CEOs Cut Investment To Sell Their Own Shares At High Prices

One of the most fundamental concerns with corporations is that they focus on short-term profit rather than investing for the long-term. This is a particular concern in the 21st century, where innovation is particularly critical for competitive success. Moreover, allegations of short-termism have serious social repercussions. Long-term investments, such as reducing carbon emissions, developing blockbuster drugs, or training workers, typically benefit stakeholders as well as shareholders, but short-term profit only goes to shareholders. The concerns that corporations exploit stakeholders to pander to shareholders has led to a substantial loss of trust in business and threatens its social license to operate.

But Where’s The Evidence?

However, actually finding evidence that short-termism even exists is extremely difficult. My prior post discussed several pieces of evidence to the contrary. Indeed, my 2007 “job market paper” (that you take on the academic job market in the final year of your PhD) was a theoretical model of how large shareholders can alleviate short-termism. In the first few minutes of most seminars, I’d get the question “What evidence is there that short-termism is even a problem in the first place?” I had to admit that there was little hard evidence – the best was a 2006 survey of executives where 78% admitted to sacrificing long-term value to meeting earnings targets, but this is only what executives claimed that they did, rather than what they actually did.

“No evidence of short-termism”, however, is not the same as “evidence of no short-termism”. There simply wasn’t evidence either way, since it’s hard to measure a CEO’s short-term concerns. One measure might be the amount of shares that she sells in the short-term. If the CEO sells a ton of shares in Q3 2017, then she wants the stock price to be particularly high in Q3 2017. Thus, she might cut investment in Q3 2017. But, a correlation between CEO equity sales and investment cuts would not imply causation. The problem is that CEO equity sales are endogenous – they are a deliberate choice of the CEO, and so this choice may be driven by other factors that also drive investment. For example, if prospects are looking bleak in Q3 2017, this might cause the CEO to rationally scale back investment, and separately to sell her shares.

Documenting Short-Termism: A New Approach

In a recent paper, Vivian Fang, Katharina Lewellen, and I* initiated a new approach. Rather than studying the shares that the CEO actually sells, we study the amount of shares that are scheduled to vest. For example, if a CEO was given a chunk of shares in Q3 2012, with a 5-year vesting period, they first become saleable in Q3 2017. CEOs typically sell a large portion of their shares when they vest, to diversify their portfolio (we verify this in the data). Thus, if the CEO knows that her shares will be vesting in Q3 2017, and so she’s likely to sell a large portion, she has incentives to cut Q3 2017 investment. Importantly, the driver of Q3 2017 vesting equity is the decision to grant the CEO shares back in Q3 2012. That was five years ago, and so is likely exogenous to (not driven by) Q3 2017 investment opportunities. Thus, any correlation between Q3 vesting equity and Q3 investment cuts is likely to be causal.

We include both shares and options in our measure of vesting equity and estimate this amount at the quarterly level. This is because the highest frequency with which investment is reported is also at the quarterly level. We regressed the change in investment (measured five different ways) on vesting equity and many control variables that may also drive investment cuts (e.g. investment opportunities or financing constraints).

CEOs Cut Investment When Their Equity Vests

We find a significant negative correlation between vesting equity and the growth rate in investment – using all five investment measures. Moreover, these results are robust to:

  • Removing equity grants where vesting depends on hitting certain performance targets, rather than reaching the end of a pre-specified time period (e.g. 5 years)
  • Considering only vesting stock or only vesting options
  • Including or excluding controls
  • Regressing the change in investment not on the amount of vesting equity, but the amount of equity sales that can be predicted by vesting equity

Alternative Explanations

So, the link between vesting equity and investment cuts appears to be robust. This is consistent with the idea that the CEO inefficiently cuts good investment projects to boost short-term earnings and thus the short-term stock price (the myopia hypothesis). But, as I explained in a recent TEDx talk, finding that the data is consistent with a hypothesis does not mean that the data supports the hypothesis – because it could also be consistent with alternative hypotheses.

The main concern is the efficiency hypothesis. Perhaps the CEO cuts bad investment projects, and so the cut in investment is efficient. Let’s say cutting investment is hard. It takes effort to identify wasteful projects and shut them down, and doing so may make the CEO unpopular  CEOs may instead prefer to coast and enjoy the quiet life. But, when the CEO is about to sell her shares, she overcomes her inertia and is willing to take tough decisions. If true, then short-term pressures are motivating, rather than distracting – a bit like how an impeding essay deadline forces students to stop procrastinating.

We tested the efficiency hypothesis in two ways. First, if equity vesting causes the CEO to get her act together, you’d expect her to improve efficiency not just by cutting investment, but also by cutting other expenses or increasing sales growth. But, we find no evidence of this. Second, we show that that CEOs cut investment less when the cuts are more costly to them (the CEO is younger, so she suffers more from the long-term consequences of scrapping an efficient investment; or the firm is younger or smaller, suggesting that the investment is more valuable). These tests suggest that the investment cut is indeed likely to be inefficient.

How Does the CEO Benefit?

One complication is that Q3 earnings aren’t announced until the start of Q4. So, how does a CEO who sells equity in Q3 benefit from the earnings increase that results from the investment cut? We show that vesting equity increases the likelihood that the CEO issues positive earnings guidance in the same quarter. Doing so boosts the stock price by 2.5%, thus indeed allowing her to cash out at a high price. Indeed, we find that the CEO’s equity sales are concentrated in a small window immediately following the guidance event. So, the full picture appears to be – the CEO knows that her equity is vesting in Q3, so she cuts investment in Q3 and also issues positive earnings guidance in Q3, boosting the stock price and allowing her to sell her shares upon vesting.

If the CEO boosts earnings-per-share by 5c, how much should positive earnings guidance should she give? Probably around 4-5c – then, she will benefit as much as possible from the earnings increase – but not more than that else she will subsequently undeperform expectations. (The same reason explains why the CEO can’t issue positive guidance without the investment cut – both go hand-in-hand). Indeed, we find that, when more equity vests, the firm is particularly likely to beat the analyst forecast by a narrow margin (0-1 cent) but not a wide margin, consistent with the CEO communicating nearly all of the earnings increase ahead of time.

What Does It Mean For CEO Pay Design?

Executive pay is a highly controversial topic. Most people agree that it should be reformed, but the reforms typically focus on the level of pay. As I wrote earlier (see myth #5), the level of average CEO pay in the US is only 0.05% of firm value. Instead, these results suggest that the horizon of pay is more important – it affects the CEO’s incentives to invest, with potentially substantial implications for the company’s long-run success and the value it creates to other stakeholders. Cutting pay in half will win more headlines than extending the vesting horizon from (say) 3 to 7 years, but the latter is likely much more impactful. Indeed, the paper was referenced in the UK government’s Green Paper on Corporate Governance to justify the proposal to extend vesting periods. Here I describe a redesign of executive pay based in part on the results of this paper (since implemented by some companies), and here I summarize a paper by other scholars showing positive causal effects of long-term equity compensation.

* I apologize for covering one of my own papers. In this blog I typically cover other people’s papers. But, I needed to write about this paper anyway to fulfill the “dissemination” terms of my European Research Council grant, so decided to share it here.

2 replies
  1. Alexis
    Alexis says:

    Interesting thanks. One of your points is “Indeed, we find that the CEO’s equity sales are concentrated in a small window immediately following the guidance event.”. Do you factor in that CEOs (and the senior management reporting to them) are heavily subject to blackout periods, so there are only very small windows of time during which they may be allowed to trade at all? It seems plausible that the blackout is only lifted right after guidance is given.

    • Alex Edmans
      Alex Edmans says:

      Thanks Alexis for the very thoughtful comment. Yes, blackout periods are an important consideration and we address this on p2256 of the paper. (I reference the paper since we describe it more clearly there than I could paraphrase here!)


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