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E-MailChristopher Armstrong is the EY Professor of Accounting at the Wharton School of the University of Pennsylvania; Terrence Blackburne is Assistant Professor of Accounting at Oregon State University College of Business; and Phillip Quinn is Assistant Professor of Accounting at University of Washington Foster School of Business. This post is based on their recent paper, forthcoming in the Journal of Accounting and Economics.
A basic tenet of contracting theory is that risk-averse agents require higher expected returns for taking on more risk. However, this principle appears to be at odds with the modest (i.e., 3%) abnormal returns that undiversified CEOs tend to earn on voluntary purchases of their firm’s stock. In contrast to research that focuses on direct trading profits as the primary motive for CEOs’ purchases, we argue that CEOs can also indirectly benefit from prolonged tenure by purchasing shares of their firm’s stock. By voluntarily purchasing additional shares, CEOs can credibly signal their favorable private information, which informs boards as they decide whether to retain or remove CEOs. We estimate that adding the indirect benefit of prolonged tenure following purchases increases CEOs’ total annual returns from 3% to 58%.
To determine whether purchases of their firm’s stock allow CEOs to prolong their employment, we first consider the characteristics of CEOs who make net purchases (i.e., CEOs whose open market purchases exceed their open market sales during the year). We find that net purchasers typically have had a shorter tenure, oversee firms with greater idiosyncratic volatility, and make their voluntary share purchases after poor stock performance. During periods of poor stock price performance, CEOs’ tend to face a heightened risk of performance-related turnover, which provides an incentive for CEOs to purchase shares to signal their expectation of better future performance to the board and investors. To the extent that CEOs’ purchases are viewed as being personally costly, we expect that investors and boards will perceive their purchases as credible evidence that the CEO possesses favorable private information about future performance. For CEOs, who tend to be highly under-diversified, the opportunity cost of not diversifying investments is significant, and this is especially true for CEOs of firms with high idiosyncratic volatility, making purchases by these CEOs more credible.
Next, we control for other determinants of performance-related turnover and find that CEOs’ net purchases are associated with a 2.6 percentage point lower likelihood of performance-related turnover in the following year. Compared to the 5.3% average (i.e., mean) annual likelihood of turnover in our sample, this translates into an economically significant 49 percent lower likelihood of performance-related turnover. The effect of purchases on boards’ termination decisions likely depends on the weight that boards put on CEO purchases. Because boards can learn more about the ability of a CEO over time, we expect that voluntary purchases receive more weight from boards when evaluating newer CEOs. Consistent with this intuition, we find that shorter-tenured CEOs are less likely to experience performance-related turnover following purchases than are their longer-tenured counterparts who also make purchases. We also find that the negative relation between CEO purchases and performance-related turnover is increasing in the short-window market response to a CEO’s purchase, which is consistent with boards and investors interpreting CEO purchases in a similar manner. Furthermore, we find that CEOs who earn either positive or slightly negative abnormal returns have a lower probability of performance-related turnover, but no such relation for CEOs whose purchases earn significant negative returns.
Finally, we examine factors that make boards and investors view CEO purchases as less credible signals of favorable private information. Some CEOs without favorable private information may purchase additional shares to mimic CEOs with favorable private information.
Consistent with boards considering purchases as less credible when the CEO’s previous purchases earned negative abnormal returns, we find no evidence of prolonged employment for CEOs whose purchases in prior years earned negative abnormal returns. Thus, mimicking is not a sustainable strategy for CEOs without favorable information. Relatedly, we expect trivial purchases of less than $10,000 to be viewed as less credible. Consistent with this intuition, we find no evidence of a relation between trivial CEO purchases and performance-related turnover. Overall, our evidence suggests that boards use contextual information about CEOs’ prior purchases and the size of their purchases to inform their interpretation of CEO purchases.
Our study provides four contributions. First, we forge a link between the insider trading and incentive-compensation literatures. Our finding that CEO purchases are associated with a lower likelihood of performance-related turnover helps explain CEOs’ significant unconstrained equity holdings (e.g., Armstrong et al., 2018). Relatedly, this suggests that in some cases CEO diversification and compensation are substitutes. Second, we provide a nonbehavioral explanation for why CEOs’ purchases tend to earn only modest abnormal returns, and why these returns are typically less than the positive abnormal returns following CEOs’ sales. Rather than focus on directly profiting from trades as the primary reason for CEOs’ voluntary purchases, we consider contracting motives that provide an indirect benefit in the form of prolonged tenure.
Third, our evidence bolsters prior findings that CEOs are contrarian traders (i.e., trading against popular opinion by buying shares during periods of poor performance). Finally, our study extends the finding by Hayes and Schaefer (2005) about the type of information that boards consider in their executive compensation and turnover decisions.
The complete paper is available for download here.
