This article uses FAS 123R regulation to examine how reduction in CEO compensation incentives affects managerial “playing it safe” behavior. Using proxies reflecting deliberate managerial efforts to change firm risk, difference-in-difference tests show that affected firms drastically reduce both systematic and idiosyncratic risks, leading to an 8% decline in total firm risk. These reductions in risk are achieved by shifting to safer, but low-Q, segments while closing the riskier ones, without significant changes in investment levels. Our findings suggest that decrease in risk-taking incentives provided by option compensation, when not compensated for by alternative incentives or governance mechanisms, exacerbates risk-related agency problem.

We study whether industrial firms risk-shift in response to distress risk increases induced through hurricane strikes. Using new proxies capturing deliberate managerial decisions about the risk of a firm’s operating segment portfolio, differences tests suggest that hurricane strikes prompt moderately, but not highly, distressed firms to skew their asset mixes toward riskier segments by shutting down low-risk, high-average-Q segments. In turn, the moderately distressed firms observe abnormally high failure rates after a hurricane strike. Employing covenant violation data, we offer further evidence that creditor control prevents highly distressed firms from raising their risk. Our conclusions extend those of other studies by suggesting that moderate distress risk levels can lead the managers of industrial firms to not only engage in risk-taking, but, in fact, in risk-shifting.

In this article, we show that only distressed firms not identified as distressed by creditors are able to transfer wealth from creditors to shareholders. Using the number of years to future bankruptcy as a proxy for genuine distress and measures based on observable firm characteristics as proxies for perceived distress, genuinely distressed firms incorrectly perceived as healthy cut payouts to shareholders more slowly and invest more aggressively as uncertainty increases than correctly identified distressed firms. Consistent with the idea that incorrectly identified distressed firms actively hide their troubles, we show that they tend to follow more aggressive accounting policies and often resort to earnings misstatements. We also show that they are often not restricted by covenants and can borrow further debt capital at affordable rates, suggesting that a lack of monitoring by creditors allows them to transfer wealth to shareholders.