2007; Wei and Yermack, 2011), our construct of interest is the relative (to the firm) CEO debt-to-equity ratio.  Because prior work has employed several empirical proxies to capture this construct, we perform tests using four alternative measures. Using executive compensation data for firms in the Standard and Poor’s 1500 index, we find a negative association between our measures of the relative CEO debt-to-equity ratio and future stock return volatility. Additional analyses reveal that the decrease in the volatility of future stock returns can be partially explained by more conservative investment and financial policies.  Specifically, research and development (R&D) expenditures are lower and firm diversification is higher when relative CEO debt-to-equity ratios are larger. We also document a positive association between the relative CEO debt-to-equity ratio and working capital (a measure of firm asset liquidity) and a negative association between the relative CEO debt-to-equity ratio and financial leverage.

Our study provides an important contribution to an emerging stream of empirical research which investigates the theoretical prediction that inside debt holdings strengthen the alignment of CEO and debt holder incentives (Jensen and Meckling, 1976; Edmans and Liu, 2011). To date, extant research (Anantharaman, Fang, and Gong, 2010; Chen, Dou, and Wang, 2010; Wang, Xie, and Xin, 2010; Wei and Yermack, 2011) has focused on market-based implications of CEO inside debt holdings (e.g., a reduced cost of debt, fewer restrictive debt covenants, etc.).  In contrast, we provide direct evidence on several specific mechanisms through which these implications might be realized. Our study also complements and extends the literature which investigates the incentive effects of various components of CEO wealth. To date, this work has focused primarily on the implications of CEO equity holdings and finds that this form of compensation provides increased risk-taking incentives, on average (see, e.g., Guay, 1999; Rajgopal and Shevlin, 2002; Coles, Daniel, and Naveen, 2006). On the other hand, some studies find that specific types of CEO equity holdings (e.g., in-the-money options) could lead to higher levels of CEO risk aversion (see, e.g., Lambert, Larcker, and Verrecchia, 1991; Lewellen, 2006). We depart from this line of research in that we focus on a different component of CEO wealth and find that inside debt holdings can induce CEOs to become more risk-averse.  Finally, we contribute to the literature which investigates the factors (e.g., corporate governance, ownership structures, investor protection, etc.) that affect the riskiness of corporate policy choices (see, e.g., Agrawal and Mandelker, 1987; John, Litov, Yeung, 2008; Laeven and Levine, 2009).  Our results, which suggest that inside debt holdings can dampen CEOs’ risk-seeking behavior, are particularly relevant in light of the role that risky policy choices allegedly played in the recent financial crisis.

The full paper is available for download here.