In the study, CFOs versus CEOs: Equity Incentives and Crashes, forthcoming in the Journal of Financial Economics, we examine the impact of executive equity incentives on a firm’s stock price crash risk. Based on a recent theoretical study by Benmelech, Kandel, and Veronesi (2010), we argue that equity incentives motivate managers to conceal bad news about growth opportunities and to choose sub-optimal investment policies to support the pretense. The accumulation of bad news within a firm leads to a severe overvaluation and a subsequent crash in the stock price.
We measure the strength of executive equity-based incentives by calculating the dollar change in the value of the stock or option holdings of the executives given one percentage point increase in the company’s stock price. Firm-level crash risk is proxied by the probability of extreme, negative firm-specific weekly returns, the negative skewness of firm-specific weekly returns, and the asymmetric volatility of negative and positive stock returns.
Using a sample of U.S. firms from the Compustat Executive Compensation database during the period 1993 to 2009, we find that the strength of CFO option incentives is significantly and positively related to future stock price crash risk. In contrast, we find only weak evidence that the strength of CEO option incentives is positively related to crash risk. More importantly, we find that CFO option incentives dominate CEO option incentives in determining future crash risk when we include both CFO and CEO option incentives in the regression. This result suggests that CFOs are more influential in firms’ bad news hoarding decisions.
Our study has some implications for the design of executive compensation. Our findings suggest that the board needs to take special caution in using equity incentives, particularly stock options, to compensate their CFOs. In addition, our results also serve to rationalize the SEC’s recent requirement that firms disclose the compensation packages of their CFOs.
The full paper is available for download here.