Outside Opportunities, Managerial Risk Preferences, and CEO Compensation
Posted: 28 Nov 2017 Last revised: 7 Oct 2019
Date Written: October 23, 2018
Exploiting the setting of staggered adoption of the Inevitable Disclosure Doctrine (hereafter IDD) in U.S. state courts, we examine how quasi-exogenous restrictions of outside employment opportunities affect CEOs’ risk preferences. IDD adoption constrains executives’ ability to work for competitors, resulting in a reduction in their employment options. We expect IDD adoption to increase CEOs’ risk avoidance by increasing their costs of termination and reducing the reward to risk taking. Consistent with this prediction, we find that, when making investment decisions, CEOs are less responsive, post IDD adoption, to risk-inducing incentives provided by their compensation package. The effect is more pronounced for CEOs with more outside opportunities absent the IDD, whom the IDD’s restrictions are more likely to bind. Additional analyses suggest that the board adjusts compensation to overcome the reduction in risk appetite. Overall, we provide new evidence on how external labor market frictions affects CEO risk preferences and compensation.
Keywords: Managerial risk aversion, External labor market, Risk taking, IDD
JEL Classification: G32, M12, J60
Suggested Citation: Suggested Citation