Financial Distress Risk and Initial CEO Compensation Contracts

We examine the association between a firm’s ex ante risk of financial distress and the compensation and incentives provided to newly hired CEOs. Our findings are as follows. First, new CEOs at firms with higher bankruptcy risk receive substantially less compensation than new CEOs at low-risk firms. Second, while pay-performance sensitivity is higher for new CEOs at high-risk firms, the semi-elasticity of CEO pay with respect to shareholder wealth is lower. Finally, we find a negative relation between bankruptcy risk and the ratio of CEO pay-risk sensitivity to semi-elasticity, which is consistent with firms reducing potential shareholder/debtholder agency conflicts. JEL classification: J33, J24, J41, G33 We thank Elizabeth Keating and Scott Schaefer for numerous helpful discussions and Bob Bell, Mindy Wolfe and George Yong for excellent research assistance. We also greatly appreciate the comments of Robert Bushman, Mary Ellen Carter, Dhinu Srinivasan, workshop participants at the University of British Columbia, Michigan State University, Northwestern University, Southern Methodist University and the University of Utah, participants at the 2005 American Accounting Association Annual Meeting (San Francisco, CA), and participants at the EIASM VII Workshop on Accounting and Economics (Bergen, Norway). ∗Corresponding author contact information: David Eccles School of Business, 1645 E Campus Center Drive; Salt Lake City, UT 84112 Phone: 801-581-4409; Fax: 801-581-7214; E-mail: [email protected]