The downside of tournament incentives: Evidence from the trading behavior of non-promoted insiders

Abstract

We find that several non-promoted executives remain in their firm after losing CEO tournament contests and suffering a drastic reduction in their contract’s promotion-based component and a wider pay gap. We show that they use their private information to sell their holdings profitably, against the newly appointed CEOs’ optimistic and noisy buy trades. They do not trade on their private information in their rare purchases and before losing the contest, to maximize their CEO promotion probabilities, consistent with the substitution hypothesis. Those who stand to lose more from missing their promotion respond more negatively to a promotion pass-over and have a higher incentive to exploit their informational advantage in both voluntary and involuntary CEO turnover events. Their loss-averting sell transactions are more profitable than their peers who left the firm and are related to investors’ sentiments, their firm’s subsequent underperformance, board conservatism, industry tournament incentives, and their ability to implement dissimulation strategies to thwart outsiders and market regulators. Using instrumental variable to address the reverse causality concern, we show that this strategy weakens the well-documented positive relationship between tournament incentives and firm performance. Our results hold for various other specifications and robustness checks and highlight new implications of the tournament incentives models, compensation committees, and insider trading regulations.