Guess Who’s Also Minding Your Business? The Effect of Credit Ratings Changes on CEO Incentives∗

This study documents that changes in credit ratings significantly affect chief executive officer’s (CEO’s) pay-performance sensitivity. Modeling credit ratings changes and changes in CEO incentive levels as jointly endogenous, we identify significant and robust evidence that CEO incentives tend to increase subsequent to the downgrades of credit ratings, and decrease after the upgrades. We also find that the effect of credit ratings changes on CEO incentives is stronger for larger firms, for firms with investment grade debts and larger presence of institutional investors, and for firms whose investors have less access to public information. More importantly, we find the credit ratings changes have larger impact on CEO incentives for firms whose CEOs have been either over- or under-compensated previously. Our empirical findings suggest that rating agencies’, or more generally, debt-holders’, disciplines complement equity-based incentive pay to resolve agency conflicts between managers and stakeholders