Reducing managers’ incentives to cannibalize: Managerial stock options when shareholders are diversified

We analyze the relative advantage of option grants compared to stock compensation when shareholders are diversified. Our analysis recognizes a conflict that is largely neglected in the corporate finance literature. Shareholders want to maximize their portfolio value while capital budgeting rules direct managers to choose projects that maximize firm (equity) value. Options can reduce this conflict by motivating managers to avoid projects that enhance the value of one firm at the expense of another firm. Also, in our framework, relative performance evaluation destroys value for shareholders as it encourages firms to engage in cannibalistic activity. Consistent with the predictions of our model we find that firms with lower insider ownership, higher institutional ownership, and lower leverage tend to provide more option grants as compensation to their executives.     

Independent directors’ board networks and controlling shareholders’ tunneling behavior

As one of the channels by which board directors build important relationships, board networks can affect the governance role of independent directors. Defining director board networks as their connections based on direct ties they establish when serving on at least one common board, this paper explores the role of the network centrality of independent directors in restraining tunneling behavior by controlling shareholders in the Chinese capital market. Our empirical evidence shows that tunneling behavior by controlling shareholders is negatively related to the network centrality of independent directors and that this relationship is stronger when non-operating fund occupation is used as the measure of tunneling. The results of our study show that board networks can help independent directors to restrain tunneling behavior by large shareholders, which plays a positive role in corporate governance.     

Is backdating executive stock options always costly to shareholders?

We use a binomial model to investigate the cost to shareholders of backdating employee stock option (ESO) grants to award in‐the‐money rather than at‐the‐money options to a manager. When the expected return of the stock underlying an ESO is sufficiently close to the risk‐free rate, a backdating arrangement can always be structured to simultaneously improve shareholders’ wealth and the manager's utility. The smaller the manager's non‐option wealth, personal income tax rate or risk tolerance, the more likely a backdating arrangement can be welfare improving.     

Can real options explain financing behavior?

Trade-off models commonly invoke financial transaction costs in order to explain observed leverage fluctuations. This paper offers an alternative explanation based on real options. The model is frictionless on the financing side but incorporates irreversibility and fixed costs of investment. Results obtained from simulating the model are broadly consistent with observed financing patterns. Market leverage ratios are negatively related to profitability, mean-reverting, and depend on past stock returns. The gradual and lumpy leverage adjustments can occur in the absence of financial transaction costs. This evidence shows that incorporating real frictions into structural models increases their explanatory power.     

Stock options and managers’ incentives to cheat

This paper develops a continuous-time real options’ pricing model to study managers’ incentives to cheat in the presence of equity-based compensation plans. It shows that managers’ incentives to cheat are strongly influenced by the efficiency of the justice. The model’s main result is that managers have greater incentives to commit fraudulent actions under stock options than under common stocks based compensation plans.     

CEO stock options and analysts’ forecast accuracy and bias

This paper investigates the relationship between CEO stock options and analysts’ earnings forecast accuracy and bias. A higher level of stock options may induce managers to undertake riskier projects, to change and/or reallocate their effort, and to possibly engage in gaming (such as opportunistic earnings and disclosure management). These managerial behaviors result in an increase in the complexity of forecasting and hence, less accurate analysts’ forecasts. Analysts’ optimistic forecast bias may also increase as the level of stock options pay increases. Because forecast complexity increases with stock options pay, analysts, needing greater access to management’s information to produce accurate forecasts, have incentives to increase the optimistic bias in their forecasts. Alternatively, a higher level of stock options pay may lead to improved disclosure because it better aligns managers’ and shareholders’ interests. The improved disclosure, in turn, may result in more accurate and less biased analysts’ forecasts. Our empirical evidence indicates that analysts’ earnings forecast accuracy decreases and forecast optimism increases as the level of CEO stock options increases. This evidence suggests that the incentive alignment effects of stock options are more than offset by the investment, effort allocation and gaming incentives induced by stock options grants to CEOs.     

Auditing regulations and bank shareholders’ wealth: An international analysis

This paper examines the ability of auditing regulation to protect bank shareholders’ wealth during the time of normal growth and during the 2007–2009 global financial crises. The study uses the bank regulation database available at the World Bank website. We select a sample of 2467 banks from 107 countries for the years 1999–2009. We perform multivariate regression analyses and find that while auditing regulations enhance bank equity prices in normal growth periods, there is no evidence that auditing regulations are associated with bank share prices during the period of financial crisis. We observe similar results for both developed and emerging countries and for the common and code law countries. Our results suggest an immediate need to strengthen audit regulations so that investor confidence is more likely to persist during periods of financial downturn.     

Venture capitalists and portfolio companies’ real activities manipulation

I study the relation between venture capitalists’ (VCs) presence and real activities manipulation (RM). I find that compared to non-venture-backed companies, venture-backed companies show significantly less RM in the first post-IPO fiscal year. The results are robust after controlling for the VC selection endogeneity. This is consistent with the argument that VCs do not inflate earnings when they exit the IPO firm but instead exercise a monitoring role to reduce the RM by other insiders. By the end of the second post-IPO fiscal year when VCs exit the portfolio companies, their impact on portfolio companies’ RM decreases dramatically. This suggests that the impact of VCs on portfolio companies is mainly through direct monitoring rather than through the establishment of a governance structure. A partitioned sample analysis indicates that VCs lapse their control and do not restrain RM during the Internet Bubble. VCs also tighten their control and reduce significantly RM in technology companies where managers engage in more aggressive RM, but they have no influence on RM in non-tech companies. Furthermore, using alternative VCs’ reputation proxies, I find that portfolio companies’ RM is negatively associated with VCs’ reputation.     

Australia’s ‘two-strikes’ rule and the pay-performance link: Are shareholders judicious?

To improve accountability of executive compensation, Australia introduced the ‘say-on-pay’ legislation in 2011, which is widely known as the ‘two-strikes’ rule. We investigate the consequences of this new rule for the pay-performance link in Australian firms. Employing a matched-pair design, we find that pay changes of the chief executive officer and the key management personnel were not significantly positively related to the stock returns of the firms that registered a ‘first strike’ in 2011 under the ‘two-strikes’ rule. However, the relations improved significantly in 2012. Our results also suggest that the shareholders of the ‘first-strike’ firms may have been over-enthusiastic about their voting power in 2011 but exercised this power more judiciously in 2012. Our findings provide important insights for the global debate on governance of executive compensation.     

Major shareholders’ trust and market risk: Substituting weak institutions with trust

This study examines the impact of foreign controlling shareholder trust on firm market risk using two measures of total and idiosyncratic risk. An extensive global sample of 12,496 firm-year observations from 43 countries is employed. The results show that firms controlled by foreign trusting shareholders display lower levels of risk in both market measures. Trust appears more important for firms based in countries with a less favourable institutional environment, whereby it varies with the investment horizon of foreign controlling shareholders. The results are robust after controlling for cultural measures, endogeneity, selection bias and alternate model specifications.     

Controlling shareholders’ opportunistic use of share repurchases

This study examines how share repurchase and dividend policies are influenced by controlling shareholders in an emerging market. We maintain that the controlling shareholders can utilize share repurchase opportunistically, particularly when they exercise voting rights in excess of cash-flow rights. The evidence of Korean firms suggests that the wedge between the voting rights and cash-flow rights positively affects share repurchases but negatively affects cash dividends. We also find that share repurchases are not always supported by operating performances. The results indicate that firms may utilize share repurchases as a means to pursue private benefits of the controlling shareholders. We also document that share repurchases do not substitute for cash dividends, suggesting that share repurchases are not genuine distributions. Furthermore, we find that the wedge of share repurchases reduces firm value. Overall, our results indicate that the controlling shareholders of Korean firms use share repurchases opportunistically rather than strategically.     

Executive stock-based compensation and firms’ cash payout: the role of shareholders’ tax-related payout preferences

We hypothesize that the structure of executive stock-based compensation helps to align managers’ payout choices with shareholders’ tax-related payout preferences. Specifically, stock options, which are not dividend-protected, can deter self-interested executives from using dividends as a form of payout. In contrast, restricted stock, which is dividend-protected, is more likely to induce the use of dividends. Relatedly, shareholders’ preferences for dividends, which are taxed as ordinary income, can depend on the income tax consequences of dividends relative to those of long-term capital gains. To test our hypothesis, we investigate whether the exogenous changes in shareholders’ tax-related payout preferences following the 2003 dividend tax rate reduction result in predictable shifts in executive stock-based compensation and in managers’ payout choices. Consistent with our prediction, we find a positive relation between the increased use of dividends in firms’ payouts and the increased (decreased) use of restricted stock (stock options) in executive compensation, particularly for firms with a greater percentage ownership by individual investors and with lower costs associated with modifying the structure of their compensation plans. Our investigation of the role of shareholders’ tax-related payout preferences in the design of executive stock-based compensation extends the prior literature that has largely focused on the role of incentive contracts in inducing managerial effort, risk taking, and retention.     

Are real options a missing piece in the diversification-value puzzle?

This paper examines the impact of corporate diversification on a firm's market value in terms of changes in its mix of value sources between growth options and assets-in-place. We argue that the traditionally assumed replicability of corporate diversification benefits by individual investors might not be as feasible when diversification implies acquiring new growth options as when it only involves assets-in-place investments. We further explain why a different effect of diversification on a firm's mix of value sources can occur, therefore leading to a mediating role of growth options between diversification and market value. Using a panel sample of U.S. firms from 1998 to 2010, we find that a firm's growth options portfolio helps explain the effect of diversification strategy on its market value.     

Australia’s equity home bias and real exchange rate volatility

The main purpose of this paper is to consider the effect of real exchange rate volatility on equity investment by Australian investors. Equity investment is of major importance to savers and investors in Australia. Also real exchange rate volatility is an important influence on Australia’s financial integration in the global economy. Analysis of the effect of real exchange rate volatility on Australia’s equity home bias is important since Australian dollar is a commodity currency. There is a close relationship between Australia’s terms of trade and real exchange rate volatility. Home bias is measured on the basis of free float-adjusted market capitalization in recognition of the fact that closely held shares are not available to ordinary investors. Real exchange rate volatility is measured by deviations from purchasing power parity on a bilateral basis between Australia and 35 countries. The cross-border equity investment data over the period 2001–2007 are from International Monetary Fund’s Coordinated Portfolio Investment Survey. Australian investors are found to invest significantly less in a country if the real exchange rate volatility of that country is relatively high (results that are robust to standard control measures and generalized method of moments).     

CLA’s,PLA’s and a new method for pricing general passport options

This paper is primarily concerned with pricing a general passport option (GPO) within the standard Black–Scholes framework. We show that in all possible cases of the allowed trading strategy, the price can be decomposed into simple portfolios of standard European calls and puts and a contract we call a ‘PLA’ or a put on the log-asset price. For completeness, we also introduce the call on the log-asset price (or CLA) and explore their properties and applications. The decomposition of the GPO into its constituent parts is achieved with the help of the Method of Images to convert certain barrier option payoffs into equivalent European payoffs. This technique considerably simplifies the calculation and adds significant transparency to what is otherwise regarded as very complex problem. Curiously, a spin-off of the method to price the GPO suggests an alternative and simpler way to price lookback options.     

Assessing the FDIC's premium and examination policies using ‘Soviet’ put options

The FDIC's total liability for insuring a bank's deposits during a fixed period diminishes as the frequency of examinations increases, since a marginally solvent bank can be closed while losses are small. The paper develops a technique for pricing the insurance liability over a fixed period during which there are multiple examinations. Under current policy most banks are examined annually and reviewed every six months, at which time the fees for insurance may be adjusted. Since the current schedule of fees allows only a narrow range and a few discrete levels, the FDIC typically retains some positive or negative residual liability in each six-month period and for the entire year. We show how to estimate this net liability. The calculations of total and net liability are illustrated for a sample of large banks.     

Large shareholders’ power and the quality of corporate governance: An analysis of Brazilian firms

This paper analyzes the incentives of large shareholders to implement the corporate governance system that favors their interests within a framework of highly concentrated ownership and poor legal protection for investors. A metric for corporate governance based on the fulfillment of non-mandatory rules of good corporate governance is used. System GMM (Generalized Method of Moments) estimates for a balanced panel data of Brazilian firms reveal that the ownership concentration is detrimental to corporate governance quality and the quality of board composition. In accordance with the expropriation effect on principal-principal agency conflicts, by weakening the corporate governance system and board composition, large controlling shareholders may use private benefits of control. As proposed by the substitution effect, in a complementary way, controlling shareholders may renounce strong boards and directly perform management monitoring, mitigating agency conflicts with managers. Finally, the ability of large shareholders other than the main blockholder is not enough to contest his/her power to shape the corporate governance system. The work provides evidence of the prominence of the principal–principal agency problem in an emerging market, by analyzing the effect of ownership concentration over the quality of the corporate governance system, and also that other large non-controlling shareholders are not able to contest the power of the main blockholder.     

Does firm payout policy affect shareholders’ dissatisfaction with directors?

Review of Quantitative Finance and Accounting - In this study we investigate the information content of firm payout policy to shareholders. We focus on the association between a firm’s payout...     

Discussion of “Executive stock-based compensation and firms’ cash payout: the role of shareholders’ tax-related payout preferences”

Aboody and Kasznik (Rev Acc Stud, this issue, 2008) develop and test cross-sectional predictions about how firms might respond to the 2003 dividend tax cuts. My discussion suggests some alternative firm responses, a restructuring of the main tests to be consistent with the theory and predictions, and an interpretation of the magnitude of the observed associations. Overall, the paper addresses an interesting issue, recognizes that executive compensation is endogenous in this event, and adds to the long literature on dividend payout policy.