Transparency is the cornerstone of corporate governance in the United States. Public companies must stick to a rigid schedule for reporting profits, losses and other financial data. And they must quickly disclose unscheduled events that current and potential shareholders will need to know about in order to assess the firm’s health and prospects.
It all seems quite simple.
But in practice, chief executives have some wiggle room: the power to choose just when to release certain types of information. New research by Wharton finance professor Alex Edmans and three colleagues shows that executives tend to use this flexibility to their advantage, releasing some types of information when it will boost the value of their own equity.
“When they expect to sell equity, they want the price to be high,” says Edmans, who is also a finance professor at the London Business School.
The research, described in the paper “Strategic News Releases in Equity Vesting Months,” is co-authored with Luis Goncalves-Pinto of the National University of Singapore, Yanbo Wang of INSEAD and Moqi Xu of the London School of Economics. It exploits the fact that CEOs’ stock and options come with a vesting period, during which the CEO is not allowed to sell them, but after the vesting date passes, CEOs typically cash out a significant fraction. The executive therefore makes more if his or her company’s share price is as high as possible on the vesting date. “Positive information will obviously push the stock price up,” Edmans says, adding: “If the CEO was given in December 2009 some equity with a five-year vesting period, then it would vest in [December 2014], and that expected vesting would cause the CEO to be concerned about the short-term stock price.”
“We show that firms release significantly more discretionary news in vesting months than in non-vesting months.”
This research is related to another paper co-authored by Edmans, entitled “Equity Vesting and Managerial Myopia,” which shows that CEOs cut investment in research and development, advertising and capital expenditure when their equity is scheduled to vest. But, the effect on news is an interesting independent consequence to study, as it suggests that the CEO’s contract affects not just internal corporate decisions, but also financial markets. (See: ‘Managerial Myopia’: How CEOs Pump Up Earnings for Their Own Gain.)
Because many financial disclosures such as quarterly and annual reports are issued on a set schedule that the CEO can’t change, the research separated out these non-discretionary disclosures from discretionary disclosures, such as press releases announcing strategy changes. As expected, positive news can boost the share price. But neutral news can raise stock prices as well, by drawing attention to the firm or making investors more confident that they know what is going on with the company. For example, “uninformed” investors — those who typically feel they have less information than the pros — may feel that a news release reduces their information disadvantage, which can encourage them to buy the stock or drop plans to sell it. Higher demand pushes the share price up.
“Timely information flows are thus important,” the authors write, noting that rules like Regulation Fair Disclosure of 2000 and the Sarbanes Oxley Act of 2002 made news releases more important in communicating relevant information to investors. “News releases do not occur mechanically whenever corporate events take place, but are a discretionary decision of the CEO,” Edmans and his colleagues write. “This paper investigates whether CEOs strategically time news releases for personal gain.”
There is, they note, a chicken-and-egg issue that can cloud the question: Simply looking at a CEO’s stock sales and the number of discretionary news releases in a given month can’t, by itself, show whether the executive is manipulating the flow of news, because the news itself could change a CEO’s behavior. It could be, for instance, that a number of newsworthy events took place in a certain month, raising the share price and giving the CEO an incentive to sell. “Thus, disclosure causes equity sales rather than expected equity sales causing disclosure,” the researchers note.
“If news is being manipulated, this is something that does affect stock prices.”
To overcome this problem, the research focused on stock options and share grants awarded to the CEO several years before they vest. Experts generally urge executives to sell equity acquired this way as soon as they can, to avoid the excess risk involved in owning too much equity in a single company. Since the executive can’t control these vesting dates, equity sales made on these dates are unlikely to have been caused by news disclosures — the sales are likely to occur regardless.
(The study excluded from consideration options that are “out of the money,” or could not be exercised at a profit, because the CEO has no financial incentive to exercise them. Also excluded were grants whose vesting dates were linked to the firm’s stock performance, since this performance may have been affected by the news releases.)
So the key question is: Do the approaches of potentially profitable vesting dates lead CEOs to release information that could just as well be released earlier or later, with the aim of raising short-term share prices?
Evidence of Strategic Timing
Edmans and his colleagues used a Key Developments database from Capital IQ, a market information firm, that classifies releases into categories that make it possible to distinguish discretionary releases, such as announcements of conferences, new client relationships and product decisions, from non-discretionary news such as earnings. They studied 166,000 news releases from 1994-2011.
“We show that firms release significantly more discretionary news in vesting months than in non-vesting months,” the researchers write. “There are 2% more discretionary news releases in vesting months than in non-vesting months, and 5% more than in prior months.” The greater the value of the equity that is vesting, the greater the number of discretionary releases, the study found. Meanwhile, the number of non-discretionary news releases is the same in vesting and non-vesting months. This is consistent with the CEO having less latitude in the timing of such releases.
“Five percent is statistically significant,” Edmans says. “But it is also within the bounds of plausibility — it’s not so large that it would ring alarm bells with regulators or the board.”
The study looked at news coverage after discretionary releases, finding that it tended to be more positive in vesting months. Thus, in vesting months, CEOs are releasing not only a greater number of news items, but also more positive news items.
The manipulation has little effect on the firm itself — but it can be harmful to shareholders, suppliers, customers or business partners.
Indeed, share prices did rise after press releases. A single release in a vesting month boosted the share price by 28 basis points, or 0.28%, over the 16 days that followed. But the boost was temporary, falling to 14 basis points after 31 days. That shows the CEO has an incentive to release information close to the vesting date rather than well before. CEOs do appear to take advantage of these short-term price gains, with half of them selling all of their vested shares within seven days of a discretionary release.
How Much Profit Is Involved?
Because CEOs receive large quantities of stock, this news manipulation can be profitable. Edmans and his colleagues found that the average vesting date involved $5.18 million in equity. Boosting the share price by 28 basis points increases the profit by $14,504, which, the researchers note, is similar to the gains associated with illegal insider trading. And of course, a CEO can release more than one news item.
“Those gains come at little cost: changing the timing of news releases is legal, and involves less effort than other actions to boost the stock price, such as cutting investment projects,” the researchers write, referring to cost cutting that boosts earnings.
Is anyone hurt by this? The manipulation has little effect on the firm itself, Edmans and the other researchers write. The main harm is on shareholders, suppliers, customers or business partners who make decisions without information that they could have received but which CEOs postpone for their own benefit.
In addition, savvy investors could use the study’s insights to ride on CEOs’ coattails, purchasing shares of a company ahead of its CEO’s vesting month, and postponing sales until afterward.