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Non-Executive Employee Ownership and Corporate Risk-Taking
Joseph L. Rotman School of Management, University of Toronto Francesco.Bova@rotman.utoronto.ca
Yale School of Management firstname.lastname@example.org
Yale School of Management email@example.com
Yale School of Management firstname.lastname@example.org
July 29, 2013
Abstract. Prior research documents a negative link between risk and executive holding of stock (positive link observed for options). We find a similar negative relation for non-executive holding of stock. Our finding is consistent with the view that non-executives not only face significant incentives to reduce risk when they hold stock, but they are also able to influence decisions that affect firm risk. While endogeneity cannot be fully ruled out, the results of a battery of tests suggest that it plays a limited role. A second robust result is that the documented relation becomes more negative as option-based executive compensation increases. Overall, corporate risk is related to the incentives created by stock and options held by both executives and non-executives, as well as interactions among those incentives.
JEL classification: G30.
Keywords: Employee ownership, employee compensation, executive compensation, risk-taking
We thank Mingming Qiu, Ilona Babenko, and Rik Sen for sharing data, and Joseph Blasi, Robert Bushman, Brian Cadman, Mary Ellen Carter, John Core, Richard Frankel, Wayne Guay, Rachel Hayes, Gilles Hilary, Doug Kruse, DJ Nanda, Darius Palia, Dan Taylor, Robert Verrechia, Terry Warfield, and seminar participants at the 2012 AAA Annual Meeting, University of Alberta Accounting Research Conference, Colorado Summer Accounting Research Conference, Concordia University, London Business School, the Louis O. Kelso Fellowship mid-year meeting, IAFEP Conference, INSEAD, University of Maastricht, University of Miami, the University of Toronto, and University of Wisconsin for their valuable feedback. Bova and Thomas are grateful for funding from the Louis O. Kelso Faculty Fellowship for research in employee ownership and Yale School of Management, respectively.
An extensive literature considers how different forms of compensation create incentives
for managers to alter the distribution of stock returns. A subset of that research focuses on
incentives to alter the variance of stock returns by actions that either increase volatility (e.g.,
invest in risky projects or increase leverage) or decrease volatility (e.g., hedge exposure to
operating risk). Prior research (e.g., Stulz 1984; Smith and Stulz 1985; Guay 1999) predicts a
negative relation between stockholding and stock volatility. The empirical evidence (e.g., May
1995) confirms that prediction. These findings are based mainly on compensation paid to senior
executives, however. We investigate here whether the negative relation between stockholding
and stock volatility observed in prior research extends to non-executive employees.
Our motivation to do so is two-fold. First, of the eight subgroups of research investigating
equity-based compensationrepresented by the interaction among how holdings of
stocks/options create incentives for executives/non-executives to affect the first/second moment
of returnsthe incentives created by stock held by non-executives to affect the second moment
of returns is the subgroup receiving the least attention. Second, the arguments for a negative
relation between risk and stockholding are weaker for non-executives, relative to executives,
because of the lower likelihood that two necessary conditions hold: a) the fraction of wealth
including human capital (future compensation)that is correlated with employer stock price has
to be large enough to result in significant incentives to reduce risk, and b) employees have the
ability to alter risk, either by eliminating risky alternatives from consideration or by taking
actions subsequently to reduce volatility. We discuss in the following section reasons why these
conditions may or may not hold for non-executives. Even though our research hypothesis is
stated as if the conditions hold, we are agnostic and let the data speak.
Returning to the theory underlying empirical investigations of the relation between
efforts to alter stock volatility and managerial holding of stocks, prior research (e.g., Stulz 1984;
Smith and Stulz 1985; Guay 1999) suggests that the relation will, in most cases, be negative.
While higher stock volatility increases the value of compensation that has a convex relation with
stock price, such convexity becomes relevant for stockholding only when firms are close to
financial distress. Even if convexity is present, higher stock volatility creates greater disutility for
managers holding stock, relative to non-employee equity holders. Managers are both a) more risk
averse, and b) less able to diversify, and thus bear both systematic and idiosyncratic risk. Further,
higher stock volatility creates additional manager disutility if human capital (future
compensation) is also tied to the firms fortunes. We believe that the same arguments apply to
For our dependent variable we use two measures that reflect the extent to which
employees influence corporate decisions that affect stock volatility. Our first risk measure is the
standard deviation of daily stock returns over the 12 months following the disclosure of non-
executive stockholding. As stock volatility is affected by factors other than those controlled by
employees, it represents a noisy measure of intent to affect risk.1 To provide an alternative and
potentially less noisy measure of such intent, we consider a second risk proxy based on
accounting data: the standard deviation of seasonally-differenced quarterly accounting return on
assets over the next 20 quarters. Finally, we also consider other indirect measures of risk-taking,
such as the level of R&D expenditures.
Our main independent variable, employee stockholding, is derived from Form 5500 data
filed with the Department of Labor for defined contribution plans invested in employer stock.
1 One alternative is to replace observed stock volatility with volatility implied by put and call option prices. We
find similar results for a subsample with available option data. Section 5 contains robustness analyses that investigate the extent to which our results are sensitive to alternative proxies for our variables.
These data cover retirement plans, for which employees are eligible to receive benefits at or after
retirementsuch as employee stock ownership plans and 401(k) plans, but exclude non-
retirement planssuch as restricted stock and stock purchase plans (see Frye 2004 for a
discussion of this taxonomy). Thus, while our measure does not encompass all employer stock
held by non-executive employees, it captures a significant portion of the holdings that are
involuntary (voluntary holdings, which can be sold at any time, should create lower incentives on
a sustained basis to reduce risk).
The research design in more recent studies (e.g., Guay 1999; Coles et al. 2006) uses the
vega of executive wealth (options plus stock plus human capital) as the explanatory variable,
while controlling for its delta, where delta (vega) represents the sensitivity of managerial wealth
to changes in share price (return variance). As the available data do not allow estimation of delta
and vega for non-executive wealth, we use the research design from earlier studies where the
explanatory variable is the level of employee shareholding.
We consider a number of control variables to incorporate other factors that are likely to
affect our risk measures. These variables include market capitalization, book-to-market ratio,
leverage, presence of tax loss carryforwards, and effective tax rates. To control for the incentives
of senior executives to also influence risk, we include shares held by those executives (again, as
a percent of total shares outstanding) and option awards (as a percent of total compensation).
While our main results do not include controls for non-executive optionholdings as these data are
not available on Compustat before 2004, we include those controls for the subperiod with
available data to confirm that our inferences are not sensitive to this omission.
Given that we are unable to control for all relevant effects and the variables we use are
likely measured with error, we consider possible ways in which the omission of controls and
measurement error might bias negatively our estimated coefficient on non-executive
stockholding. We conduct extensive sensitivity analyses and conclude that any bias that is
created works against our predictions.2
We find two robust relations. First, employee stockholding is strongly negatively related
to risk measures that reflect efforts to increase stock volatility. Second, this relation becomes
more negative as the level of executive optionholding increases. Taken together, our results
suggest that corporate risk is affected by executive and non-executive holdings of stock and
options, as well as interactions among these holdings.3
Moving from association to in