Not So Lucky Any More:CEO Compensation in Financially Distressed Firms

There is a debate on whether executive pay reflects rent extraction due to “managerialpower” or is the result of arms-length bargaining in a principal-agent framework. In this paperwe offer a test of the managerial power hypothesis by empirically examining the CEOcompensation of U.S. public companies that were ever in financial distress between 1992and 2005. Using a bias-corrected matching estimator that estimates the causal effects offinancial distress, we find that, for the distressed firms, CEO turnover rates increase markedlyand their CEOs, both incumbents and successors, experience significant reductions in totalcompensation. The bulk of the reduction in total compensation derives from the decline invalue of stock option grants, which we argue is due to a change in the opportunistic timing ofoption grants. We define “lucky” grants as those with grant prices below or at the lowest stockprice of the grant month, and we find that the proportion of lucky grants for financiallydistressed firms is higher before insolvency and lower upon and after insolvency, while theproportion for similar but solvent firms remains stable throughout the period. We interpret thisevidence as consistent with a decrease in managerial power induced by a tightening in the“outrage” constraint due to the episode of financial distress....