Are CEOs’ Purchases More Profitable Than They Appear?

Abstract

Little is known about why CEOs voluntarily purchase shares of their firm other than because they expect to directly profit from doing so. However, since CEOs are risk-averse, highly un-diversified, and face litigation costs from trading on favorable private information, direct profits are unlikely to be the sole motive — especially considering that many of their purchases are ultimately unprofitable. We conjecture and find evidence that CEOs who have recently purchased shares are less likely to be terminated following poor performance and that this relation varies predictably depending on (i) the board’s access to alternative sources of information about the CEO, (ii) the CEOs’ expected cost of the purchase, and (iii) whether the CEO is already bonded via unrestricted shareholdings. Collectively, our results provide evidence that some CEOs voluntarily purchase shares despite the relatively high (opportunity) cost of foregone diversification — and, in some cases, outright un-profitability — of doing so to indirectly benefit by prolonging their tenure. Our estimates imply that the average direct (i.e., monetary) abnormal returns earned by CEOs’ purchases increase from 3% to 58% after accounting for the indirect benefit of prolonged tenure.

Keywords: Insider Trading, Private Information, CEO Turnover, Incentive Contracting, Signalling

JEL Classification: A00, A10, C73, C78, D01, D02, D61, D81, D86, G30, L21, M41, M51, M52, M55