Academic journal article Academy of Accounting and Financial Studies Journal

Bank Loan Agreement and CEO Compensation

Academic journal article Academy of Accounting and Financial Studies Journal

Bank Loan Agreement and CEO Compensation

Article excerpt

INTRODUCTION

An extensive body of literature establishes the commercial banks' certification role pertaining to information advantage, special monitory abilities, and securities underwriting (e.g. Leland & Pyle, 1977; Diamond, 1984, 1991; Fama, 1985). Specifically, these studies argue that commercial banks possess the technical skills and capacities to monitor their corporate clients over extended periods of time and ensure more reliable disclosure. The capital market regards banks as firm insiders and therefore reacts positively to the announcement of a bank loan relation (e.g. James, 1987; Mikkelson & Partch, 1986; Billett, Flannery & Garfinkel, 1995). One may expect that this certification role affects corporate control mechanisms as well. In due course, commercial bank monitoring should be able to help mitigate corporate agency costs seeing that lending banks generally restrict managers from engaging in risky behavior and require more transparency and disclosure (Preece & Mullineaux, 1984).

An additional consequence of increased monitoring can equally be a valuable argument for a manager to negotiate higher compensation. In fact, when a CEO believes that there are no major risky investments to undertake in the near future, he would turn to a bank loan to finance the relatively safe investments (see Holthausen & Leftwich, 1986; Hand, Holthausen, & Leftwich, 1992). Bank loans provide less expensive capital and bank monitoring prevents the firm from engaging in risky investments, which is in line with the CEOs short-term strategy. Knowing that the firm is undertaking safer investments, the CEO does not expect to have outstanding return on investment and therefore higher compensation in the near future. Consequently, one would expect the CEO to aggressively demand higher compensation following the grant of a major bank loan and use this event to secure an above average increase in compensation. The increased monitoring from highly reputable banks is proved to send a positive signal to the capital markets. The CEO may typically advocate the positive stock market reaction following the announcement of the loan agreement along with the increased transparency and scrutiny provided by the bank relation. While major bank loans may benefit shareholders by improving profitability and providing leverage, it has uncertain economic merit and may increase the firms' total risk. A recent study by Billett, Flannery and Garfinkel (2006) examines the post-announcement performance of bank borrowers and finds that firms announcing bank loans suffer significant negative abnormal returns over the subsequent three years. This fact seems to contradict the market expectations from a bank loan agreement. CEO compensation is then affected by two opposing forces: the first is the favorable market reaction attributable to the bank relation and the second is the documented future underperformance. It is therefore interesting to study the behavior of CEO compensation following bank loan agreement.

The purpose of this paper is to examine the behavior of CEO compensation following the grant of a major bank loan. Using an extensive sample of 743 bank loan agreements from 1992 to 2007, we find that, despite the lower long-term returns for shareholders, CEOs benefit from the bank relation through an increase in total compensation and a reduction in pay-at-risk compensation components. Particularly, we conclude that borrowing CEOs gain a greater bargaining power that allows them to negotiate a higher compensation scheme unrelated to firm performance. Overall, the results have several implications on optimal compensation policy, CEOs incentive alignment, and corporate governance theory.

We make two major contributions to the literature. First, we document a substantial increase in CEO compensation following private loan agreement despite the firms' long-term underperformance. Second, our study analyzes the relation between managerial incentives and corporate financing decision. …

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