Posts Tagged ‘Stock options’

Motivating Innovation in Newly Public Firms

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday February 12, 2014 at 9:00 am
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Editor’s Note: The following post comes to us from Nina Baranchuk and Robert Kieschnick, both of the Finance and Managerial Economics Area at the University of Texas at Dallas, and Rabih Moussawi of the Wharton School at the University of Pennsylvania.

How do shareholders motivate managers to pursue innovations that result in patents when substantial potential costs exist to managers who do so? This question has taken on special importance as promoting these kinds of innovations has become a critical element of not only the competition between companies, but also the competition between nations. In our paper, Motivating Innovation in Newly Public Firms, forthcoming in the Journal of Financial Economics, we address this question by providing empirical tests of predictions arising from recent theoretical studies of this issue.

…continue reading: Motivating Innovation in Newly Public Firms

Indexing Executive Compensation Contracts

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday January 29, 2014 at 9:00 am
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Editor’s Note: The following post comes to us from Ingolf Dittmann, Professor of Finance at Erasmus University Rotterdam; Ernst Maug, Professor of Finance at the University of Mannheim; and Oliver Spalt of the Department of Finance at Tilburg University.

Standard principal-agent theory prescribes that managers should not be compensated on exogenous risks, such as general market movements. Rather, firms should index pay and use contracts that filter exogenous risks (e.g., Holmstrom 1979, 1982; Diamond and Verrecchia 1982). This prescription is intuitive and agrees with common sense: CEOs should receive exceptional pay only for exceptional performance, and “rational” compensation practice should not permit CEOs to obtain windfall profits in rising stock markets. However, observed compensation contracts are typically not indexed. Specifically, stock options almost never tie the strike price of the option to an index that reflects market performance or the performance of peers. Commentators often cite this glaring difference between theory and practice as evidence for the inefficiency of executive compensation practice and, more generally, as evidence for major deficiencies of corporate governance in U.S. firms (e.g., Rappaport and Nodine 1999; Bertrand and Mullainathan 2001; Bebchuk and Fried 2004). This paper therefore contributes to the discussion about which compensation practices reveal deficiencies in the pay-setting process.

…continue reading: Indexing Executive Compensation Contracts

How Does Corporate Governance Affect Bank Capitalization Strategies?

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday January 24, 2014 at 9:00 am
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Editor’s Note: The following post comes to us from Deniz Anginer of the Department of Finance at Virginal Tech, Asli Demirgüç-Kunt, Director of Research at the World Bank; Harry Huizinga, Professor of Economics at Tilburg University; and Kebin Ma of the World Bank.

In our paper, How Does Corporate Governance Affect Bank Capitalization Strategies?, which was recently made publicly available on SSRN, we examine how corporate governance and executive compensation affect bank capitalization strategies for an international sample of banks over the 2003-2011 period.

We find that ‘good’ corporate governance—or corporate governance that causes the bank to act in the interests of bank shareholders—engenders lower levels of bank capital. Specifically, we find that bank boards of intermediate size (big enough to escape capture by management, but small enough to avoid free rider problems within the board), separation of the CEO and chairman of the board roles, and an absence of anti-takeover provisions lead to lower capitalization rates. ‘Good’ corporate governance thus may be bad for bank stability and potentially entail high social costs. This disadvantage of ‘good’ corporate governance has be balanced with presumed benefits in terms of restricting management’s ability to perform less badly in other areas—for instance, by shirking or acquiring perks—at the expense of bank shareholders.

…continue reading: How Does Corporate Governance Affect Bank Capitalization Strategies?

CEO Compensation and Corporate Risk

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Thursday November 7, 2013 at 9:07 am
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Editor’s Note: The following post comes to us from Todd Gormley of the Department of Finance at the University of Pennsylvania, David Matsa of the Department of Finance at Northwestern University, and Todd Milbourn, Professor of Finance at Washington University in St. Louis.

Every firm is exposed to business risks, including the possibilities of large, adverse shocks to cash flows. Potential sources for such shocks abound—examples include disruptive product innovations, the relaxation of international trade barriers, and changes in government regulations. In our paper, CEO Compensation and Corporate Risk: Evidence from a Natural Experiment, forthcoming in the Journal of Accounting and Economics, we examine (1) how boards adjust CEOs’ exposure to their firms’ risk after the risk of such shocks increase and (2) how incentives given by the CEOs’ pre-existing portfolios of stock and options affect their firms’ response to this risk. Specifically, we study what happens when a firm learns that it is exposing workers to carcinogens, which increase the risks of significant corporate legal liability and costly workplace regulations.

The results presented in this paper suggest that corporate boards respond quickly to changes in their firms’ business risk by adjusting the structure of CEOs’ compensation, but that the changes only slowly impact the overall portfolio incentives CEOs face. After the unexpected increase in left-tail risk, corporate boards reduce CEOs exposure to their firms’ risk; the sensitivities of the flow of managers’ annual compensation to stock price movements and to return volatility decrease. Various factors likely contribute to the board’s decision, including CEOs’ reduced willingness to accept a large exposure to their firms’ risk and the decline in shareholders’ desired investment after left-tail risk increases. Indeed, managers act to further reduce their exposure to the firm’s risk by exercising more options than do managers of unexposed firms. These changes, however, only slowly move CEOs’ overall exposure to their firm’s risk because the magnitude of their pre-existing portfolios continues to influence their financial exposure to the firm.

…continue reading: CEO Compensation and Corporate Risk

Rich-Hunt: The Speech

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday October 15, 2012 at 8:55 am
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Editor’s Note: The following post comes to us from Roger Donway, program director of the Atlas Society’s Business Rights Center. This post is based on an edited version of Mr. Donway’s remarks at the Atlas Society’s 2012 summer conference, available here.

My monograph Rich-Hunt is subtitled “The Backdated Options Frenzy and the Ordeal of Greg Reyes.” But if you have not read the monograph, and if you missed the whole frenzy of 2005–2011, you may well wonder: What is a backdated option? Indeed, you may not even be quite sure about what an option is and how it works. So, let me start there.

An option is a type of security that gives a person the right to buy a share of a company’s stock at a specified price. For example, an option might give you the right to buy a share of Google at $5. That would be a very valuable option. Or an option might give you the right to buy a share of Google at $5,000. That would not be so valuable.

Typically, when a company gives options to its employees as a form of compensation, the employees are allowed to buy shares in the company (which is called “exercising the options”), and the price at which they may buy the stock is called the option’s “exercise price,” or “strike price.” Typically, however, they can exercise their options only after a defined span of time (called “the vesting period”) and before a certain date (called “the expiration date”).

So, the value of such option grants rests entirely on the possibility that the stock will be selling above the strike price during the period of time that the employee is permitted to use the option to buy a share. If the stock price is higher than the exercise price, the employee can reap a profit by purchasing a share of stock at the exercise price and then immediately selling that share on the stock market. Of course, if the stock price does not rise above the strike price between the time that the options vest and the time that they expire, then the options are forever worthless.

…continue reading: Rich-Hunt: The Speech

Stock Options and Managerial Incentives for Risk Taking

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday April 4, 2012 at 10:07 am
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Editor’s Note: The following post comes to us from Rachel Hayes, Professor of Accounting at the University of Utah; Michael Lemmon, Professor of Finance at the University of Utah; and Mingming Qiu of the Department of Finance at the University of Utah.

In our forthcoming Journal of Financial Economics paper, Stock Options and Managerial Incentives for Risk Taking, we exploit the change in the accounting treatment of stock-based compensation under FAS 123R, which was issued by the Financial Accounting Standards Board (FASB) and took effect in December 2005, to provide new evidence on the role that convexity in compensation contracts plays in providing incentives for risk taking by managers.  An additional rationale that is often stated for the dramatic rise in option-based compensation over time revolves around how stock options were treated for accounting purposes. Prior to the implementation of FAS 123R, firms were allowed to expense stock options at their intrinsic value. Because nearly all firms granted stock options at-the-money, no expenses for option-based compensation were generally reported on the income statement.

Hall and Murphy (2003) argue that, due to their favorable accounting treatment and the fact that there is no cash outlay at the time of the grant, firms act as though the perceived cost of options is lower than their true economic cost. If firms make decisions based on the perceived costs instead of the economic costs, they grant more options than they would otherwise, and options with their favorable accounting treatment are preferred to possibly better incentive plans with less favorable accounting treatment. Consistent with this view, Carter, Lynch, and Tuna (2007) provide evidence that the accounting treatment of stock options affected their use, showing that a comprehensive proxy for financial reporting concerns was positively related to the use of stock options prior to FAS 123R. The implementation of FAS 123R eliminated the ability to expense options at their intrinsic value and instead required firms to begin expensing stock-based compensation at its fair value, effectively eliminating any accounting advantages associated with stock options.

…continue reading: Stock Options and Managerial Incentives for Risk Taking

Executive Stock Options, Differential Risk-Taking Incentives, and Firm Value

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday January 25, 2012 at 10:09 am
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Editor’s Note: The following post comes to us from Christopher Armstrong and Rahul Vashishtha, both of the Accounting Department at the University of Pennsylvania.

In our paper, Executive Stock Options, Differential Risk-Taking Incentives, and Firm Value, forthcoming in the Journal of Financial Economics, we examine how executive stock options (ESOs) give chief executive officers (CEOs) differential incentives to alter their firms’ systematic and idiosyncratic risk. Since ESOs give CEOs incentives to alter their firms’ risk profile through both their sensitivity to stock return volatility, or vega, and their sensitivity to stock price, or delta, we examine both effects.

Theory suggests that vega gives risk-averse managers more of an incentive to increase total risk by increasing systematic rather than idiosyncratic risk, since, for a given level of vega, an increase in systematic risk always results in a greater increase in a CEO’s subjective value of his or her stock-option portfolio than does an equivalent increase in idiosyncratic risk. This differential risk-taking incentive manifests because a CEO who can trade the market portfolio can hedge any unwanted increase in the firm’s systematic risk. Consistent with this prediction, we provide evidence of a strong positive relationship between vega and the level of both total and systematic risk. However, we do not find vega and idiosyncratic risk to be significantly related.

…continue reading: Executive Stock Options, Differential Risk-Taking Incentives, and Firm Value

Voluntary Disclosures That Disavow the Reliability of Mandated Fair Value Information

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday November 11, 2011 at 9:04 am
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Editor’s Note: The following post comes to us from Walter Blacconiere (deceased); James Frederickson, Professor of Accounting at the Melbourne Business School; Marilyn Johnson of the Department of Accounting at Michigan State University; and Melissa Lewis of the Department of Accounting at the University of Utah.

U.S. and international accounting standards mandate recognition and/or disclosure of fair value information for an increasing number of items. Fair value estimates require judgment, introducing the possibility of biases in measurements, measurers, and/or models. In addition, unanticipated changes in market risk result in realized values differing from fair value estimates. Accompanying the shift to fair value accounting is the emergence of voluntary disclosures in audited financial statement footnotes that alert investors to management’s concerns about the reliability of mandated fair value information. We refer to such disclosures as reliability disavowals (hereafter, disavowals). In our paper, Are voluntary disclosures that disavow the reliability of mandated fair value information informative or opportunistic? forthcoming in the Journal of Accounting and Economics as published by Elsevier, we examine whether disavowals are informative; that is whether they are a truthful revelation by management that their fair value estimates are unreliable. We also consider that managerial opportunism may contribute to—or even solely motivate—the decision to disavow.

…continue reading: Voluntary Disclosures That Disavow the Reliability of Mandated Fair Value Information

Should Size Matter When Regulating Firms?

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday June 13, 2011 at 9:37 am
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Editor’s Note: The following post comes to us from Deniz Anginer, Financial Economist in the Development Research Group at the World Bank; M. P. Narayanan, Professor of Finance at the University of Michigan; Cindy Schipani, Professor of Business Law at the University of Michigan; and H. Nejat Seyhun, Professor of Finance at the University of Michigan.

In our paper, Should Size Matter When Regulating Firms? Implications from Backdating of Executive Options [15 N.Y.U. J. Legis. & Pub. Pol'y (forthcoming Winter 2011)], we present a data point relevant to significant issues of policy concerning areas of law where small firms have either been granted exemption from regulations or not investigated for violations of laws that, on their face, apply to them. Whether small firms should be exempted is an empirical question the answer to which depends on the likelihood of such firms violating regulations.

There are numerous instances in the law where small firms have been granted exemptions from regulatory restrictions. The major justification offered by the proponents for this exemption of small firms is the claim that regulation has a disproportionate effect on these companies. For example, in the area of securities law, regulation of small firms has drawn criticism throughout the years. It has been lamented that “the [Securities Exchange Commission] SEC [has] never . . . understood small businesses, their capital needs, their importance to our economy, and the special circumstance they face…” Similarly, since its enactment in 2002, the Sarbanes-Oxley legislation (SOX) has been highly criticized for the level of expense it has imposed upon firms’ efforts to comply with the legislation. In order to decide if regulation should be lenient towards small firms, we need to first understand what types of firms are likely to be engaged in illicit activity. If we knew that small firms are also likely to violate laws, as a matter of public policy, should we continue to exempt firms from regulatory scrutiny solely due to size? That is, should size matter in regulatory policy decisions? Furthermore, should size be a factor when prosecutors target firms for investigation?

…continue reading: Should Size Matter When Regulating Firms?

Employee Stock Ownership Plans

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday May 23, 2011 at 10:51 am
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Editor’s Note: The following post comes to us from E. Han Kim, Professor of Finance and International Business at the University of Michigan, and Paige Ouimet of the Finance Department at the University of North Carolina at Chapel Hill.

In our paper, Employee Stock Ownership Plans: Employee Compensation and Firm Value, which was recently made publicly available on SSRN, we investigate whether adopting a broad-based employee stock ownership plan enhances productivity by improving team incentives and co-monitoring. That is, does employee capitalism work? If so, how are gains divided between shareholders and employees?

We find that small ESOPs increase productivity. Unlike Jones and Kato (1995) on Japanese ESOPs, our evidence of productivity gains is based on the effects on two main beneficiaries of such gains: employees and shareholders. Because our evidence indicates both stakeholders gain from adopting small ESOPs, we infer employee share ownership increases the size of the economic pie by improving worker productivity.

This causal interpretation is substantiated by our evidence on how the division of productivity gains is related to employee mobility within an establishment’s industry and location of work place. We find that when labor mobility increases, increasing workers’ bargaining power vis-à-vis shareholders’, employees’ share of gains increases and stockholders’ share decreases.

…continue reading: Employee Stock Ownership Plans

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