the role of stock liquidity in executive compensat

THEACCOUNTINGREVIEWAmericanAccountingAssociationVol.87,No.2DOI:10.2308/accr-102042012pp.537–563TheRoleofStockLiquidityinExecutiveCompensationSudarshanJayaramanToddT.MilbournWashingtonUniversityinSt.LouisABSTRACT:WeexploretheroleofstockliquidityininfluencingthecompositionofCEOannualpayandthesensitivityofmanagerialwealthtostockprices.Wefindthatasstockliquiditygoesup,theproportionofequity-basedcompensationintotalcompensationincreaseswhiletheproportionofcash-basedcompensationdeclines.Further,theCEO’spay-for-performancesensitivitywithrespecttostockpricesisincreasingintheliquidityofthestock.Ourmainfindingsaresupportedbyadditionaltestsbasedonshockstostockliquidityandtwo-stageleastsquaresspecificationsthatmitigateendogeneityconcerns.Ourresultsareconsistentwithoptimalcontractingtheoriesandcontributetotheongoingdebateabouttheincreasingtrendofbothequity-basedovercash-basedcompensationandthesensitivityoftotalCEOwealthtostockpricesratherthanearnings.Keywords:stockliquidity;executivecompensation;optimalcontracting.DataAvailability:Datausedforthisstudyarederivedfrompubliclyavailablesources....overthelastthreedecades,thetotalsensitivityofexecutivewealthtochangesinshareholderwealthhasbecomedominatedbyexecutives’stockandstockoptionportfolios,asopposedtocashcompensationorothercomponentsofexecutives’paypackages...Inaddition,cashcompensationitselfappearstohavebecomealessimportantcomponentoftheoverallpay-performancesensitivitiesoftopexecutives.—BushmanandSmith(2001,242)WeappreciatehelpfulcommentsfromLongChen,GeraldGarvey,GarenMarkarian,ShawnMobbs(FMAdiscussant),RamThirumalai(ISBdiscussant),aswellasparticipantsatthe2009IndianSchoolofBusiness(ISB)AccountingConference,2010AmericanAccountingAssociationAnnualMeeting,2010FinancialManagementAssociationAnnualMeeting,andbrown-bagparticipantsatWashingtonUniversityinSt.Louis.Wealsothanktheeditorandtwoanonymousrefereesforcommentsthathavegreatlyimprovedthepaper.Anyremainingerrorsareofcourseourown.Editor’snote:AcceptedbyJohnHarryEvansIII.Submitted:September2009Accepted:July2011PublishedOnline:October2011537I.INTRODUCTIONAstheabovequoteindicates,theimportanceofstockpricesasopposedtothatofaccountingnumbersinexecutivepaycontractshasbeenincreasingdramatically.Thesechangescanbeseeninboththecompositionofpay(salaryandbonuspayoutsversusstockgrants)andinthesensitivityoftotalpaytobothaccountingearningsandstockreturns.Specifically,inempiricalteststhatregressCEOpayonbothstockreturnsandearnings,Bushmanetal.(1998)findthatthecoefficientonaccountingearningshasbeenrelativelyconstantovertime,butthatonstockreturnshasbeenconsistentlyincreasing.Theculpritbehindthisshiftincompositionandsensitivityisreadilyidentifiable:overthistimeperiod,firmsdramaticallyincreasedtheirgrantsofbothstockoptionsandrestrictedstock.Andwhilethesechangesincompensationpolicieswerelikelyinresponsetocallstoincreaseshareholdervalue,BushmanandSmith(2001)emphasizethatthereasonsunderlyingthesechangesarestillnotverywellunderstood.Inthispaper,werelyontheoriesofmarketmicrostructureandproposestockliquidityasonepossiblecontributortobothfeaturesofcompensationcontracts—(1)thedecliningimportanceofcash-basedcompensationinannualCEOpaypackagesand(2)thegreaterrelianceonstockpricesoverearningsinpay-for-performancesensitivity(PPS).Empirically,wefindthatgreaterstockliquidityisassociatedwithalowerproportionofcash-basedpayandwithhigherPPSwithrespecttostockprices.Theseresultsholdbothcross-sectionallyandovertime,andourinterpretationisthatincreasesinstockliquidityaffectcompensationcontractsintwoways.First,becauseexecutivesvalueliquidity,greaterstockliquidityincreasestheirpreferenceforstock-basedcompensationrelativetocash-basedcompensation.Second,asstockliquidityincreases,thereducedtradingcostsencourageinformedtraderstoimpoundmoreinformationaboutthemanager’sactionsinthestockprice(seeChordiaetal.2008).TheseincreasesinstockpriceinformativenessresultingreaterreliancebeingplacedonstockpricesinPPSrelativetootherperformancemetricssuchasearnings(seeHolmstromandTirole1993;Fangetal.2009).Theaboveargumentsassumeapositiveassociationbetweenthevaluationandcontractingrolesofstockprices.Thatis,whenstockpricesaremoreinformativetoinvestorsinthemarket,theyarealsoassumedtobemoreinformativeaboutthemanager’sactionsandthusmoreusefulforcontractingpurposes.Whilesometheorists(e.g.,Gjesdal1981;Paul1992;Lambert1993)havesuggestedthatthesealternativeusesofinformationneednotcoincide,recentstudiessuchasBushmanetal.(2006)showanalyticallythatperformancemeasuresthatincorporatemulti-periodeffectsofthemanager’sactions(notfullycapturedbycurrentperiodearnings)performbothavaluationaswellasacontractingrole.Stockliquidity,inoursetting,performssuchadualrole.Inthissense,ourstudyaddstothefindingsofBankeretal.(2009)andBushmanetal.(2006)whofindapositiveassociationbetweenthecontractingandvaluationrolesofperformancemeasures.Ourargumentsrestonthepremisethatdifferencesinstockliquiditydeterminetheextentofstockpriceinformativeness,andnottheotherwayaround.ThislinkismotivatedbyGrossmanandStiglitz(1980),Kyle(1985),HolmstromandT