br Acknowledgements The authors have no
Acknowledgements The authors have no ethical conflicts to disclose. The authors have no conflicts of interest to declare. This work was funded by the Research Council of Lithuania.
Introduction This paper studies whether there is a causal influence of the risk-taking incentives provided by option compensation on corporate debt maturity choices. The contribution of this Sunitinib Malate study is two-fold: First, while many empirical studies investigate the economic consequences of the risk-taking incentives provided by option compensation, evidence on the causal effects is quite limited largely due to the well-known identification challenges (Edmans and Gabaix, 2016). This paper addresses this challenge by using a quasi-natural experiment created by the 2005 mandate that firms comply with Financial Accounting Standard (FAS) 123R. Second, the literature mainly focuses on the effects of the risk-taking incentives provided by option compensation on corporate investment risk, cash holding and leverage. Their effect on debt maturity has received less attention. This might be due to the perception that debt maturity is a secondary source of financial risks compared with leverage. However, a recent growing literature emphasizes severe risk-amplifying consequences of short-maturity debt especially during credit rationing periods (Acharya et al., 2011; He and Xiong, 2012; Gopalan et al., 2014). Thus, this study also contributes by taking a new angle to investigate the effect on debt maturity. There are two ways that the risk-taking incentives provided by option compensation can affect corporate debt maturity choices. First, option compensation can induce great risk-taking incentives from managers to overcome their risk aversion and align their interests with shareholders' because of its covex payoff structure (Jensen and Meckling, 1976; John and John, 1993). Since corporate financing and investment decisions are, to a large extent, at the discretion of management, managers granted with more options would be more willing to adopt risky policies such as borrowing debt in the short rather than long term to lower the interest rate (due to the term structure), while increase the firm's rollover and liquidity risk (Diamond, 1991; Brunnermeier, 2009; Gopalan et al., 2014). We call this the “manager channel.” Second, with greater risk-taking incentives provided by option compensation, managers, on behalf of shareholders, may choose to shift into riskier corporate policies at the expense of creditors, thus aggravating creditor-shareholder agency conflicts (Jensen and Meckling, 1976; John and John, 1993). To mitigate this risk-shifting agency problem, firms should borrow in the short rather than long term because short-term debt is less sensitive to changes in firm risk (Barnea et al., 1980; Leland and Toft, 1996). We call this the “creditor channel.” In this paper, to establish the causal link, we use a quasi-natural experiment created by the 2005 mandate that firms comply with Financial Accounting Standard (FAS) 123R. FAS 123R requires firms to expense executive and employee stock options at fair value, which dramatically increases the cost of using options to compensate managers (Murphy, 2013). The empirical literature, e.g., Carter et al. (2007), Hayes et al. (2012), and Bakke et al. (2016), document a significant cutback in option compensation, thus resulting in a significant reduction in managerial risk-taking incentives as measured by “vega”, i.e., the sensitivity of the CEO's option compensation to a firm's stock return volatility. This exogenous sudden drop in managerial compensation risk-taking incentives induced by the adoption of FAS 123R provides us an ideal opportunity to examine the causal relationship. To empirically test how the reduction in compensation vega induced by the adoption of FAS 123R affects corporate debt maturity, we use comprehensive data on debt issues including both bond and loan issues as well as CEO compensation packages during the period 2003–2007. Because the fair value expensing requirement for stock options became effective on December 15, 2005, we define fiscal year 2003–2004 as the pre-FAS 123R period and fiscal year 2005–2007 as the post-FAS 123R period. As in Bakke et al. (2016), firms in the control group are defined as those that did not grant options to CEOs in 2003 and 2004, or those that already voluntarily chose to expense the stock options at fair value in or prior to 2002. These two groups of firms are unlikely to be affected by FAS 123R. The treated group include other sample firms excluding control firms. The firms in the treated group face a sharp decline in vega induced by FAS 123R while those in the control group are not affected. We employ a difference-in-differences methodology.