Title: CEO Contract Horizon and Investment (PDF)
Author: Moqi Xu (INSEAD)
Publisher: INSEAD Working Paper
Date Published: June 2011
The common wisdom has it that as time winds down on a CEO’s contract, boards should be worried about a couple of possibilities. Concern number one: To earn a higher end-of-term bonus and/or a new contract, the CEO might underinvest in long-term R&D and capital expenditures in an effort to make short-term earnings look stronger. Concern number two: The CEO might overinvest in risky projects to show that he or she is “indispensable” to a just-launched initiative.
The reality of the dangers posed by these so-called myopic CEOs is actually somewhat worse than that conventional wisdom, says this paper, which examines how the length and type of a CEO contract affects investment behavior. Using 20 years of data about the performance of more than 3,700 CEOs, the author finds that overall investment activity declines as the contract deadline nears. But if short-term CEOs are cutting back on investments to bolster earnings or throwing money at them to prove their indispensability, they don’t seem to be succeeding: Their firms are no more profitable than others, according to the researcher.
The study is the first to find that a chief executive’s investment strategies depend on the length of time remaining on his or her contract; the author calls this the contract horizon effect. CEOs invest much more at the beginning of their term, the researcher says, suggesting that chief executives who are tied to long contracts feel stable and secure enough to make long-term investments.
To keep CEOs focused on the right kind of investments, and not have their decisions distorted by end-of-term worries, the paper implies, boards should consider renegotiating CEO contracts before they enter their final phase. The paper’s findings also have implications for how boards should view the performance of CEOs who don’t have a fixed-term contract. Compared with chief executives who have fixed terms, these CEOs, working under a so-called at-will arrangement, invest much less throughout their tenure and produce lower earnings as their time comes to a close, the author says.
The author analyzed 3,717 employment contracts or summaries of employment terms, culled from U.S. Securities and Exchange Commission filings and from the Corporate Library, an independent corporate governance research firm. Spanning the period from 1989 through 2008, the contracts covered 2,371 U.S. firms with an average book value of US$1.18 billion. The data set allowed the author to track changes in CEOs’ investment behavior during the course of their tenure and to measure the impact of their contract type and length on executive and firm performance.
First, the author had to differentiate between fixed and at-will arrangements. Under at-will employment, the company or the employee can sever ties at any time, so that a CEO is effectively working with the constant possibility of losing the job. Under fixed-term contracts, early termination leads to severance pay or costly litigation.
The industry with the highest number of at-will contracts in the sample was software, which is in line with the argument that firms with high operating risks prefer to protect themselves with more flexible CEO arrangements. The highest number of fixed contracts was in banking. (Not all CEOs sign explicit employment documents, so the author treated those without formal contracts as at-will employees, which had no effect on the resulting analysis.)
Although having a fixed contract doesn’t necessarily mean that a CEO will stay for the entire stipulated period, it does generally result in a longer tenure than an at-will arrangement. On average, the author found that CEOs with fixed-term deals stayed two years more than at-will CEOs.