09 Sep 2014
The dangers of short-term incentives
New research by a leading financial expert at London Business School finds that CEOs strategically time corporate news releases to coincide with months in which their equity vests.
The paper, ‘Strategic News Releases in Equity Vesting Months’, by co-author Alex Edmans, Professor of Finance, London Business School, visiting from The Wharton School examines this issue by focusing on the period when options “vest”, then becoming possible for executives to cash them in.
Professor Edmans says: “CEOs reallocate news into vesting months, and away from prior and subsequent months. They release 5% more discretionary news in vesting months than prior months, but there is no difference for non-discretionary news.
“These news releases lead to favourable media coverage, suggesting they are positive in tone. They also generate a temporary run-up in stock prices and market liquidity, potentially resulting from increased investor attention or reduced information asymmetry. The CEO takes advantage of these effects by cashing out shortly after the news releases.”
Edmans argues that this is an easy way to pump up the short-term stock price, as news attracts attention to the stock. This attention also increases trading volume, which allows the CEO to cash out their equity in a more liquid market, with the average CEO cashing out all of their vesting equity seven days after the news release.
The increase in news releases only relates to discretionary news such as conferences, client and product announcements, and special dividends which are within the CEO’s control, and not non-discretionary news such as scheduled earnings announcements, Edmans adds.
Moreover, the CEO reduces discretionary news releases in both the month before and the month after the vesting month, suggesting he’s strategically reallocating news away from adjacent months and into the vesting month.
In addition to releasing more news items in the vesting month, the CEO releases more positive news – media articles immediately following these news releases contain significantly more positive words than normal.
This paper contributes to the broader debate on how to reform CEO pay. While much of the current focus is on the level of pay, or the sensitivity of pay to performance, this new paper focuses on the horizon of incentives, showing that short-term incentives lead to short-term behaviour.
The new research builds on another recent paper on short-termism by Professor Edmans and co-authors, entitled ‘Equity Vesting and Managerial Myopia’. That paper finds that, in years in which significant equity vests, managers significantly cut investment in various forms – research and development, advertising, and capital expenditure. In addition, they are particularly likely to exactly meet, or just beat, analyst earnings forecasts. Moreover, the magnitude of the investment cut is just enough to allow the CEO to meet the forecast. Thus, vesting equity induces the CEO to act myopically – to cut investment to meet short-term targets.