Asymmetric sensitivity of CEO cash compensation to

JournalofAccountingandEconomics42(2006)167–192AsymmetricsensitivityofCEOcashcompensationtostockreturns$AndrewJ.Leonea,JoannaShuangWub,
,JeroldL.ZimmermanbaSmealCollegeofBusiness,PennsylvaniaStateUniversity,UniversityPark,PA16802-1912,USAbWilliamE.SimonGraduateSchoolofBusinessAdministration,UniversityofRochester,Rochester,NY14627,USAReceived1March2004;receivedinrevisedform5February2005;accepted6April2005Availableonline5June2006AbstractWedocumentthatCEOcashcompensationistwiceassensitivetonegativestockreturnsasitistopositivestockreturns.Sincestockreturnsincludebothunrealizedgainsandunrealizedlosses,weexpectcashcompensationtobelesssensitivetostockreturnswhenreturnscontainunrealizedgains(positivereturns)thanwhenreturnscontainunrealizedlosses(negativereturns).ThisisconsistentwithboardsofdirectorsexercisingdiscretiontoreducecostlyexpostsettlingupincashcompensationpaidtoCEOs.r2006PublishedbyElsevierB.V.JELclassification:D23;J33;M40;M46Keywords:Managementcompensation;Contracting;Pay-performancesensitivity;ExpostsettlingupARTICLEINPRESS:10.1016/j.jacceco.2006.04.001$WegratefullyacknowledgethehelpfulcommentsfromworkshopparticipantsatUCBerkeley,theUniversityofChicago,UniversityofColorado,CornellUniversity,GeorgiaStateUniversity,HarvardUniversity,PennStateUniversity,UniversityofRochester,andtheJournalofAccountingandEconomics2004conference,andRayBall,DanBens,JimBrickley,PatriciaDechow(therefereeanddiscussant),ZhaoyangGu,PhilipJoos,DJNanda,ShailPandit,DougSkinner(theeditor),CharlesWasley,andRossWatts.TheJohnM.OlinFoundationandtheBradleyPolicyResearchCenterattheUniversityofRochesterprovidedsupport.Thispaperwaspreviouslytitled‘‘ConservatisminCEOCashCompensation.’’
Correspondingauthor.Tel.:[phone];fax:[phone].E-mailaddress:[e-mail](J.S.Wu).1.IntroductionAnumberofstudiesinaccountingdevelopandtesttheoriesabouthowcertainattributesofstockreturnsandearningsaffecttheirrelativeuseasperformancemeasuresinexecutivecompensationcontracts.Forexample,LambertandLarcker(1987)testwhethertheweightplacedonearningsversusreturnsisafunctionoftheirrelativesignal-to-noiseratios.Ourstudyextendsthisresearchbyexploringhowotherfeaturesofstockreturnsandearnings,namelythetreatmentofunrealizedgainsandlosses,influencethesensitivityofcashcompensationtostockreturnsandearnings.Inparticular,weconsiderhowtheinclusionofunrealizedgainsinaperformancemeasure,suchasstockreturns,cangiverisetocostlyexpostsettlingup.Theexpostsettlingupproblemariseswhenmanagersarepaidforexpectedfuturecashflowsthatdonotmaterialize.Forexample,iftheCEOreceivesabonusforsigningafirm-valueincreasinglong-termcontract,butlaterthecontractiscanceled,thestockholdersincurcostsrecoupingthebonuspaidforexpectedcashflowsthatvanish(Watts,2003a;Barclayetal.,2005).1Wearguethatefficientcashcompensationcontractsmitigatetheexpostsettlingupproblembylimitingcashdistributionstomanagersforunrealizedgainsthatmaylaterdisappear.Weusetheterm‘realization’tomeantheprocessofconvertingchangesinfirmvalueintocashorintowhatcanlaterbeconvertedintocashwithahighdegreeofcertainty.Notethatbyourdefinition,‘realization’doesnotrequireconversionintocashitself.Forexample,accountingrevenuesareconsideredtoberealizedforcompensationpurposesduetotheirhighdegreeofverifiability(Watts,2003a).Anotherexampleisthediscoveryofagolddepositbyagoldminecompany.TheCEOshouldbecompensatedforthediscoveryifthevalueofthedepositishighlyverifiable.Ifthefirmpaysthemanageracashbonusforanunrealizedgain,butthatgaindoesnotlatermaterialize,themanagercanquitthefirmandtheshareholderswillhavedifficultyrecoveringthecashpaidforthatunrealizedgain.Managers,likeshareholders,havelimitedliability,whichcreatescostlyexpostsettlingupwhenmanagersarepaidforunrealizedgainsthatevaporate(Watts,2003a).BynotrewardingaCEOimmediatelywithcashforunrealizedgains,theboardalsoprovidestheCEOanincentivetotakethenecessaryactionstorealizethosegains.Incontrasttounrealizedgains,weexpectcashcompensationtoreflectunrealizedlosses,topreventmanagersfromevadingthecashcompensationconsequencesoftheselosses.Weemphasizethatmanagersshouldberewardedforgeneratingunrealizedgainsbutcompensatingmanagersimmediatelywithcashforunrealizedgainslikelyincreasesthecostofexpostsettlingupcomparedtootherformsofcompensation,suchasequity-basedcompensationwithvestingconstraints.Eventhoughrewardingmanagersforunrealizedgainswithequityratherthanimmediatelywithcashimposescompensationriskonarisk-averseCEO,thecostsofimposingtheadditionalcompensationriskcanbeoffsetbythegainsfrommitigatingexpostsettlingupincashcompensation.Sincestockreturnsincorporatebothunrealizedgainsandunrealizedlosses,wepredictCEOcashpaytobeasymmetricallyrelatedtostockreturnsinthesensethatpayislessARTICLEINPRESS1Recenteffortsbyseveralcompanies,forexampleFannieMae,FreddieMac,Conseco,andComputerAssociates,torecoupcashcompensationpaidtoexecutivesindicatejusthowcostlyexpostsettlingupcanbe.Litigationandproxyfightsareofteninvolvedinordertoforcetheexecutivestoreturnthecashthe