Stock options have been a part of executive pay at major U.S. corporations for approximately 100 years. They have had an important role for approximately 70 years, starting in the 1950s. They have gone through periods of extraordinary popularity (e.g., the 1990s) and have been less popular during periods when the stock markets were in the doldrums. They survived the change in accounting rules (2006) that now require them to be a charge against earnings. This post examines this history and takes a look at where options are today. 
Posts Tagged ‘Stock options’
Three categories of performers are rewarded for value creation in U.S. public corporations. They are: (1) the executives who manage the corporations; (2) the directors who oversee the performance of these corporations; and (3) the individual asset managers and others who provide investment services to investors who own, directly or indirectly, these corporations.
The following post takes a look at the correlation between the long-term incentive compensation of these three categories of performers and long-term value creation in U.S. public corporations that is attributable to them. In fact, such correlation appears to be limited. In addition, the article will consider a definition of “long-term” value creation, the roles of these three categories of performers in creating “long-term” value and the methods of compensating these different categories of performers in their respective roles in “long-term” value creation.
Corporations rely on dividends, share repurchases, or a combination of both payout methods to return earnings to their shareholders. Over the last decade, the importance of the dominating payout method—dividends—seems to be somewhat eroded at UK firms, with an increasing number of firms combining share repurchases with dividends. What explains the surge in the use of combined share repurchases and dividends in the UK? Is there a link between firm’s payout decision and executive remuneration?
The protest against short termism in corporate America is rising. Business and political leaders are decrying the emphasis on quarterly results—which they claim is preventing corporations from making long-term investments needed for sustainable growth.
However, these critics of short termism have a skewed view of the facts and there are logical flaws in their arguments. Moreover, their proposals would dramatically cut back on shareholder rights to hold companies accountable.
The critics of short termism stress how much the average daily share volume has increased over the last few decades. Although this is factually correct, this sharp average increase is caused primarily by a tremendous rise in intraday trading.
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.
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.
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.
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.
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.
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.