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DOES CEO INSIDE DEBT MITIGATE CORPORATE SOCIAL IRRESPONSIBILITY?

DOES CEO INSIDE DEBT MITIGATE CORPORATE SOCIAL IRRESPONSIBILITY?. Long Chen (George Mason University) Guanming He ( Durham University ) Gopal Krishnan (Bentley University). Background.

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DOES CEO INSIDE DEBT MITIGATE CORPORATE SOCIAL IRRESPONSIBILITY?

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  1. DOES CEO INSIDE DEBT MITIGATE CORPORATE SOCIAL IRRESPONSIBILITY? Long Chen (George Mason University) Guanming He (Durham University) Gopal Krishnan (Bentley University)

  2. Background • Corporate social irresponsibility (CSI) can have adverse consequences to investors as well as to other stakeholders and the society at large. • Examples: BP had to pay over $18B in fines for the 2010 Deepwater Horizon oil spill disaster. • Volkswagen emissions cheating scandal: lost 40% of MV • CSR vs. CSI: Prior research indicates that investors demand a higher rate of return from firms with net environmental concerns while no significant relation is found between expected returns and environmental strengths (Chava 2014; Oikonomou et al. 2014). • Evidence on mechanisms that mitigate CSI is of fundamental interest to investors, BOD, regulators, and others.

  3. Research Objective • The objective of this study is to provide empirical evidence on the role of one such mechanism, CEO’s inside debt in mitigating a firm’s environmental, social, and governance (ESG) risks. • CEO’s inside debt: debt-type compensation consisting of accumulated pension benefits and deferred compensation.

  4. ESG Risks

  5. The RepRisk Index (RRI) • RepRisk Index is based on 28 ESG issues and is developed by RepRisk AG, a Swiss firm. • RepRisk screens, on a daily basis, over 80,000 media, stakeholder, and third-party sources to identify ESG risk information. • Each risk incident is analyzed according to three parameters: • severity (harshness) of the risk incident or criticism; • reach (influence) of the information source; and • novelty of the issue. • RepRisk uses a proprietary algorithm to develop RRI. • RRI ranges from 0 (lowest) to 100 (highest). Index in the range of 26-49 is considered medium ESG-related risk exposure while 50-59, 60-74, and 75-100 are considered, respectively, high, very high, and extremely high risk exposures. • RRI is recalculated when there is new news about a firm and RRI decays to 0 over a maximum period of two years if no new criticism is captured.

  6. CEO’s Inside Debt • Unlike equity-based incentives where the CEO could reap upside potential and limit downside losses, CEO’s inside debt is a fixed form of compensation, which is generally an unsecured and unfunded promise by the firm. • Thus, the value of these claims is sensitive to the default probability and the liquidation value of the firm in the event of bankruptcy (Sundaram and Yermack 2007 and Edmans and Liu 2011). • Therefore, inside debt motivates the CEO to refrain from risk-seeking behavior and take a long-term view of a firm’s future prospects (He 2015).

  7. Prior Research on CEO Inside Debt • Jensen and Meckling (1976) were the first to propose that debt held by the manager could mitigate agency costs of debt. • Sundaram and Yermack (2007): when a CEO’s inside debt ratio increases, CEOs take actions to reduce the probability of a debt default. • Cassell et al. (2012): document a negative relation between CEO inside debt and future stock return volatility, driven by more conservative R&D expenditures and higher firm diversification. They also find a negative relation between CEO inside debt and financial leverage. • Tung and Wang (2012) examine the behavior of bank CEOs during the Global Financial Crisis and find that CEO’s inside debt is negatively associated with risk taking and positively associated with improved bank performance.

  8. Prior Research on CEO Inside Debt • Phan (2014) finds a negative relation between CEO inside debt and a firm’s M&A propensity and positive associations with short-term M&A announcement abnormal bond returns and long-term operating performance. • He (2015) finds that higher CEO inside debt holdings are associated with high financial reporting quality (lower abnormal accruals and lower likelihood of an earnings restatement), lower stock price crash risk, and lower likelihood of material internal control weakness. • Anantharaman et al. (2014): CEO’s inside debt is associated with lower spreads and fewer covenants in loan contracts. • CEO inside debt mitigates tax avoidance and tax sheltering (Alexander and Jacob 2016; Chi et al. 2017). • Brisker et al. (2016): CEO inside debt is associated with net purchasing of shares by firm insiders, suggesting insiders believe there are positive benefits associated with CEO inside debt. • Taken together, the above findings support the notion that CEO’s inside debt incentivizes the CEO to refrain from risk-seeking behavior and align her incentives with those of the debtholders.

  9. Prior Research on Consequences of ESG Risk to Investors • El Ghoul et al. (2011): firms in two “sin” industries, i.e., tobacco and nuclear power, face higher cost of equity. • Chava (2014): significant positive relation between the net environmental concerns of a firm and expected stock returns; however, no significant relation is found between environmental strengths and expected returns, indicating that investors care more about CSI than CSR. • Cheng et al. (2017): firms with superior CSR performance face lower capital constraints, consistent with the notion that CSR reporting signals a long-term focus and reduces information asymmetry between the firm and investors. • Kolbel et al. (2017): coverage in the media about CSI is significantly associated with financial risk, consistent with the notion that negative coverage exacerbates the risk of stakeholder sanctions on the firm. • Burke et al. (2016): client reputational risk (ESG risk) has a positive impact on audit fees and the likelihood of auditor changes, consistent with the auditor business risk explanation.

  10. Hypothesis • Prior research: CSI can have adverse consequences to investors via higher cost of capital, reduced access to capital, higher financial risk due to sanctions imposed by stakeholders. • Further, CEO inside debt is associated with lower risk of earnings management, more conservative corporate policies with regard to R&D spending and leverage, lower M&A propensity and tax sheltering. • The nature of CEO’s inside debt – unsecured and unfunded claims whose value depends not only on firm’s default risk but also the liquidation value of the firm in the event of bankruptcy. • Since ESG risk exposure exacerbates a firm’s default risk and diminishes the value of CEO’s claims, we predict that: • There is a negative relation between ESG risk exposure and CEO’s inside debt holdings.

  11. Tension exists on the relationship between ESG risks and CEO inside debt • Accounting fraud, tax sheltering, leverage, financial reporting quality, R&D expenditures, insider trades, and M&A activities are relatively easier to control/manage by managers, compared with ESG risk. • CEOs with large inside debt have incentives to lower ESG risks, but may not be able to effectively controls potential ESG risk. • We state our hypothesis in a null form: • H1: There is norelation between ESG risk exposure and CEO’s inside debt holdings.

  12. Preview of Results • We find a significant negative relation between CEO’s inside debt holdings and the firm’s exposure to ESG risks as proxied by RepRisk Index measures. • We also find significant cross-sectional variations in the relation between CEO’s inside debt and exposure to ESG risks.

  13. Empirical Model Weestimate the following regression to test our hypothesis: RepRisk= α0 + α1 ceodebt + α2 lagRepRisk + α3 roa + α4 opacity + α5 stdearn + α6 stdsales + α7 stdcfo + α8 size + α9 btm + α10 rating + α11 lanacov + α12 debt + α13 insti + α14 lfirmage + α15 idiovol + Year FE + Industry FE + ε (1) • All the independent variables, including ceodebt are measured at year t-1, while ESG variables are measured at year t to mitigate endogeneity concerns. • To mitigate the dynamic endogeneity concern (previous year’s ESG risks might affect current year’s CEO inside debt and therein influence future ESG risks) we include lagged ESG risks as a control. • The coefficient of interest in model (1) is α1. A negative coefficient will be consistent with the notion that CEO’s inside debt mitigates the firm’s exposure to ESG risks.

  14. Sample • We obtain our initial sample on CEO inside debt of 15,561 firm-year observations for the period of 2007-2014 from ExecuCom database, which covers S&P 1500 firms that disclose their CEO's pension and deferred compensation. • Then, we merge the CEO inside debt data with the RRI data obtained from the RepRisk database for the period of 2007-2015, and our sample size drops to 5,818 observations. • We further merge our sample with the data required to construct all the control variables used in the main multivariate tests, which results in the final sample that consists of 2,064 firm-year observations for 463 unique firms across years 2008-2015.

  15. TABLE 3: Test of the relation between CEO inside debt and ESG risks Hypothesis is supported.

  16. TABLE 4: The impact threshold for a confounding variable (ITCV) test: The association between CEO inside debt and ESG risks Larcker and Rusticus (2010): the larger the value of ITCV, the less susceptible the results are to the potential omitted-variable bias. 0.0415 (absolute value) exceeds absolute values in the last column.

  17. TABLE 5: Placebo test: The association between non-senior-executives inside debt and ESG risks

  18. TABLE 6: Change in ESG risk exposures in response to change in CEO inside debt

  19. TABLE 7: Subsample analysis: The moderating effect of financial constraints

  20. TABLE 8: Subsample analysis: The moderating effects of outside debt and credit rating

  21. Moderating Effect of CEO Tenure and CEO Age • Longer CEO tenure/older CEO age could be a proxy for firms’ short-term inside debt that is presumed to be close to "maturity". • CEOs that are close to retirements tend to have a shorter-horizon on their investment/operation decision-making, compared with younger CEOs. • On the other hand, shorter-tenured or younger CEOs have stronger incentives to establish and develop their reputation to achieve their long-term career prospects; such incentives would be amplified by high inside debt holdings, making the CEOs even more averse to ESG risks. • We predict that the negative association between CEO inside debt and ESG risk exposure is weaker for firms with short-term inside debt that manifests itself in longer CEO tenure or older CEO age.

  22. TABLE 9: Subsample analysis: The moderating effects of CEO tenure and CEO age

  23. TABLE 10: Additional test: Separation of governance risk exposures from the overall ESG risks

  24. Summary of Results • We find that CEO inside debt is negatively related to ESG risk exposures. • Further, the negative relation between CEO inside debt and ESG risk exposure is stronger when • firms are confronted with financial constraints, • have larger outside debt or low credit ratings, and • CEOs are younger or have shorter tenure. • Finally, our analyses based on components of ESG risks suggest that CEOs with large inside debt are able to manage potential default risk via effective controls over the environmental and social risks, but not over the governance risks.

  25. Contributions • To the best of our knowledge, this is the first study to provide empirical evidence that inside debt holders manage the default risk by managing environmental, social, and governance risks. • While prior research has largely focused on how inside debt mitigates financial risk, our findings shed light on how CEO inside debt mitigates ESG risks after controlling for financial risk. • Our study provides a new model to predict a firm’s ESG risks and explain its cross-sectional variations. Future studies on CSR/CSI and ESG risks can build on our model to further explore managerial incentives that encourage or discourage CEOs to manage ESG risks.

  26. Implications • Our findings have important implications for boards of directors, investors, financial analysts, and other information users. • The board of directors has a responsibility to manage ESG risks and our study sheds some light on managing ESG risks through CEO compensation policy. • In particular, although our study does not speak to the optimal level of CEO inside debt in constraining the ESG risk exposure, our findings underscore the importance of incentivizing the CEO to take a long-term view of a firm’s future prospects. • Similarly, analysts, investors, auditors, and regulators need to carefully evaluate the firms whose CEOs have little inside debt as this may suggest greater ESG risk exposure for these firms.

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