CEO Compensation and Covenant Violations

59 Pages Posted: 17 Mar 2011 Last revised: 19 May 2011

See all articles by Bill B. Francis

Bill B. Francis

Rensselaer Polytechnic Institute (RPI) - Lally School of Management

Iftekhar Hasan

Fordham University - Gabelli School of Business; Bank of Finland

Xian Sun

Johns Hopkins University - Carey Business School

Date Written: May 17, 2011

Abstract

Although covenant violations are common and have significant negative consequences for firm value, little is known about why firms violate covenants, especially from manager’s incentive perspective. This study examines the relationship between CEO compensation and covenant violations. Consistent with the risk-shift hypothesis developed by Carlson and Lazrak (2010), we find that firms with CEOs whose salaries constitute a higher proportion of their total compensation are more likely to violate covenants. Those CEOs also actively change their pay structure prior to a violation so as to reduce their wealth exposure to a negative event byincreasing their salaries even higher and/or reducing their share ownership. The results suggest that the likelihood of a future violation increases by 13.6% for every percentage-point increase in salary as a proportion of total compensation and by 4.9% when the salary portion increases by 1% in the year of violation. The difference-in-difference analysis shows that creditors have significant though limited impacts on CEO’s pay structure after a violation. Specifically, the favorable changes include that bonus component increases, the value of options granted reduces and CEO’s total wealth sensitivity to stock prices increases after a violation. Salary component, however, does not decrease but increase. We find that firms that fail to adjust CEO salaries after a violation are more likely to experience multiple violations. Our analysis also shows a negative relationship between the entrenchment index and the likelihood of covenant violations, which reflects the conflicts between shareholders and creditors.

Keywords: CEO Compensation, Covenant Violation, Creditor Rights, Corporate Governance

JEL Classification: J33, G30, G31, G32, G33, G34

Suggested Citation

Francis, Bill B. and Hasan, Iftekhar and Sun, Xian, CEO Compensation and Covenant Violations (May 17, 2011). Available at SSRN: https://ssrn.com/abstract=1786590 or http://dx.doi.org/10.2139/ssrn.1786590

Bill B. Francis

Rensselaer Polytechnic Institute (RPI) - Lally School of Management ( email )

Troy, NY 12180
United States

Iftekhar Hasan

Fordham University - Gabelli School of Business ( email )

Rose Hill Campus Bronx
New York, NY 10458
United States

Bank of Finland ( email )

P.O. Box 160
Helsinki 00101
Finland

Xian Sun (Contact Author)

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States

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