Wait for the Bad News

Jae Bum Kim found that pay duration affects a CEO's willingness to deliver negative forecasts.

By Margie Peterson
Image by iStock/Axllll

illustration of man with tape over mouth

No CEO wants to give shareholders bad news about the company’s future earnings, but what role do the chief executive officer’s stock options play in his or her willingness to deliver that news?   

That was the question Jae Bum Kim, associate professor of accounting at Lehigh, explored with two former colleagues from Singapore Management University. Their research paper, published in the Journal of Business Finance and Accounting, looks at CEO compensation in sample data of 3,000 companies in the U.S. from 2006 to 2011.

“In our research, we tried to understand the role of stock-based compensation for managers’ behavior and their disclosure decisions,” Kim says.

Of the businesses that included stock-based compensation such as stock options and restricted stocks in CEO compensation, there was a huge variation in the vesting period. Some required a vesting period of as much as 10 years before the chief executive could exercise those options and others allowed the stock options to be exercised right away.

What the study found was that at companies with longer vesting periods for management stock options, there was a greater likelihood that CEOs would voluntarily disclose bad news in earnings forecasts to shareholders in a timely fashion. The study also found that the bad news forecasts delivered by managers with longer vesting periods were more accurate.

Kim explains: “What is the role of the stock option? Why don’t I receive cash instead of a stock option? It’s because my interests would be better aligned with the shareholders and investors. As a manager, I want to make more value-enhancing decisions and I have a duty to provide complete information so stockholders can make a more informed decisions.”

So, for example, in their daily work, a manager might get negative information that leads them to believe the future stock price might drop to $150 a share from $200 a share.

If managers are able to exercise stock options, say, within a couple of months, they are more apt to withhold the bad news from stockholders until after they sell.   

“When the managers’ personal wealth is tied to the stock price of their own firm, they try to avoid disclosing bad news,” Kim says. “But when my stock options will be vested for a long time, my concern about a stock price decline in the near future doesn’t matter, which makes me disclose bad news right away,” with the hope the company will improve its performance to overcome the news.

The longer vesting period allows CEOs to take the long view. “From the board of director’s perspective, their compensation policy acts in their intended direction,” Kim says.

That long view may be especially important for companies with less independent boards. The effect of the vesting period “is more pronounced for firms with weaker monitoring and with poorer information environments,” the study says. “The effect is also greater for firms facing lower litigation risk and operating in more homogenous industries.”

Why it Matters

Kim hopes his research can be a tool to help companies structure their management compensation to reduce incentives for CEOs to delay disclosure of bad news to stockholders.