Downside Risk and the Design of CEO Incentives

In our paper, Downside Risk and the Design of CEO Incentives: Evidence from a Natural Experiment, which was recently made publicly available on SSRN, we investigate how downside risk influences the design of CEOs’ incentives. Studying the relationship between firm risk and managerial incentives is a difficult task due to the endogenous nature of the relationship: empiricists cannot easily disentangle the effect of compensation on risk from the effect of risk on compensation (Prendergast, 2002). We address the identification challenge by exploiting a randomized natural experiment that exogenously increased downside equity risk through the relaxation of short-selling constraints. Because the removal of short-selling constraints may cause an increase – or the fear of an increase – in bear raids and market manipulation by short-sellers (Goldstein and Guembel (2008)), this increase in downside risk potentially exposes managers to losses that are beyond their control. In this scenario, CEOs may sub-optimally reduce the risk of their firms to protect their personal wealth and firm-specific human capital (Amihud and Lev (1981), May (1995)). Consistent with this view, firms and their CEOs display an acute aversion to short-sellers, and go to great lengths to fight them and reduce their influence on stock prices (Lamont (2012)). As a result, firms that maximize shareholder value should respond to an exogenous increase in short selling activity by increasing their CEOs’ risk-taking incentives to avoid sub-optimal risk reduction policies, and/or by immunizing their CEOs against the downside risk that lies outside of their control and does not reflect their performance.

Consistent with the notion that firms take downside risk into consideration when designing CEO incentive compensation contracts, we find that the firms affected by this exogenous shock include relatively more stock options in the compensation packages of their CEO and other top managers. Furthermore, we find that these firms adopted other pecuniary and non-pecuniary forms of compensation (severance packages, anti-takeover provisions) to protect their CEOs from the increase in downside risk. Overall, our evidence reveals that there is a causal effect of downside risk on the design of CEO incentives.

Our experiment is based on the SEC’s approval of Regulation SHO (Reg SHO) in 2004, which removed the “uptick rule” for a randomly selected sample of firms (pilot firms). Since the “uptick rule” prevents investors from short selling stocks when prices decline, the firms selected for the Reg SHO experiment became more susceptible to downside risk. As documented by Grullon, Michenaud, and Weston (2011), the increase in short-selling activity after the announcement of Reg SHO led to an increase in the sensitivity of stock returns to negative news. Consistent with these results, we find that firms in the pilot group exhibit more negative returns on bad-market days, become more sensitive to large negative earnings surprises, and display an increase in the volatility-skew of puts on their stocks, suggesting that investors anticipate large negative jumps in price levels. Moreover, this shock to equity risk appears to be asymmetric: there are no significant differences in stock price reactions between the two groups for large positive news, and no increase in the volatility-skew of calls on the stocks. Taken together, these findings suggest that the volatility of pilot firms’ stock prices has only increased on the downside. Hence, we use the Reg SHO experiment to investigate whether an exogenous shock to the downside risk affects CEO compensation.

Since granting more stock options relative to restricted stocks increases the convexity of CEOs’ compensation payoff and provides increased protection on the downside (stock-options granted at the money are less affected by increases in downside risk than restricted stocks), one would expect firms experiencing an exogenous increase in downside risk to use relatively more stock options in their compensation packages. One potential reason for this is that the increase in downside risk leads to an increase in the relative cost of granting stocks as risk-averse managers demand a premium for the exposure to downside risk. Using a difference-in-differences approach, we find evidence consistent with this prediction. In particular, we find that the shock to downside risk does not affect the total value of equity grants awarded by the firm to its CEO, but it affects the structure of the equity grants, which consist of stock options and restricted stocks. Firms in the pilot group respond to the announcement of Reg SHO by increasing the proportion of stock options grants in the new equity grants awarded to CEOs by 7% to 8%.

Additional difference-in-differences tests show that the difference in the structure of new equity grants between pilot and control firms persists over the 2-year period following the announcement and the implementation of the experiment. The difference disappears immediately following the repeal of the uptick rule on all US stock markets in 2007. Furthermore, we also observe that the change in the structure of new equity grants is significantly larger for pilot firms that exhibit the largest increase in their sensitivity to negative news around the announcement date of Reg SHO. This finding suggests that the increase in downside risk is the primary driver of our main results. In addition, we find that this change in the structure of new equity grants extends to other top executives of the firm. We also find evidence that pilot firms further protect CEOs from downside risk by adopting new anti-takeover provisions such as staggered boards, and supermajority rules, and by providing severance packages.

Finally, we investigate the interaction between the design of CEO incentives and investment policies. While Grullon et al. (2011) find that pilot firms reduce their investment activity after the adoption of Reg SHO, we find evidence that the provision of risk-taking incentives via stock options grants potentially mitigates this effect. Specifically, we find that the pilot firms that responded the most to changes in downside equity risk by increasing stock option grants experience the largest increase in capital expenditures and research and development expenses. Although these results shed light on the potential real effects of CEO incentive contracts, we cannot rule out that firms provide more risk-taking incentives via stock options because they have more investment opportunities, and thus we are cautious not to draw any causality inferences from this analysis.

Our results are related to several predictions from principal-agent theories. First, our findings are overall consistent with the trade-off between risk and incentives (Holmstrom (1979)). By changing the structure of new equity grants and insuring their managers against the adverse effects associated with the increased probability of hostile takeovers and dismissals, firms reduce the amount of risk borne by their managers and thus the expected compensation costs. Also related to our results, the model proposed by Hemmer, Kim, and Verrecchia (2000) shows that the convexity in the compensation payoff will be related to the skewness of the price distribution, arguably a measure of downside risk. Second, our evidence is consistent with the view that options potentially induce more risk-taking incentives (Jensen and Meckling (1976)). Risk-averse managers may suboptimally lower firm risk when exposed to more risk they cannot control, i.e. stock price risk. By providing more risk-taking incentives in managerial contracts, firms may be able to offset this adverse effect. Finally, our results are also related to a recent contracting model proposed by Dittmann, Maug, and Spalt (2010) who show that the presence of options in an optimal contract can be justified by CEOs’ loss-aversion. To the extent that downside risk is observationally equivalent to loss-aversion, our results would be consistent with their arguments.

The full paper is available for download here.