How CEO Protection Shapes Corporate Debt

What happens when CEOs are shielded by employment and severance agreements? Researchers from Singapore Management University, University of Hong Kong, Boston College, and led by Dr. Xia Chen put forward this critical question.  

The study investigates how CEO contractual protection impacts corporate debt contracting. With insights from a comprehensive analysis of loans from major publicly traded companies, the team explore how these protections can influence CEO behavior, risk-taking, and the financial terms imposed by debt holders.

Read the original research: https://doi.org/10.1111/jbfa.12664

Transcript

Hello and welcome to Research Pod! Thank you for listening and joining us today.  

In this episode we will be looking at the work of business and management researchers from Singapore Management University, University of Hong Kong, and the Carroll School of Management of Boston College in Massachusetts in the USA. 

Xia Chen, Qiang Cheng, Alvis Lo, and Xin Wang have recently published a study about CEO incentives and corporate debt contracting. They wanted to find out about the impact on debt contracting of the contractual protection enjoyed by companies’ Chief Executive Officers or CEOs. 

The CEOs of many leading firms enjoy this kind of protection in the form of employment agreements and severance pay agreements, but how does it affect their decision-making? 

Other studies have looked at this issue from the perspective of shareholders. Published in the Journal of Business, Finance, and Accounting, the new paper breaks new ground by investigating CEO contractual protection from the debt holders’ position. 

Led by Dr Chen, the research is based on a study of loans of publicly-traded companies included in the Standard and Poor’s 1500 stock market index. 

CEO employment agreements and severance pay agreements are common in publicly listed companies. They are generally used to attract, motivate, and protect CEOs from personal financial loss, should business decisions go awry and their contracts are terminated. 

Employment agreements, for example, are usually fixed-term, and may include things like non-competition clauses, as well as the terms on which agreements may be ended. Severance agreements are not fixed term, and specify the conditions that may lead to termination, as well as the compensation that CEOs would receive if they were asked to leave the company. 

However, as the research team’s literature review confirmed, it’s widely recognised that contractual protection for CEOs can be a double-edged sword, not least because it raises the costs associated with terminating a CEO’s employment contract.  

On the one hand, by protecting CEOs from personal financial loss in the wake of poor business outcomes, employment agreements may encourage CEOs to engage in higher risk investments. This may sometimes pay off and benefit firms – and no doubt CEOs. But debt-holders don’t share in the gains, and so they often impose additional contracting terms and mechanisms to monitor CEOs’ risk-taking behaviour. 

On the other hand, by sheltering CEOs from financial loss and contract termination, employment agreements may lead to CEO ‘entrenchment’ – that is, to CEOs favouring stability in pursuit of what Dr Chen’s team calls a ‘quiet life’. 

As a result, CEOs may be more averse to risks, for example they may not want to expand into new business areas to pursue growth. Reducing financial risk may reduce the need for CEO monitoring. But it might also mean that firms miss out on opportunities for financial gain. CEOs might act in the interests of their own job security and financial goals, rather than those of their business.  

The team led by Dr Chen wanted to find out whether loans of firms with CEO contractual protection are different from loans borrowed by other firms.  

The researchers expected to find that if CEOs who have contractual protection are more likely to invest in risky projects, this encourages debt-holders to use other mechanisms to monitor CEO’s risk-taking behaviour. 

They also wanted to test the findings of prior research, which suggests that risk-taking is more likely to be associated with younger CEOs, and businesses that are in the growth stage of their life cycle. 

Last but not least, for firms with more experienced CEOs, and CEOs with a higher proportion of cash compensation and lower board independence, the team wanted to probe the relationship between CEO contractual protection and the use of financial and performance covenants in debt contracts.  

Performance pricing of debt contracts, for example, links the interest rate on loans to the borrower’s business performance. In this way, interest rates may be reduced if the borrower’s business performance and credit rating improves. Conversely, if the borrower’s credit quality deteriorates, the interest rate on loans may be increased. 

The study was based on a sample of more than 6,000 loans borrowed by a broad range of companies in Standard and Poor’s 1500 stock market index. The loans studied were all granted in the 13-year period between 1995 and the 2008.  

Information about CEOs’ employment agreements was gathered from the proxy statements that companies have to issue to shareholders before shareholder meetings. These include information about firms’ boards of directors and executive payments, including CEOs’ contractual protection.  

Information about loans was gathered from the DealScan database. This database provides record of the global commercial loan market, including the terms and conditions on which individual loans are granted. 

The researchers then used well-accepted statistical techniques, and controlled for confounding variables, to look at the relationship between the characteristics of the sample firms’ debt contracts and CEOs’ contractual protection agreements. 

In this way, they were able to quantitatively and comparatively evaluate the impact of CEO protection on debt contracting. 

Analysis showed that around three-quarters of the loans in the sample were by firms whose CEOs had employment and severance pay agreements. 

The study found that, on average, firms whose CEOs enjoyed contractual protection did act differently from firms whose CEOs did not have this kind of protection. 

In general, when compared with other loans, loans by firms with CEO contractual protection had a higher degree of debt oversight, higher interest rates, and a wider base of lenders. 

In particular, firms with CEO contractual protection had 8.2% more performance covenants to evaluate and monitor a business’s operational and financial performance. In addition, they were 12.4% more likely to include provisions which linked interest rates to company performance. 

The use of performance covenants was also more likely to be associated with younger CEOs, and firms at an early stage in their growth cycle. 

Researchers found that the impact of CEO contractual protection on debt contracts was weaker when CEOs were more risk-averse, preferring the so-called ‘quiet life’. Interestingly, the results did not suggest that CEO employment and severance pay agreements made debt holders more concerned about CEOs avoiding their responsibilities. 

The study also showed that the impact of CEO contractual protection on debt contracts was stronger when CEOs had greater protection from personal financial loss. 

Loans from firms with CEO employment and severance pay agreements were also more likely to include covenants restricting borrowers’ capital expenditure. This effect increased with CEOs’ risk-raking incentives and opportunities, but decreased with CEOs’ preference for stability and a ‘quiet life’. 

The study found that the impact of CEO contractual protection on debt covenants was more pronounced when CEOs had a greater appetite and opportunity for risk-taking. However, when CEOs’ preferences for a ‘quiet life’ were greater, the impact of CEOs’ employment and severance pay agreements were less noticeable.  

The research team rejected the idea that the entrenchment effect of CEO contractual protection makes it more likely for debt holders to demand monitoring. Instead it found that CEOs’ preference for stability alleviates debt-holders’ fears about risk. 

The research led by Dr Chen fills a gap in the academic literature by looking at CEO contractual protection and debt contracting from the position of debt-holders, rather than shareholders’. 

It sheds new light on the impact that CEOs’ employment and severance pay agreements have on debt contracting. In addition, it confirms that CEO contractual protection affects corporate outcomes. 

In particular, the study finds that CEOs’ contractual protection affects the terms and conditions that are imposed on business loans. Compared with other loans, loans borrowed by firms with CEO contractual protection contain more financial covenants, particularly performance covenants, and have higher loan spreads. 

This effect increases with CEOs’ incentives and opportunities to take risks, and decreases with CEOs’ preference for stability and a ‘quiet life’. 

In all, the study concludes that CEOs’ contractual protection can lead CEOs to both invest in riskier businesses and support innovation. However, by being associated with more financial covenants and increased rates of interest, CEOs’ contractual protection can also increase the cost of debt financing and reduce businesses’ financial flexibility. 

That’s all for this episode – thanks for listening. Links to the original research can be found in the shownotes for this episode. Don’t forget to stay subscribed to Research Pod for more of the latest science.  

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