Warnings & CEO Compensation

While warnings that their companies’ earnings won’t meet expectations have little impact on a CEO’s salary, they can have a measurable effect on their bonuses and stock options.
CEOS SOMETIMES VOLUNTARILY issue warnings that their companies’ earnings won’t meet expectations so that stakeholders will not be taken by surprise. But how does that disclosure affect CEO compensation? While warnings have little impact on a CEO’s salary, they can have a measurable effect on a CEO’s bonuses and stock options, say researchers Ping Wang of Pace University’s Lubin School of Business in New York City, Masako Darrough of Baruch College of the City University of New York, and Linna Shi of Binghamton University of the State Univer­sity of New York.

The researchers analyzed data related to voluntary warnings of negative earnings issued from 1996 to 2010. They discov­ered that compensation committees often decrease their CEOs’ bonuses after an earn­ings warning, but increase stock options. The likely reason, the researchers point out, is that compensating committees want to realign the CEO’s fortunes with those of stockholders by making company stock a greater percentage of the salary package.

The researchers also found that warn­ings did not directly affect CEO turnover. However, CEOs who had not generated positive stock returns in the year after a warning were replaced at higher rates.

Only 13 percent of CEOs in their sample issued voluntary warnings—even though most firms benefit by informing share­holders ahead of disappointing earnings reports. That finding “is consistent with the notion that direct benefits [of issuing warnings] may be limited to a small subset of CEOs who can afford to take more risk.”

“Earnings Warnings and CEO Welfare” is forthcoming in the Journal of Business Finance and Accounting. It can be previewed at ssrn.com/abstract= 2798173.