CEO Inside Debt and Insider Trading
64 Pages Posted: 21 Sep 2016 Last revised: 19 Nov 2018
Date Written: November 15, 2018
Managerial compensation theory proposes that both equity- and debt-type compensation should be included in the optimal compensation contract in order to align managers’ interests with those of both shareholders and debtholders of the firm. However, this reasoning also suggests that the two forms of compensation are directly in conflict with each other in that shareholders (debtholders) should respond negatively to debt-type (equity-type) compensation. In this study, we examine insider trading in order to determine how firm insiders react to CEO debt-type compensation. Despite existing theoretical predictions, we report that higher CEO debt-type compensation is associated with greater net purchasing of shares by firm insiders. This surprising finding is robust to using two different proxies for debt-type compensation as well as several different variations of a net insider purchasing measure, such as definitions based on opportunistic trades and trades by directors and officers only. The results also hold when we control for a host of alternative factors that affect trading decisions, including asset value uncertainty, which could render CEOs reluctant to take on inside debt. Further, we alleviate endogeneity concerns with the robust results of the instrumental variables tests we employ. Our findings indicate that well-informed insiders are receptive to increases in debt-type compensation, perhaps because they perceive the CEO’s willingness to accept this unsecured promise of future pay as a positive signal to shareholders about the prospective viability of the firm.
Keywords: Inside debt; Insider trading; Compensation; Agency conflict; Inside debt signaling
JEL Classification: G14, G30, G32, G33, G34
Suggested Citation: Suggested Citation