Executive stock option vesting conditions,corporate governance and CEO attributes: evidence from Australia

We investigate the association between executive stock option (ESO) vesting conditions, corporate governance and CEO attributes. Using observations from the 250 largest Australian firms, we find that stronger corporate governance is positively associated with the length of the vesting period and the use of performance hurdles. We also find that when CEOs approach retirement, firms are more likely to grant longer time‐vesting options but are less likely to impose performance hurdles. Further, more powerful CEOs appear to influence the granting of ESOs with less restrictive vesting conditions. Our findings suggest that both corporate governance and CEO attributes significantly shape the design of ESOs.     

Stock option grant vesting terms: economic and financial reporting determinants

Option grant vesting terms are a contractual provision that is shaped by accounting standards and other economic factors. We examine the effect of accounting standards, specifically SFAS 123(R), on the vesting terms of stock option grants while also modeling other economic determinants of this contract feature. We document significant variation in stock option grant vesting periods and patterns suggesting that firms actively choose vesting terms. Consistent with financial reporting incentives influencing contract design, we find that firms simultaneously lengthen vesting periods and alter vesting patterns after the adoption of SFAS 123(R). The changes in vesting patterns are consistent with firms trying to defer recognition of the option expense, while limiting the incremental risk imposed on the CEO. In addition, we find that vesting schedules are longer in growth firms where lengthening the executive’s investment horizon is more important and that firms with more powerful CEOs and weaker governance grant options with shorter vesting periods.     

CEO incentives and the cost of debt

Motivated by concerns that stock-based compensation might lead to excessive risk-taking, this paper’s main purpose is to examine the relations between CEO incentives and the cost of debt. Unlike prior research, this paper uses the sensitivities of CEO stock and option portfolios to stock price (delta) and stock return volatility (vega) to measure CEO incentives to invest in risky projects. Higher delta (vega) is predicted to be related to lower (higher) cost of debt. The results show that yield spreads on new debt issues are lower for firms with higher CEO delta and are unrelated to CEO vega. The results also show that yield spreads are higher for firms whose CEOs hold more shares and stock options. In sum, the results suggest that both percentage-ownership and option sensitivity variables are important in understanding relations between CEO incentives and the cost of debt.     

Accelerated Vesting in Takeovers: The Impact on Shareholder Wealth

We study the impact of accelerated vesting of equity awards on takeovers, whereby the restricted stock and/or stock options of the target chief executive officer (CEO) immediately vest and become unrestricted upon the close of the acquisition. We find that takeover premiums are significantly larger when the target CEO receives the benefit of accelerated vesting as compared to target firms with CEO's that continue to vest in their awards after closing the deal. Our evidence suggests that these cash windfalls triggered by accelerated vesting are beneficial to shareholders in completed deals. Accelerated vesting appears to be an efficient form of ex ante managerial contracting.     

Employee stock options with performance conditions: do commonly used valuation heuristics work?

Valuation heuristics are widely used to value traditional time vesting option plans. This study analyses if these heuristics also qualify for valuing performance vesting plans. We examine performance conditions tied to the underlying stock, the stock's performance relative to a stock index, and an earnings measure. The differences between the approximated option values and the values assuming optimal exercise are overall smaller with the performance conditions than without them. In particular, this result holds when the heuristic exercise assumptions are based on the case without performance conditions, which is a considerable simplification in practice.     

Option Expensing and Managerial Equity Incentives

We examine the impact of mandatory option expensing on managerial equity incentives. Though effective only after June 15, 2005, there is evidence that U.S. firms begin preparing for option expensing as early as 2002 by making changes to their equity incentive plans. We find that (1) CEO option incentives exhibit a sharp reversal during the period 1993-2005, with the median CEO option incentives increasing 25% a year before 2002 but declining 17% a year after 2001; (2) the reduction in option incentives after 2001 is larger for firms that use excessive levels of equity incentives prior to 2002; (3) firms make similar reductions to options granted to CEOs, other top executives and lower-level employees; (4) CEO stock incentives increase throughout the entire 13-year period, rising at an even greater rate after 2001; and (5) the increase in stock incentives after 2001 is far from offsetting the corresponding decrease in option incentives. These findings are robust to controls for firm and CEO characteristics and for concurrent regulatory, business and market events such as the Sarbanes-Oxley Act of 2002, the option backdating scandal, and the 2000 stock market crash. We also provide a theoretical explanation for the documented changes in option incentives.     

Valuing employee reload options under the time vesting requirement

Upon the exercise of an employee stock option, the embedded reload provision entitles the holder to receive additional units of new options from the employer. The number of units of new options received is equal to the number of shares tendered as payment of strike and the new strike is set at the prevailing stock price. The reload provision may be subject to a time vesting requirement, that is, after each exercise, the employee is prohibited from exercising the reload until the end of a vesting period. In this paper, we construct an efficient numerical algorithm that computes the market value of the employee reload options under a time vesting requirement. Also, we explore the analytic properties of the price functions and optimal exercise policies of the employee reload options.     

A test of the Bolton–Scheinkman–Xiong hypothesis of how speculation affects the vesting time of options granted to directors

This paper investigates empirically the Bolton et al. (2006) hypothesis, according to which initial shareholders may provide incentives to managers to take actions that stimulate speculative bubbles. We test this hypothesis with data on up to 8544 directors and up to 1677 companies between 2004–2008. Using vesting time as a measure of the short-term performance weighting in CEO compensation and various alternative measures of the extent of speculation, the findings support the hypothesis: vesting time decreases with more intensive speculation. The results prove robust in various empirical model specifications.     

A Proposal for Expensing Employee Compensatory Stock Options for Financial Reporting Purposes

This article presents an accounting approach for employee stock options based on the insight that the currentperiod compensation expense should reflect only that part of the option value that is earned independent of the obligation of continued employment. Given that the maturity of vested options is typically shortened to 90 days when an employee resigns or is terminated, this method views the employee as owning a 90-day option (even if the stated maturity of the option is ten years) and earning a 90-day extension to that option each quarter as a result of the employee's continued employment. In the case of vested options, the compensation expense in each quarterly accounting period is thus the value of the 90-day extension of the option's maturity. There is no option expense in the quarter when the option is either exercised or expires.
In the case of unvested options, the expected option value at vesting should be estimated quarterly starting at the time of grant and the corresponding estimated expense should be revised and allocated as a pro rata accrual each quarter over the vesting period. The cumulative expense over the entire vesting period will equal the fair market value of the option at its vesting date.
Besides reflecting the economics of the exchange of value for labor involved in stock option grants, this approach has a number of practical advantages:

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  The 90-day maturity permits the use of publicly traded options to determine fair market value and makes Black-Scholes and other (lattice) pricing models more reliable.

       
  
  

Optimal Incentive Contracts for Loss‐Averse Managers: Stock Options versus Restricted Stock Grants

This paper provides an explanation for the widespread use of stock option grants in executive compensation. It shows that the optimal incentive contract for loss‐averse managers must contain a substantial portion of stock options even when it should consist exclusively of stock grants for “classical” risk‐averse managers. The paper also provides an explanation for the drastic increase in the risk‐adjusted level of CEO compensations over the past two decades and argues that more option‐based compensation should be used in firms with higher cash flow volatility and in industries with a higher degree of heterogeneity among firms.     

Compensation committee governance quality,chief executive officer stock option grants,and future firm performance

This paper examines whether the relationship between future firm performance and chief executive officer (CEO) stock option grants is affected by the quality of the compensation committee. Compensation committee quality is measured using six committee characteristics – the proportion of directors appointed during the tenure of the incumbent CEO, the proportion of directors with at least ten years’ board service, the proportion of directors who are CEOs at other companies, the aggregate shareholding of directors on the compensation committee, the proportion of directors with three or more additional board seats, and compensation committee size. We find that future firm performance is more positively associated with stock option grants as compensation committee quality increases.     

Revisiting the incentive effects of executive stock options

We develop a multiperiod framework to evaluate the incentive effects of executive stock options (ESOs). For a given increase in the grant-date firm stock price (and a concurrent increase in return volatility), the increment of total value at the vesting date acts as a proxy for the incentive effects of ESOs. If the option is attached to the existing contract without adjusting cash compensation, we suggest that a firm should not always fix the strike price to the grant-date stock price; instead, the strike price should vary with the length of the vesting period. We also show that, compared with at-the-money options, restricted stock generates greater incentives to increase stock prices in some scenarios, especially when equity-based awards are vested early. If the vesting period is long, the firm could grant options instead of restricted stock to maximize incentives.     

CEO Stock Options and Equity Risk Incentives

Abstract:   We test the hypothesis that the risk incentive effects of CEO stock option grants motivate managers to take on more risk than they would otherwise. Using a sample of mergers we document that the ratio of post‐ to pre‐merger stock return variance is positively related to the risk incentive effect of CEO stock option compensation but this relationship is conditioned on firm size, with firm size having a moderating effect on the risk incentive effect of stock options. Using a broader time‐series cross‐sectional sample of firms we find a strong positive relationship between CEO risk incentive embedded in the stock options and subsequent equity return volatility. As in the case of the merger sample, this relationship is stronger for smaller firms.     

Entrenchment or incentive? CEO employment contracts and acquisition decisions

A long-standing controversy is whether CEO employment contracts insulate inferior managers from discipline leading to shareholder wealth destruction, or whether contracts alleviate managerial risk aversion and encourage value-enhancing decisions. Using a unique dataset on S&P 500 CEO employment contracts during 1993–2005, I find that acquirers with a CEO contract obtain better announcement returns, pay lower premiums for their targets, garner superior long-run post-acquisition operating performance, and undertake riskier deals than acquirers without a contract. Further investigation of individual contract provisions reveals substantial heterogeneity. Specifically, the fixed term rather than at will contract, longer contract duration, long-term equity incentives, accelerated stock and option vesting provisions in severance arrangement, and more refined definitions of just cause (good reason) for CEO termination (resignation) alleviate managerial risk aversion, reduce contracting ambiguity, and motivate value-creating decisions.     

Is U.S. CEO Compensation Broken?

This article addresses four major concerns about the pay of U.S. CEOs: (1) failure to pay for performance; (2) excessive levels of pay; (3) failure to index options and other equity-based pay, resulting in windfalls; and (4) too much unwinding of incentives. The authors' main message is that most if not all of these concerns are exaggerated by the popular tendency to focus on the annual income of CEOs (consisting of salary, bonus, and stock and option grants) while ignoring their existing holdings of company equity.
Taking into account the effect of stock price changes on CEO wealth leads the authors to a number of interesting conclusions. First, the pay-for-performance relationship is strong and has grown significantly in recent years. Second, what may appear as above-normal growth in annual pay levels may be necessary to compensate CEOs for the increased risk associated with their growing level of equity-based incentives. Third, conventional (that is, unindexed) stock and options, when viewed as a combination of market risk and firm-specific risk, may provide an optimal solution to two conflicting demands: shareholders' demand for executive rewards tied to company performance and executives' preference to diversify their wealth. Finally, there is little evidence of widespread CEO unwinding of incentives, and levels of CEO equity ownership in the U.S. remain impressively high.     

Employee Stock Option Exercise and Firm Cost

We develop an empirical model of employee stock option exercise that is suitable for valuation and allows for behavioral channels. We estimate exercise rates as functions of option, stock, and employee characteristics using all employee exercises at 88 public firms, 27 of them in the S&P 500. Increasing vesting frequency from annual to monthly reduces option value by 11% to 16%. Men exercise faster, reducing value by 2% to 4%, while top employees exercise slower, increasing value by 2% to 7%. Finally, we develop an analytic valuation approximation that is more accurate than methods used in practice.     

Earnings Warnings and CEO Welfare

Some CEOs decide voluntarily to issue a warning when they expect a negative earnings surprise. Prior research suggests that warnings contain incremental information beyond actual earnings; warning firms tend to experience permanent earnings decreases. This paper investigates whether compensation committees take warnings into account in setting CEO compensation. We find that warnings are significantly negatively (positively) associated with CEO bonus (option grants), suggesting that compensation committees adjust CEO compensation towards a more high‐powered structure after warnings. However, the sensitivity of bonus or option grants to earnings and stock returns is not affected except for bonus sensitivity to stock returns. We also find weak evidence of an increase in forced CEO turnover after warnings, accompanied by a significant increase in its sensitivity to stock returns. This benefits CEOs with higher ability but imposes more risk on other CEOs. These findings provide a partial explanation of why not every CEO facing a negative surprise decides to issue a warning. Our results are robust to various specifications. In particular, the impact of warnings on compensation appears invariant to the timing or the number of warnings. Overall, these findings suggest that the signal from warnings is used in determining CEO compensation and retention.     

Motivating Innovation

Motivating innovation is important in many incentive problems. This paper shows that the optimal innovation‐motivating incentive scheme exhibits substantial tolerance (or even reward) for early failure and reward for long‐term success. Moreover, commitment to a long‐term compensation plan, job security, and timely feedback on performance are essential to motivate innovation. In the context of managerial compensation, the optimal innovation‐motivating incentive scheme can be implemented via a combination of stock options with long vesting periods, option repricing, golden parachutes, and managerial entrenchment.     

Duration of Executive Compensation

Extensive discussions on the inefficiencies of “short‐termism” in executive compensation notwithstanding, little is known empirically about the extent of such short‐termism. We develop a novel measure of executive pay duration that reflects the vesting periods of different pay components, thereby quantifying the extent to which compensation is short‐term. We calculate pay duration in various industries and document its correlation with firm characteristics. Pay duration is longer in firms with more growth opportunities, more long‐term assets, greater R&D intensity, lower risk, and better recent stock performance. Longer CEO pay duration is negatively related to the extent of earnings‐increasing accruals.     

CEO Compensation and Firm Performance: an Empirical Investigation of UK Panel Data

This paper examines the link between CEO pay and performance employing a unique, hand‐collected panel data set of 390 UK non‐financial firms from the FTSE All Share Index for the period 1999–2005. We include both cash (salary and bonus) and equity‐based (stock options and long‐term incentive plans) components of CEO compensation, and CEO wealth based on share holdings, stock option and stock awards holdings in our analysis. In addition, we control for a comprehensive set of corporate governance variables. The empirical results show that in comparison to the previous findings for US CEOs, pay‐performance elasticity for UK CEOs seems to be lower; pay‐performance elasticity for UK CEOs is 0.075 (0.095) for cash compensation (total direct compensation), indicating that a ten percentage increase in shareholder return corresponds to an increase of 0.75% (0.95%) in cash (total direct) compensation. We also find that both the median share holdings and stock‐based pay‐performance sensitivity are lower for UK CEOs when we compare our findings with the previous findings for US CEOs. Thus, our results suggest that corporate governance reports in the UK, such as the Greenbury Report (1995) that proposed CEO compensation be more closely linked to performance, have not been totally effective. Our findings also indicate that institutional ownership has a positive and significant influence on CEO pay‐performance sensitivity of option grants. Finally, we find that longer CEO tenure is associated with lower pay‐performance sensitivity of option grants suggesting the entrenchment effect of CEO tenure.