Inside Debt and Stock Price Performance

Abstract:     
We analyze whether paying CEOs with inside debt (pensions and deferred compensation) benefits shareholders. We find that stock price reaction to initial revelation of inside debt information following the SEC amendment is significant and positive, albeit delayed. In the subsequent revelation of information pertaining to the use of inside debt for firms that disclosed no inside debt compensation in the first revelation, the stock price response is immediate and significantly positive. In and after the recent financial crisis, firms that use a combination of inside debt and equity in compensating their CEOs had better stock price performance than firms that pay their CEOs with equity, but no inside debt. During the crisis, among firms that use inside debt, firms that employ a debt bias in compensation (debt-to-equity compensation of the CEO exceeds the corporate leverage ratio) performed better than firms that employ an equity bias and vice versa after the crisis. In the crisis (post-crisis) period firms that employ a debt (equity) bias in compensation outperformed the value-weighted market portfolio on a risk-adjusted basis. Notably, firms that employ a debt bias did not experience substantial stock price decline in the post-crisis period. Our evidence support Edmans and Liu (2011)’s theoretical propositions that optimal level of inside debt is strictly positive and pure equity compensation is inefficient and, in most cases an equity bias is desired to induce effort; however, a debt bias is desired when insolvency is likelier. Findings have implications for firms and policymakers in terms of risk management through managerial compensation. We deduce that inside debt also enhances hedging possibilities for stock investors through stock selection and portfolio choice.

Number of Pages in PDF File: 54

Keywords: Defined benefit pensions, deferred compensation, managerial incentives, abnormal return

JEL Classification: G12, G14, G32, M52

working papers series