Abstract
We document that the CEO pay-for-performance incentive positively predicts firm’s stock liquidity. The evidence is consistent with the hypothesis that, to mitigate their undiversified price risk and reduce the transaction costs, CEOs with high pay-for-performance incentive compensations exert extra efforts in shaping firms’ information environment to improve stock liquidity. We further identify three internal and two external channels through which incentivized CEOs stimulate firms’ stock liquidity. Specifically, we find that firms with highly incentivized CEOs tend to provide earnings guidance, file more readable 10-K reports, and perform more stock splits. In addition, these firms attract larger analyst following and have lower earnings forecast dispersions.
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Notes
Ghosh and Moon (2010) even document a non-linear relation between the CEO ownership and firms’ information quality.
We thank the referee for suggesting to include the two external channels.
We are grateful to the referee’s suggestion of reconciling the discrepancies between our findings and earlier papers on the adverse effects of CEO incentives. In the Appendix, along the lines of Burns and Kedia (2006), we show that CEO pay-for-performance compensation contributes to the increased probability of financial restatement. But the number of restatements is very low, and the effect is mostly driven by firms with weak corporate governance, consistent with our finding that the adverse impact of CEO incentives is more pronounced in these firms.
We also use CEO’s gender and education background as an alternative set of instrumental variables for CEO Delta. The results are similar.
To further identify the causality between CEO Delta and firms’ stock liquidity, we employ the vector autoregression (VAR) model to perform the panel Granger causality test between ILLIQ and Delta. The evidence indicates significant bi-directional causality between ILLIQ and Delta.
http://webuser.bus.umich.edu/feng/. Per Li (2008), “The Fog index is from the computational linguistics literature, which combines the number of words per sentence and the number of syllables per word to create a measure of readability.”
Sometimes, Execucomp reports the compensation data of both departing and incoming CEOs. In these cases, we use the data of the new CEO.
We thank the referee for pointing out this issue. For example, as shown in the contemporaneous regression (model (1)) in Table 3, the estimated coefficients for Delta and Vega are -0.004 and 0.004, respectively, both of which are significant at the 1% level. From Table 1, Delta and Vega have similar standard deviations. Therefore, the effects of Delta and Vega may be offsetting each other.
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Acknowledgements
We would like to thank the anonymous referee, Greg Eaton, Ramesh Rao, Yanjian Zhu, Track Chairs of FMA best paper awards of the FMA annual conference 2016, participants of the SWFA annual conference 2015, the FMA annual conference 2016, and seminar participants at Oklahoma State University and Zhejiang University for helpful comments.
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Appendix
Appendix
1.1 A.1 Causality
In a recent study, Jayaraman and Milbourn (2012) examine the impact of stock liquidity on CEO pay-for-performance incentive, Delta. They document that as stock liquidity increases, the reduced trading costs encourage CEOs to take stock-based compensations rather than cash-based compensations. Our paper complements Jayaraman and Milbourn (2012) by showing that CEO Delta can positively influence stock liquidity. The findings in Jayaraman and Milbourn (2012) and this paper suggest a bi-directional causality between Delta and stock liquidity.
To further identify the directions of the causality, we employ the Granger causality test by estimating the panel vector autoregression model (VAR(1)) for ILLIQ and CEO Delta. The estimation results are shown in Table 15. The estimated coefficient on Delta in the ILLIQ equation is − 0.010 and significant at the 1% level with the t-statistic at − 10.00, consistent with our findings that Delta positively predicts stock liquidity. The coefficient on ILLIQ in the Delta equation is − 0.825 and significant at the 1% level with the t-statistic at \(-\) 6.042, consistent with the evidence in Jayaraman and Milbourn (2012) that firms’ stock liquidity positively influences CEO Delta. The F-test statistic is highly significant for both equations, rejecting the null the nulls that Delta and ILLIQ do not Granger-cause one another. We have also estimated VAR specifications with more lags and control variables. The inference does not change qualitatively for the alternative regressions. The results for alternative stock liquidity measures such as Turnover are also similar. In sum, the evidence indicates a bi-directional causality between Delta and stock liquidity.
1.2 A.2 CEO pay-for-performance incentive and restatements
Previous studies have shown that CEO pay-for-performance incentive can cause the CEO to manipulate or conceal information, which is detrimental to stock liquidity, opposite to our findings. To reconcile the opposite predictions, we examine the positive relation between CEO incentives and financial restatement documented in Burns and Kedia (2006). We estimate logit regressions of financial restatement on lagged Delta. The results are shown in Table 16. Clearly, higher Delta leads to higher likelihood of financial restatement as the coefficient of Delta is positive and significant at the 5% level in all four models, consistent with the findings of Burns and Kedia (2006).
The evidence suggests that the “Dark Side” of CEO incentives exists. One explanation of the discrepancy between the results of this paper and the previous studies is that the “Bright Side” dominates the “Dark Side” in the data so that the net impact of CEO Delta on stock liquidity is positive. This can be seen from the small number of cases of financial restatement, only 312 during 2000–2015 in our CEO compensation sample. Moreover, the negative coefficient of \({ Delta}\times E-{ dummy}\) indicates that the effect of CEO Delta on financial restatement is mostly significant for firms with weak corporate governance, consistent with our findings that CEO Delta affects stock liquidity more for firms with strong corporate governance.
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Feng, H., Yan, S. CEO incentive compensation and stock liquidity. Rev Quant Finan Acc 53, 1069–1098 (2019). https://doi.org/10.1007/s11156-018-0775-9
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DOI: https://doi.org/10.1007/s11156-018-0775-9