Publication and Working PapersPapers available from SSRN
The Economics of Super Managers, joint with Nina Baranchuk and Glenn MacDonald, forthcoming at Review of Financial Studies. Download PDF
We study a model where agents differ in ability, and competitive firms choose both incentives and size. Firms hiring more able CEOs complement ability with greater size, stronger incentives, and higher pay. We derive many empirically testable implications. Some preliminary empirics show the model is useful for understanding interesting compensation trends, e.g. CEO pay and firm size are becoming more closely associated. In the model, a closer association is the outcome of demand growth. In the twelve Fama-French industries, where the association between CEO pay and size has increased is also where industry sales growth has been greatest.
This paper documents the features of the newly disclosed compensation peer groups and demonstrates their significant role in explaining variations in CEO compensation beyond that of other benchmarks such as the industry-size peers. After controlling for industry, size, visibility, CEO responsibility and talent flows, we find that firms appear to select highly paid peers to justify their CEO compensation and this effect is stronger in firms where the compensation peer group is smaller, where the CEO is the Chairman of the Board of Directors, where the CEO has longer tenure, and where directors are busier serving on multiple boards.
This paper studies a three-sided moral hazard problem with one agent exerting upfront effort and two agents exerting ongoing effort in a continuous-time model. The agents' effort jointly affects the probability of survival and thus the expected cash flow of the project. In the optimal contract, the timing of payments reflects the timing of effort: payments for upfront effort precede payments for ongoing effort. Several patterns are possible for the cash allocation between the two agents with ongoing effort. In one case where the two agents face equally severe moral hazard, they share the cash flow equally at each point of time. In another case where the two agents have different severities of moral hazard, their payments are sequential. In a more general case, the two agents with ongoing effort split the cash flow first over time and then over quantity at each point of time. This study provides a framework to understanding a broad set of contracting issues in business. The characteristics suggested in the optimal contract help us identify the causes of business failures such as the recent debacle of Mortgage-Backed Securities (MBS).
Disclosure by firms would seem to reduce the informational asymmetry that is a cause of investment inefficiency in firms. However, the effect of disclosure is subtle, especially when the link between disclosure and firm value is endogenous and depends on incentives within the firm. We analyze various disclosure regimes and determine which ones are efficient (with respect to Myers-Majluf inefficiency) in a model with optimal renegotiation-proof contracts. Disclosing only accepted contracts is not efficient, but either full transparency of all compensation negotiations or, more reasonably, additional disclosure of a forward-looking announcement is efficient. The model is robust to renegotiation in equilibrium and is also robust to changing who offers any renegotiation. The analysis illuminates optimal disclosure regulation. For example, it tells us that allowing forward-looking disclosure is beneficial provided we are in an environment that produces the optimal contract, which gives the manager an incentive for truth-telling.
It has become a regular practice for firms to justify their CEO compensation by referring to a group of companies with highly paid CEOs, claiming they compete for managerial talent with those selected peer companies. This paper examines the dynamics of the peer benchmarking process, addressing whether the 2006 regulatory requirement of disclosing compensation peers has cast sunshine on the practice and thus mitigated firms' opportunistic behavior of benchmarking CEO compensation against a group of self-selected, highly-paid peer CEOs (Faulkender and Yang, 2010; Bizjak, Lemmon, and Nguyen, 2011). Our evidence shows the manipulation of the benchmarking process did not stop after disclosure became mandatory in 2006. It actually became more severe at firms that received substantial shareholder complaints about their compensation practices, and at firms with low institutional ownership, busy Boards of Directors, and large Boards of Directors. These findings call into question the ability of mere disclosure to remedy potential abuses in determining executive compensation.
We examine why CEOs remain in power in over half of the firms that intentionally misreport earnings. We find that CEOs are more likely to remain in power when (i) the CEO and (conventionally independent) directors appear to collude: both benefit from the misstated accounting by selling their equity contingent wealth before discovery and by ratifying value-destroying mergers; (ii) the CEO is more costly to replace: the CEO has higher managerial ability, a good track record, is the founder, and has no heir apparent; and (iii) the CEO is less costly to retain: misreporting is less severe, the firm is not subject to10-b5 litigation, and the firm did not engage in excessive public debt issuance which requires assuaging bondholders. Our results obtain whether we model changes in CEO or changes in leadership, and are robust to controlling for several explanations offered in prior research. They suggest collusive trading and merger ratification as additional (and observable) means of assessing the independence of outside directors.
This paper documents the characteristics of newly disclosed performance measures and performance targets used in the annual incentive (bonus) plans for CEOs. Our sample includes the S&P 500 constituent firms in the first three years after the compliance deadline of December 15, 2006, with 1,600 performance targets for 773 firm-years. Top five performance measures are earnings per share (EPS), revenue, operating income, net income, and free cash flow. Our detailed analysis using EPS shows that EPS (growth) targets are set consistently lower than earnings expectations. In particular, EPS (growth) targets are lower than analyst consensus, and EPS growth targets are lower than historical EPS growths for the firm and its industry. In addition, we find that 59% of firms exceed their performance targets ex post. As a result, the ex-post annual incentive payouts (bonuses) are on average 114% of the target payouts. Moreover, firms’ incentive plans provide higher ex-ante valus and lower pay-for-performance sensitivities than hypothetical incentive plans that use analyst consensus as performance targets. The evidence of the effect of corporate governance on the setting of performance targets is mixed.
We develop a new Black-Scholes type closed-form valuation formula for executive stock options. This formula incorporates four important unique characteristics of these options that distinguish them from standard European options: (i) The presence of the vesting period; (ii) the tendency of executives to exercise portions of their grants right at the end of the vesting period; (iii) the ability of the executives to choose optimally whether to exercise their options or keep them; and (iv) executives may be forced to early exercise their options, possibly due to severe liquidity shocks or due to unexpected departure. We use an extensive executive option data set to calibrate our model. We show that the standard Black-Scholes formula significantly overestimates the value of executive stock options.
We analyze the effect of social pressures on CEO compensation due to interactions with other CEOs and social elites within 60 miles of the firm’s headquarters, as well as comparisons of mansions in the local area. Social premium is the portion of CEO compensation that is linked to the number of local social peers and is not explained by local economic condition, firm performance and characteristics, and corporate governance variables. For S&P 1500 companies during 1994-2005, the average social premium for a CEO increases by $560,000 if the number of peer CEOs increases from 15 to 82 (moving from the 25th to 75th percentile of the sample). Frequency of social interactions affects the social premium; peer CEOs in larger social circles or at greater geographic distance exert less social influence. The social premium result is robust to various pay measures, firm fixed effects, and state fixed effects. In addition, the social premium is greater when the board of directors better understands the local social norm.
We study the effect of the grants of executive stock options and restricted stock on earnings management and insider trading during the vesting years of these grants. In our theoretical model, an informed manager compensated by stock options (which include restricted stock as a special case) is mandated to issue an earnings report. Uninformed investors price the stock based on this report. The manager can manipulate the report to affect the stock price, but earnings management is costly to the manager. The optimal report balances the benefits from the exercised stock options and the costs of earnings management. Earnings management and insider trading occur only if the options are in-the-money post manipulation at the vesting date, and are intensified by larger grants. Consequently, both earnings management and insider trading will be more severe in periods of high stock prices. Our empirical tests focus on the link between the timing and attributes of option grants and the extent of earnings management and insider trading. Our empirical results confirm that (1) deeply in-the-money executive stock options lead to more earnings management and insider trading at the vesting years of the options; (2) more grants of options intensify the extent of earnings management at the vesting years; and (3) earnings management and insider trading are more prevalent when stock prices are high due to high past returns.
It is often taken for granted that: 1) capital markets and institutions allocate funds to firms with high returns; 2) the net gains to the economy from investments by corporations have improved in the last 30-50 years due to technological innovations; and 3) the discipline role of markets and institutions ensures that corporate assets funded with external funds earn higher returns. However, corporate real assets are long lived, and realized returns have to be tracked over a long period to verify these assertions. In this study, we perform large-scale calculations of the realized returns on assets to all firms available in the Compustat database for periods of 10, 20, 30, 40, and 50 years. Our methodology relies only on realized, not expected, cash flows between the firms and all their fund providers. We found several new and surprising results. Realized returns on corporate assets over long periods are, on the whole, lower than expected by the fund providers. They also suffer a long-term decline, and have been below the yields of 10-year Treasury Bonds since 1973. Additionally, firms that received more external financing (from capital markets and institutions) report even lower realized long-term returns. A wealth transfer from an increasingly important class of non-interest bearing liabilities augments the realized returns on equity. These unexpected results may stimulate a fresh debate on the role and long-term performance of capital markets and institutions.
Work in Process
Where Do CEOs Go After Getting Fired? joint with Xiaoyun Yu.
An Examination of Pension Contracts before Pension Freezes and Executive Departures, joint with Irina Stefanescu.
Timing of Effort and Reward: Three-sided Moral Hazard in a Two-Period Model.
J. Yang, H. Yan, and M. Taksar, 2000, Optimal Production and Setup Scheduling: a One-Machine, Two-Product System, Annal of OR on Optimization Techniques and Application, 98, 291-311.
J. Yang, H. Yan and S. Sethi, 1999, Optimal Production Planning in Pull Flow Lines with Multiple Products, European Journal of Operational Research, 119, 582-604.
F. Cheng, H. Yan, and J. Yang, 1998, Production Scheduling of Continuous Flow Lines with Setup Times and Costs, Production and Operations Management, 7, 387-401.