Relative Performance Evaluation: Evidence from Warnings and Tip-Offs

• In Event: Executive Compensation and Financial Reporting

Abstract

We investigate the effect of peer firms’ warnings and tip-offs on a firm’s CEO compensation and pay-performance sensitivity. Based on the literature on relative performance evaluation (RPE) and information transfer, we expect that the signal from peer firms’ warnings is utilized in setting CEO compensation (1) to filter out the systematic shocks that are common to industry peers; and (2) to evaluate the credibility of the CEO. Controlling for self-selection, we find evidence that (1) the sensitivities of bonus-to-stock-returns and option-to-stock-returns for warning firms decrease as the number of warning peers increases; and (2) CEO bonus of a non-warning firm decreases as the number of warning peers increases. These findings suggest that (1) for a warning firm, warnings by peer firms indicate an industry-wide effect and therefore CEO compensation becomes less responsive to poor stock returns; (2) for a non-warning firm, as the number of warning peers increases, its compensation committee becomes more concerned about the credibility of the CEO for failing to issue a warning. We also document that neither CEO compensation nor pay-performance sensitivity is affected by the number of peers that issue tip-offs. We attribute this finding to the credibility issue of good news disclosure.

Authors

• Masako Darrough, Baruch College–CUNY

• Ping Wang, Pace University