_________________________________________________________________
E M P L O Y E E B E N E F I T S , C O M P E N S A T I O N
& P E N S I O N L A W
Vol. 5, No. 5: March 11, 2004
_________________________________________________________________
Publisher: LSN Employment, Labor, Compensation & Pension Journals
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Topic of This Issue:
Equity Compensation
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T A B L E of C O N T E N T S
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NEW and FORTHCOMING ARTICLES
"How to Value Employee Stock Options"
Financial Analysts Journal, Vol. 60, No. 1, pp. 114-119,
January/February 2004
JOHN C. HULL
University of Toronto
Joseph L. Rotman School of Management
ALAN WHITE
University of Toronto
Joseph L. Rotman School of Management
"Misleading Employer Communications and the Securities Fraud
Implications of the Employee as Investor"
Villanova Law Review, Vol. 48, No. 4, p. 1217, 2003
JENNIFER O'HARE
Villanova University
School of Law
WORKING PAPERS
"Is Equity Compensation Tax Advantaged?"
DAVID I. WALKER
Boston University School of Law
"Lower Salaries and No Options: The Optimal Structure of
Executive Pay"
INGOLF DITTMANN
Humboldt University of Berlin
Department of Economics
ERNST G. MAUG
Humboldt University of Berlin
European Corporate Governance Institute (ECGI)
"The Determinants of CEO Compensation: Rent Extraction or Labour
Demand?"
KERYN CHALMERS
Monash University
Department of Accounting and Finance
PING-SHENG KOH
University of Queensland
Business School
GEOFREY P. STAPLEDON
University of Melbourne
Faculty of Law
"Employee Sentiment and Stock Option Compensation"
NITTAI BERGMAN
Massachusetts Institute of Technology (MIT)
Sloan School of Management
DIRK C. JENTER
Massachusetts Institute of Technology (MIT)
Sloan School of Management
"Why Stock and Stock-Option Compensation are Such a Terrible
Idea"
CALVIN HARSHA JOHNSON
University of Texas Law School
"Motivating Employee-Owners in ESOP Firms: Human Resource
Policies and Company Performance"
DOUGLAS L. KRUSE
Rutgers University
RICHARD B. FREEMAN
National Bureau of Economic Research (NBER)
University of London
Centre for Economic Performance (CEP)
Harvard University
JOSEPH BLASI
Rutgers University
ROBERT BUCHELE
Smith College
Department of Economics
ADRIA SCHARF
University of Washington
LOREN RODGERS
Ownership Associates, Inc.
CHRIS MACKIN
Ownership Associates, Inc.
"Broad-based Employee Stock Options in the U.S.: Company
Performance and Characteristics"
JAMES C. SESIL
Rutgers University
MAYA K. KROUMOVA
New York Institute of Technology
DOUGLAS L. KRUSE
Rutgers University
JOSEPH BLASI
Rutgers University
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N E W and F O R T H C O M I N G Articles
_________________________________________________________________
"How to Value Employee Stock Options"
Financial Analysts Journal, Vol. 60, No. 1, pp. 114-119,
January/February 2004
BY: JOHN C. HULL
University of Toronto
Joseph L. Rotman School of Management
ALAN WHITE
University of Toronto
Joseph L. Rotman School of Management
Contact: JOHN C. HULL
Email: Mailto:hull@mgmt.utoronto.ca
Postal: University of Toronto
Joseph L. Rotman School of Management
105 St. George Street
Toronto, Ontario M5S 3E6 CANADA
Phone: (416) 978-8615
Fax: 416-971-3048
Co-Auth: ALAN WHITE
Email: Mailto:alan.white@rotman.utoronto.ca
Postal: University of Toronto
Joseph L. Rotman School of Management
105 St. George Street
Toronto, Ontario M5S 3E6 CANADA
Paper Requests:
Contact Cheryl Montgomery, Associate,
Mailto:cheryl.montgomery@aimr.org Postal: AIMR, Educational
Products, 560 Ray C. Hunt Dr., Charlottesville, VA 22903. Phone:
434-591-5393. Fax: 434-951-5370. Fee $25.
ABSTRACT:
One of the arguments often used against expensing employee stock
options is that calculating their fair value at the time they
are granted is very difficult. This article presents an approach
to calculating the value of employee stock options that is
practical, easy to implement, and theoretically sound. It
explicitly considers the vesting period, the possibility that
employees will leave the company during the life of the option,
the inability of employees to trade their options, and the
relevant dilution issues. This approach is an enhancement of the
approach suggested by the Financial Accounting Standards Board's
Statement of Financial Accounting Standards No. 123 because it
does not require an arbitrary reduction in the life of the
option to allow for early exercise caused by the inability of
employees to trade their options.
JEL Classification: G13, J33, M41, M44
______________________________
"Misleading Employer Communications and the Securities Fraud
Implications of the Employee as Investor"
Villanova Law Review, Vol. 48, No. 4, p. 1217, 2003
BY: JENNIFER O'HARE
Villanova University
School of Law
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=474781
Paper ID: Villanova Law/Public Policy Research Paper No. 2003-20
Contact: JENNIFER O'HARE
Email: Mailto:OHARE@law.villanova.edu
Postal: Villanova University
School of Law
299 N. Spring Mill Road
Villanova, PA 19085 UNITED STATES
Phone: 610-519-7059
Fax: 610-519-5672
ABSTRACT:
This Article addresses the securities fraud implications of the
employee as investor. It first demonstrates that employee
investors are particularly vulnerable to securities fraud
committed by company management. Company management can
capitalize on the employment relationship and communicate
directly with their employees, through such media as employee
newsletters, employee meetings, and employer e-mails. These
communications are often promotional in nature. They may also be
misleading. Unfortunately, employees are more likely to believe
misleading employer communications because of the natural
tendency of employees to trust the senior management of their
employer. The Article then demonstrates that the anti-fraud
provisions of the federal securities laws do not adequately
address the vulnerability of employee investors. In particular,
I point out that because employer communications are not
publicly made, securities fraud actions are unlikely to be
brought, either by the SEC or by private plaintiffs. To fill
this regulatory gap, I propose that certain types of employer
communications should be disclosed to the Securities and
Exchange Commission. Requiring disclosure of employer
communications would have a disciplining effect on senior
management without chilling the disclosure of information by
employers to their employees.
______________________________
W O R K I N G P A P E R Abstracts
_________________________________________________________________
"Is Equity Compensation Tax Advantaged?"
BY: DAVID I. WALKER
Boston University School of Law
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=491162
Paper ID: Boston Univ. School of Law Working Paper No. 04-01
Date: January 21, 2004
Contact: DAVID I. WALKER
Email: Mailto:diwalker@bu.edu
Postal: Boston University School of Law
765 Commonwealth Avenue
Boston, MA 02215 UNITED STATES
ABSTRACT:
Employees who receive stock options and other forms of equity
compensation generally are able to defer paying tax on this
compensation for years, sometimes decades. In a rising market
this deferral results in a tax benefit at the employee level.
This article asks whether the employee-level tax benefit in a
rising market results in a global tax advantage for companies
that rely heavily on equity compensation and their employees.
There are two primary issues. First, on initial inspection one
might conclude that the employee-level benefit in a rising
market is offset by a disadvantage in a stagnant or declining
market. But this is not the case. This article demonstrates that
the apparently symmetric disadvantage of equity compensation in
a declining market is undermined by capital loss limitations,
the likelihood of employee-favorable ex post adjustments to
equity compensation contracts, and the general upward drift in
stock prices. Thus, equity compensation and deferral do provide
a tax benefit at the employee level on an expected value basis.
The second question is who bears the burden of the
employee-level tax benefit? This article demonstrates that the
key to determining the overall winners and losers lies in
tracking the actual corporate investment of the cash that is
saved when employees are compensated with equity. The evidence
suggests that this investment results in significant corporate
tax revenues for the fisc that offset the employee-level tax
savings. In aggregate, taxpayers do not appear to be subsidizing
corporate equity compensation programs and these programs are
not producing a global tax advantage.
However, this does not mean that equity compensation tax
reform should be off the table. The aggregate global tax
advantage (and taxpayer subsidy) could increase if companies
become more adept at hedging stock and option grants. In
addition, the employee-level tax benefit associated with equity
compensation is concentrated in the hands of senior executives,
which 1) results in vertical inequity between the taxation of
these executives and rank and file employees who tend to be cash
compensated and 2) could undermine the formation of broad-based
qualified savings plans. Thus, a modest reform to the taxation
of equity compensation, such as the imposition of a special
employee-level tax on equity gains, may be justified.
JEL Classification: H22, K34, M52
______________________________
"Lower Salaries and No Options: The Optimal Structure of
Executive Pay"
BY: INGOLF DITTMANN
Humboldt University of Berlin
Department of Economics
ERNST G. MAUG
Humboldt University of Berlin
European Corporate Governance Institute (ECGI)
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=472401
Paper ID: ECGI - Finance Working Paper No. 32/2003
Date: November 24, 2003
Contact: ERNST G. MAUG
Email: Mailto:MAUG@WIWI.HU-BERLIN.DE
Postal: Humboldt University of Berlin
Spandauer Str. 1
D-10178 Berlin, GERMANY
Phone: +49 30 2093 5641
Fax: +49 30 2093 5643
Co-Auth: INGOLF DITTMANN
Email: Mailto:dittmann@wiwi.hu-berlin.de
Postal: Humboldt University of Berlin
Department of Economics
Spandauer Strasse 1
D-10178 Berlin, GERMANY
ABSTRACT:
We estimate a standard principal agent model with constant
relative risk aversion and lognormal prices for a sample of 464
US CEOs. The model is widely used in the compensation
literature, but it predicts that none of the CEOs in our sample
should hold stock options. Therefore, 83.4% of the contracts in
our sample are inefficient according to the model. Also, CEOs
should have lower base salaries and receive additional shares in
their companies instead. For a typical value of relative risk
aversion, one third of the CEOs in our sample would be required
to purchase additional stock in their companies from their
private savings, investing on average 6% of their wealth. The
model predicts contracts that would reduce compensation costs by
14% while providing the same incentives and the same utility to
CEOs. We investigate a number of extensions and modifications of
the standard model, but find none of them to be fully
satisfactory. We conclude that either executive pay is
suboptimal, or that observed contracts cannot be analyzed by the
standard principal agent model typically used in the
literature.
Keywords: Executive Compensation, Stock Options
JEL Classification: G30, M52
______________________________
"The Determinants of CEO Compensation: Rent Extraction or Labour
Demand?"
BY: KERYN CHALMERS
Monash University
Department of Accounting and Finance
PING-SHENG KOH
University of Queensland
Business School
GEOFREY P. STAPLEDON
University of Melbourne
Faculty of Law
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=460040
Contact: PING-SHENG KOH
Email: Mailto:p.koh@business.uq.edu.au
Postal: University of Queensland
Business School
Brisbane 4072, Queensland AUSTRALIA
Phone: +61 7 3365 6249
Fax: +61 7 3365 6788
Co-Auth: KERYN CHALMERS
Email: Mailto:keryn.chalmers@buseco.monash.edu.au
Postal: Monash University
Department of Accounting and Finance
P.O. Box 11E
East Caulfield
Clayton, Victoria 3800, AUSTRALIA
Co-Auth: GEOFREY P. STAPLEDON
Email: Mailto:G.STAPLEDON@LAW.UNIMELB.EDU.AU
Postal: University of Melbourne
Faculty of Law
Victoria 3010, AUSTRALIA
ABSTRACT:
Executive pay is topical and controversial and accordingly is
receiving considerable academic attention by various academic
disciplines. This paper, capitalising on the opportunity
afforded by recent regulation requiring enhanced transparency
and specificity of CEO compensation details for Australian
firms, examines whether rent extraction or labour demand
explains CEO compensation level. In doing so, our paper examines
the determinants of CEO compensation level and explores the
relationship between excess compensation and subsequent firm
performance. Our study resembles that of Core et al. (1999)
whereby we attempt to examine the impact of governance and
ownership attributes on CEO compensation, after controlling for
economic determinants, and their impact on subsequent firm
performance. Our results suggest that governance and ownership
attributes, in addition to economic attributes are statistically
associated with CEO compensation. However, the attributes
differentially determine the various components of CEO
compensation. We find convex relations between fixed salary and
bonus components of CEO compensation, in excess of that
predicted by economic determinants, and subsequent performance.
This suggests that rent extraction theory is more plausible than
labour demand theory in determining these compensation
components. Conversely, the results suggest the determination of
stock based remuneration reflects a firm's demand for a high
quality CEO rather than rent extraction.
Keywords: CEO compensation, Corporate Governance, Ownership
structure, Firm performance
______________________________
"Employee Sentiment and Stock Option Compensation"
BY: NITTAI BERGMAN
Massachusetts Institute of Technology (MIT)
Sloan School of Management
DIRK C. JENTER
Massachusetts Institute of Technology (MIT)
Sloan School of Management
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=469843
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Paper ID: AFA 2004 San Diego Meetings
Date: December 2003
Contact: DIRK C. JENTER
Email: Mailto:djenter@mit.edu
Postal: Massachusetts Institute of Technology (MIT)
Sloan School of Management
Cambridge, MA 02142 UNITED STATES
Phone: 617-258-8947
Co-Auth: NITTAI BERGMAN
Email: Mailto:nbergman@mit.edu
Postal: Massachusetts Institute of Technology (MIT)
Sloan School of Management
50 Memorial Drive
Cambridge, MA 02142 UNITED STATES
ABSTRACT:
The use of broad equity-based compensation for employees has
become widespread. Its popularity for employees in the lower
ranks of an organization is a puzzle for standard economic
theory: any positive incentive effects should be diminished by
free rider problems, and undiversified employees should discount
company equity heavily. We point out that employees do not
appear to value company stock as prescribed by extant theory.
Employees frequently purchase company stock for their 401(k) and
ESOP plans at market prices, and especially so after company
stock has performed well, implying that their private valuation
must at least equal the market price. We show that using
equity-based compensation under these circumstances is not a
puzzle. We propose that firms pay their employees in options
whenever employee sentiment towards the firm is irrationally
positive, and when employees prefer to receive an option rather
than its market value in cash. Our empirical analysis confirms
that firms use broad-based option compensation when employees
are likely to be excessively optimistic about company stock. We
also provide evidence that managers grant more options to
rank-and-file employees whenever management believes its stock
to be overvalued, again consistent with our hypothesis.
JEL Classification: G30
______________________________
"Why Stock and Stock-Option Compensation are Such a Terrible
Idea"
BY: CALVIN HARSHA JOHNSON
University of Texas Law School
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=474362
Paper ID: U of Texas Law, Law and Econ Research Paper No. 003
Date: October 2003
Contact: CALVIN HARSHA JOHNSON
Email: Mailto:chjohnson@mail.law.utexas.edu
Postal: University of Texas Law School
727 East Dean Keeton Street
Austin, TX 78705 UNITED STATES
Phone: 512-232-1306
Fax: 512-232-2399
ABSTRACT:
Stock options have grown over the last decade to take up an
increasing percentage of the increasing compensation of top
management. Stock options worth millions of dollars are reported
to public investors as if they were free, and that allows top
management to schnooker more salary from shareholders than they
would otherwise get. The popularity of options is best
understood as arising from deceptive accounting. But for the
opportunity to understate compensation cost, stock compensation
is a terrible idea. Take away the accounting advantage and
compensatory stock and stock options would undoubtedly die off
on their own.
First, stock options give management truly perverse incentives
to invest in projects with too much downside risk. Option
holders participate in gains but not loses, so an option holder
will rationally send the company into risks that would scare the
flesh off of shareholders who do bear the losses.
Second, stock and stock options carry an unnecessarily high
discount rate. The high discount rate means the executive gets
the least current value per dollar to be paid or requires the
highest future cash payment per dollar of current value or both.
Stock carries a high discount rate because of unwelcome
volatility in the price of the stock and because of market
paranoia about management plans about retained earnings, and
neither the volatility nor the paranoia is a necessary virtue of
any compensation plan. Better management of the discount rate
would avoid stock.
Third, stock compensation, gives employees capital gains, but
compensation would almost always be more efficient if employee
capital gains were avoided. Deferred compensation is almost
always better for the executive because it delays the tax bite
on their capital. Even if there is no upfront tax on capital at
stake, employee capital gain is usually inferior tax planning
because it loses the employer deduction.
This is an edited version of Stock and Stock-Option
Compensation: A Bad Idea, 51 Canadian Tax J. No. 3, (Oct. 2003)
with the special Canadian concerns deleted out.
______________________________
"Motivating Employee-Owners in ESOP Firms: Human Resource
Policies and Company Performance"
BY: DOUGLAS L. KRUSE
Rutgers University
RICHARD B. FREEMAN
National Bureau of Economic Research (NBER)
University of London
Centre for Economic Performance (CEP)
Harvard University
JOSEPH BLASI
Rutgers University
ROBERT BUCHELE
Smith College
Department of Economics
ADRIA SCHARF
University of Washington
LOREN RODGERS
Ownership Associates, Inc.
CHRIS MACKIN
Ownership Associates, Inc.
Document: Available from the SSRN Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=481449
Paper ID: NBER Working Paper No. W10177
Date: December 2003
Contact: DOUGLAS L. KRUSE
Email: Mailto:dkruse@rci.rutgers.edu
Postal: Rutgers University
Piscataway, NJ 08854 UNITED STATES
Phone: 908-445-5991
Fax: 908-445-2830
Co-Auth: RICHARD B. FREEMAN
Email: Mailto:FREEMAN@NBER.ORG
Postal: National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138 UNITED STATES
Co-Auth: JOSEPH BLASI
Email: Mailto:jrbru@hotmail.com
Postal: Rutgers University
180 University Avenue
Newark, NJ 07102 UNITED STATES
Co-Auth: ROBERT BUCHELE
Email: Mailto:rbuchele@email.smit.edu
Postal: Smith College
Department of Economics
Northampton, MA 01063 UNITED STATES
Co-Auth: ADRIA SCHARF
Email: Mailto:author339373@ssrn.com
Postal: University of Washington
Seattle, WA 98195 UNITED STATES
Co-Auth: LOREN RODGERS
Email: Mailto:lr@ownershipassociates.com
Postal: Ownership Associates, Inc.
122 Mt. Auburn Street
Cambridge, MA 02138 UNITED STATES
Co-Auth: CHRIS MACKIN
Email: Mailto:cm@ownershipassociates.com
Postal: Ownership Associates, Inc.
122 Mt. Auburn Street
Cambridge, MA 02138 UNITED STATES
Paper Requests:
Full-Text downloads are available from SSRN Online for $5.
ABSTRACT:
What enables some employee ownership firms to overcome the free
rider problem and motivate employees to improve performance?
This study analyzes the role of human resource policies in the
performance of employee ownership companies, using employee
survey data from 14 companies and a national sample of
employee-owners. Between-firm comparisons of 11 ESOP firms show
that an index of human resource policies, nominally controlled
by management, is positively related to employee reports of
co-worker performance and other good workplace outcomes
(including perceptions of fairness, good supervision, and worker
input and influence). Within-firm comparisons in three ESOP
firms, and exploratory results from a national survey, show that
employee-owners who participate in employee involvement
committees are more likely to exert peer pressure on shirking
co-workers. We conclude that an understanding of how and when
employee ownership works successfully requires a three-pronged
analysis of: 1) the incentives that ownership gives; 2) the
participative mechanisms available to workers to act on those
incentives; and 3) the corporate culture that battles against
tendencies to free ride.
JEL Classification: J330, J540
______________________________
"Broad-based Employee Stock Options in the U.S.: Company
Performance and Characteristics"
BY: JAMES C. SESIL
Rutgers University
MAYA K. KROUMOVA
New York Institute of Technology
DOUGLAS L. KRUSE
Rutgers University
JOSEPH BLASI
Rutgers University
Date: January 2004
Contact: JAMES C. SESIL
Email: Mailto:sesil@rci.rutgers.edu
Postal: Rutgers University
180 University Avenue
Newark, NJ 07102 UNITED STATES
Co-Auth: MAYA K. KROUMOVA
Email: Mailto:mkroumov@nyit.edu
Postal: New York Institute of Technology
New York, NY 10023 UNITED STATES
Co-Auth: DOUGLAS L. KRUSE
Email: Mailto:dkruse@rci.rutgers.edu
Postal: Rutgers University
Piscataway, NJ 08854 UNITED STATES
Co-Auth: JOSEPH BLASI
Email: Mailto:jrbru@hotmail.com
Postal: Rutgers University
180 University Avenue
Newark, NJ 07102 UNITED STATES
ABSTRACT:
While stock options have traditionally been reserved to top
management employees, in recent years there has been strong
growth of plans making stock options available to a broader
group of employees. This paper analyses data on 490 companies
with broad-based stock option plans, matched to data from
Compustat in order to compare their characteristics and
performance to that of other public companies. Major findings
are that 1) companies with broad-based plans have higher levels
of productivity, Tobin's Q, and employment and sales growth than
otherwise-similar firms, 2) average compensation levels are
higher among such companies both before and after the
introduction of broad-based plans, indicating that stock options
appear to come on top of other compensation, and 3) increases in
average productivity appear to counterbalance the dilution
effect so that average total shareholder returns are unaffected
by the introduction of broad-based stock option plans.