CEO Contractual Protection And Managerial Short-Termism
Singapore Management University
Up-and-Coming Small- and Mid-cap Portfolio Managers #MICUS (Morningstar Conference)
Singapore Management University
University of Hong Kong – School of Business
The Accounting Review, September 2015, Forthcoming
How to address managerial short-termism is an important issue for companies, regulators, and researchers. We examine the effect of CEO contractual protection, in the form of employment agreements and severance pay agreements, on managerial short-termism. We find that firms with CEO contractual protection are less likely to cut R&D expenditures to avoid earnings decreases and are less likely to engage in real earnings management. The effect of CEO contractual protection is both statistically and economically significant. We further find that this effect increases with the duration and monetary strength of CEO contractual protection. The cross-sectional analyses indicate that the effect is stronger for firms in more homogeneous industries and for firms with higher transient institutional ownership, as protection is particularly important for CEOs in these firms, and is stronger when there are weaker alternative monitoring mechanisms.
CEO Contractual Protection And Managerial Short-Termism – Introduction
Managerial short-termism, or managerial myopia, has attracted increasing attention from researchers and practitioners in the past couple of decades. Managerial short-termism refers to cutting long-term investments, such as research and development, to meet or beat short-term performance targets (Porter 1992). Prior studies have extensively examined whether and how managerial short-termism can be alleviated by enhancing monitoring or by granting stock-based compensation to managers (e.g., Bushee 1998; Cheng 2004; Farber 2005).1 However, the role of CEO contractual protection in influencing managerial myopia has not been explored, despite the prevalence of CEO contractual protection and its importance in affecting managerial behavior.
In this paper, we investigate whether CEO contractual protection can affect managers’ incentives to engage in myopic behavior and hence influence the extent of managerial short-termism. The fundamental driver of managerial short-termism is the pressure on managers to deliver short-term performance.2 CEO employment contracts can ease such pressure by protecting CEOs from short-term performance swings and downside risk (e.g., Rau and Xu 2013). We thus predict that CEOs with contractual protection are under lower pressure to maintain high short-term performance and are thus less likely to engage in myopic behavior compared to those without contractual protection.
We focus on two types of CEO contractual protection: CEO employment agreements and standalone ex-ante severance pay agreements.3 CEO employment agreements are fixed-term comprehensive contracts between CEOs and firms; they generally specify termination payments and other terms such as non-competition and confidentiality. CEOs with employment agreements cannot be fired within the term without good cause. Standalone severance pay agreements stipulate the amount and terms of payments that executives can receive when their employment is terminated. CEO employment agreements and standalone severance pay agreements are the outcome of the negotiation between the firm and the CEO.4 From the firm’s perspective, such agreements increase the cost of firing the CEO, but they benefit the firm by incentivizing the CEO to undertake long-term risky projects and invest in firm-specific human capital. From the CEO’s perspective, such agreements offer protection by compensating the CEO for termination and downside risk (Rusticus 2006; Xu 2012).
We test our prediction using S&P 500 firms with required data over the 1995-2008 period. We hand collect information on CEO employment agreements and severance pay agreements from proxy statements. Following previous studies (e.g., Baber, Fairfield, and Haggard 1991; Bushee 1998), in the main analyses we capture managerial short-termism using the likelihood of cutting R&D expenditures. We choose this proxy because the tradeoff between meeting current earnings targets and increasing long-term firm performance is particularly salient in the case of cutting R&D (e.g., Graham, Harvey, and Rajgopal 2005). Given that the existence of CEO contractual protection varies with firm and CEO characteristics (e.g., Gillan, Hartzell, and Parrino 2009; Rau and Xu 2013), we control for the endogeneity using both the instrument variable approach and the Heckman approach (e.g., Doidge, Karolyi, and Stulz 2004).
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