Should a Chief Executive Officer be required to own stock in his or her firm?

The age-old question of whether or not to force CEOs to buy into their company continues to generate significant debate, with much of the discussion centering on whether standard equity ownership by senior management and external board members is too low to motivate appropriate financing and investment decisions that increase shareholder value. In response to this and other criticisms by shareholders and corporate governance activists, a number of companies have adopted target ownership plans.

Often the target ownership plan and the reasons for adopting it are announced in a company’s proxy statement, which, as might be expected, says the action is being taken to increase shareholder value. For example, the proxy statement of Morrison Restaurants, dated August 26, 1993, reads in part: "Believing that equity ownership plays a key role in aligning the interests of company personnel with company stockholders, the company encourages all employees to make a personal investment in company stock. The company’s goal is that 10% of the common stock will be owned by employees by the year 2000 and that 80% of employees with more than two years of experience with the company will own common stock."

Although common sense suggests that a CEO, and the management group in general, with an equity stake tends to turn in better performance, research on this important topic has turned up strikingly contradictory conclusions. Some studies, for example, suggest that corporate performance could be improved by increases in managerial ownership as long as it was kept to less than 50%. Other researchers, however, found no relationship at all between levels of ownership and firm performance.

In search of a definitive answer to this question, Wharton professors John E. Core and David F. Larcker conducted a study of 195 firms across different industrial and service sectors that disclosed the adoption of target ownership plans in their 1992 to 1996 proxy statements. Target ownership plans are formal contracts between the board of directors and senior-level managers that specify the minimum level of equity, relative to base salary, to be held by executives. Interestingly, before they adopted a stock ownership plan, which typically required a CEO to own equity valued at least four times his or her base salary, these companies exhibited relatively low levels of officer equity ownership and low stock price performance.

Most of the target stock ownership plans require executives to own the stock outright, exclusive of any indirect ownership provided by option holdings. In addition, some companies set a maximum time permitted to achieve target ownership levels and state the penalties that would be levied against executives who missed the target. For the companies that Core and Larcker studied, CEO equity ownership did increase significantly in the two years following plan adoption. Thus, the target ownership plans were not simply "window dressing" attempting to appease corporate governance activists and institutional shareholders. Rather, they substantially changed the CEO’s personal investment portfolio.

The researchers’ theory is as follows:

  • Poor firm performance is related to low levels of managerial equity ownership
  • Significant increase in CEO equity ownership would result in improvements in the company’s future operating and stock market performance.

Consistent with this explanation, return on assets (ROA), a measure of profitability, for adopting firms was about 1.8% higher than comparable firms (firms in the same industry and having roughly the same level of ROA in the year before adoption) in the two years after adopting target ownership plans. Additionally, stock price returns were approximately 5.9% higher (again relative to comparable firms) in the first six months of the fiscal year in which the plan was announced. Core and Larcker thus conclude that improvements in firm performance are associated with requiring an increase in the level of managerial equity ownership. They report these conclusions in a paper titled, "Performance Consequences of Requiring Target Stock Ownership Levels."

In the end, the researchers say, firms with under-performing stock should examine the holdings of their CEO and consider adopting a target ownership plan. While such an approach may not be a magic bullet, Core and Larcker have found that when CEOs with below-average equity ownership are required to increase their ownership levels, company performance definitely improves.