Powerful CEOs And Stock Price Crash Risk
Md. Al Mamun
La Trobe University
La Trobe University -Department of Economics and Finance; Financial Research Network (FIRN)
Huu Nhan Duong
Monash University – Department of Banking and Finance; Financial Research Network (FIRN)
June 18, 2016
We find that firms with powerful CEOs experience stock price crash. Further, we show that the impact of earnings management, tax avoidance, CFO option incentives and CEO overconfidence on crash is more pronounced for firms with powerful CEOs. The takeover index, proxy for corporate governance engendered by legal environment, mitigate stock price crash for firms with non-powerful CEOs, however, has no impact on stock price crash for firms with founder CEOs. The impact of CEO power on crash is more pronounced for firms in competitive product markets. Our findings provide new insights on the role of CEO power on crash.
Powerful CEOs And Stock Price Crash Risk – Introduction
Managers have incentives to stockpile bad news, however, once the accumulated bad news reaches an overwhelming level, managers give up and release it altogether, leading to a stock price crash (Jin and Myers (2006), Hutton, Marcus, and Tehranian (2009), Kim, Li and Zhang (2011a and b)). Hutton et al. (2009) and Kim et al. (2011a) show that managers use earnings management and tax avoidance, respectively to hoard bad news, which in turn, lead to stock price crash. Dichev, Graham, Harvey and Rajgopal (2013) survey and interview CFOs of U.S firms and find that earnings management occurs in an attempt to influence stock price, because of outside and inside pressure to hit earnings benchmarks, and to avoid adverse compensation and career consequences for senior executives. Further, Dichev et al. (2013, p.30) document that “CFOs believe that it is difficult for outside observers to unravel earnings management, especially when such earnings are managed using subtle unobservable choices or real actions. However, they advocate paying close attention to the key managers running the firm……”
However, the literature is silent on role played by CEO power on stock price crash. Considering that insiders (Dichev et al., 2013) pressure CFOs to manage earnings, and CFOs believe that it is difficult to unravel earnings management by outsiders as earnings are managed by using subtle unobservable choices or real actions, we argue that CEO power will capture the unobservable actions of the CEO to hoard bad news, which lead to stock price crash. In this paper, we provide new insights with respect to powerful CEO’s role on stock price crash risk by addressing the following research questions. Does CEO power lead to stock crash risk? Do governance mechanisms mitigate the likelihood of stock price crash risk? To what extent do governance mechanisms mitigate the CEO power to curtail stock price crash risk?
Recent studies on CEO power suggest that powerful CEOs are self-motivating and divert firms resources for their own gains, and have negative impact on profitability and firm value (e.g., Coles, Daniel, and Naveen, 2014; Feng et al., 2011; Friedman, 2014; Grinstein and Hribar, 2004; Khanna et al., 2015; Morse et al., 2011). Further, anecdotal evidence suggests that some powerful CEOs provide wrong signal to the market and create an opaque information environment to maintain a stock price bubble (see for example, Enron, Madoff Inv., Morgan Stanley, Tyco, WorldCom). We argue that power in the hands of CEOs gives them the means and justification to divert firm resources for their own gain and withhold bad news from investors, which results in a stock price crash.
Further, the literature on market for corporate control shows that the threat of takeover provides additional incentives for the board of directors to fire poorly performing CEOs (see Fama (1980), Fama and Jensen (1983), Hirshleifer and Thakor (1998) and Lel and Miller (2015)). Cain, McKeon, and Solomon (2015) argue that the Takeover Index (TOIND), constructed from a full array of takeover laws, offers researchers the most comprehensive tool currently available to measure external forces on corporate governance engendered by the legal environment and provides new evidential support for the beneficial role that the disciplinary market for corporate control can play in corporate governance. We argue that stronger market for corporate control governance mechanism will discipline poorly performing CEOs, which in turn, reduce the likelihood of stock price crash.
Kim et al. (2011b) argue that option incentives are more powerful in inducing managerial bad news hoarding behavior, because managers’ losses from option holdings are limited when a stock price crash event occurs in the future and show that option incentives to CFO predict stock price crash. Kim, Wang and Zhang (2016) argue that overconfident CEOs believe that they are maximizing long-term firm value by continuing negative NPV projects and hiding the “temporary” bad performance of those projects. They find that firms with overconfident CEOs have higher stock price crash risk than firms with non-overconfident CEOs, this impact is more pronounced among firms with higher pay slice for CEOs relative to top 5 executive team. However, they urge future research, given the lack of an exogenous shock in their research designs. We predict that the impact of earnings management, tax avoidance, CFO option incentives, CEO overconfidence will be stronger for firms with powerful CEOs. We also expect that CEO power will capture the other omitted channels, a CEO can use to hoard bad news.
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