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SOCIAL SCIENCE RESEARCH NETWORK
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. 7, No. 35: November 30, 2006
Editors: PAMELA J. PERUN
Urban Institute
PAMELA@PLANETNOW.COM
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Topic of This Issue:
Executive Compensation
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T A B L E O F C O N T E N T S
"IRC Section 162(m) and the Law of Unintended Consequences"
JAMES S. WALLACE
Claremont Colleges - Peter F. Drucker Graduate School of
Management
KENNETH R. FERRIS
Thunderbird, American Graduate School of International
Management - Accounting
"Lucky CEOs"
LUCIAN ARYE BEBCHUK
Harvard Law School, National Bureau of Economic Research
(NBER)
YANIV GRINSTEIN
Cornell University - Samuel Curtis Johnson Graduate
School of Management
URS PEYER
INSEAD - Finance
"Some Observations on the Stock Option Backdating Scandal of
2006"
DAVID I. WALKER
Boston University School of Law
"Pay without Performance: Overview of the Issues"
LUCIAN ARYE BEBCHUK
Harvard Law School, National Bureau of Economic Research
(NBER)
JESSE M. FRIED
University of California, Berkeley - School of Law
"Do Executive Stock Option Grants Have Value Implications for
Firm Performance?"
SWEE SUM LAM
National University of Singapore - NUS Business School
BEY FEN CHNG
ExxonMobil Asia Pacific Pte, Ltd.
"The Economic Impact of Backdating of Executive Stock Options"
M.P. NARAYANAN
University of Michigan - Stephen M. Ross School of
Business
CINDY A. SCHIPANI
University of Michigan - Stephen M. Ross School of
Business
HASAN NEJAT SEYHUN
University of Michigan at Ann Arbor - Finance
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"IRC Section 162(m) and the Law of Unintended Consequences"
Contact: JAMES S. WALLACE
Claremont Colleges - Peter F. Drucker Graduate
School of Management
Email: james.wallace@cgu.edu
Auth-Page: http://ssrn.com/author=48072
Co-Author: KENNETH R. FERRIS
Thunderbird, American Graduate School of
International Management - Accounting
Email: ferrisk@t-bird.edu
Auth-Page: http://ssrn.com/author=482311
Full Text: http://ssrn.com/abstract=942667
ABSTRACT: In 1993, Section 162(m) of the U.S. Internal Revenue
Code was passed into law. The intent of this law was to reign in
outsized executive compensation by eliminating the
tax-deductibility of executive compensation above $1 million
unless the excess compensation was performance-based. One
unintended consequence of the legislation was that executives'
total compensation actually increased in the post-1993 period.
One compensation package component whose use dramatically
increased, as expected, following the adoption of Section 162(m)
was performance-based employee stock options. Employee stock
options, however, have unintended consequences of their own. For
example, the economic value of performance-based stock options
may be influenced by executive decision-making when the options
are valued using the Black-Scholes model or some variant thereof.
This study investigates whether the incentives embedded in stock
options are associated with such unintended consequences as
increased market volatility and reduced dividend yields. Using
data from the Standard and Poor's ExecuComp Database, empirical
results for the period 1992 through 2004 reveal a significant,
positive relation between the quantity of options held by CEOs
and share price volatility, and a significant, negative relation
between the quantity of options held by CEOs and dividend yields.
These results suggest that executives used their discretion to
positively impact the performance-based component of their
compensation through actions affecting share price volatility and
dividend yields, assumptions implicit in option-valuation models.
______________________________
"Lucky CEOs"
Harvard Law and Economics Discussion Paper No. 566
Contact: LUCIAN ARYE BEBCHUK
Harvard Law School, National Bureau of Economic
Research (NBER)
Email: bebchuk@law.harvard.edu
Auth-Page: http://ssrn.com/author=17037
Co-Author: YANIV GRINSTEIN
Cornell University - Samuel Curtis Johnson Graduate
School of Management
Email: yg33@cornell.edu
Auth-Page: http://ssrn.com/author=328371
Co-Author: URS PEYER
INSEAD - Finance
Email: urs.peyer@insead.edu
Auth-Page: http://ssrn.com/author=273466
Full Text: http://ssrn.com/abstract=945392
ABSTRACT: We study the relation between corporate governance and
opportunistic option grant manipulation. Our methodology for
studying grant manipulation focuses on how grant date prices rank
within the price distribution of the grant month. Investigating
the incidence of lucky grants - defined as grants given at the
lowest price of the month - we estimate that about 1150 lucky
grants resulted from manipulation and that 12% of firms provided
one or more lucky grant due to manipulation during the period
1996-2005. Examining the circumstances and consequences of lucky
grants we find:
- Lucky grants were more likely when the company did not have a
majority of independent directors on the board and/or the CEO had
longer tenure - factors that are both associated with increased
influence of the CEO on pay-setting and board decision-making.
- Lucky grants were more likely to occur when the potential
payoffs from such luck were high; indeed, even for the same CEO,
grants were more likely to be lucky when granted in months in
which the potential payoffs from manipulation were relatively
higher.
- Luck was persistent: a CEO's chance of getting a lucky grant
increases when a preceding grant was lucky as well.
- In contrast to impressions produced by cases coming under
scrutiny thus far, grant manipulation has not been primarily
concentrated in new economy firms but rather has been widespread
throughout the economy, with a significant incidence of
manipulation in each of the economy's 12 (Fama-French)
industries.
- We find no evidence that gains from manipulated option grants
served as a substitute for compensation paid through other
sources; indeed, total reported compensation from such sources in
firms providing lucky grants was higher.
- We estimate the average gain to CEOs from grants that were
backdated to the lowest price of the month to exceed 20% of the
reported value of the grant and to increase the CEO's total
reported compensation for the year by more than 10%.
- About 1,000 (43%) of the lucky grants were super-lucky, having
been given at the lowest price not only of the month but also of
the quarter, and we estimate that about 62% of them were
manipulated.
- We identify certain pools of grants with an especially high
probability of manipulation. For example, we identify a pool of
600 grants out of which 88% are estimated to be manipulated.
______________________________
"Some Observations on the Stock Option Backdating Scandal of
2006"
Boston Univ. School of Law Working Paper No. 06-31
Contact: DAVID I. WALKER
Boston University School of Law
Email: diwalker@bu.edu
Auth-Page: http://ssrn.com/author=189230
Full Text: http://ssrn.com/abstract=929702
ABSTRACT: The corporate stock option backdating scandal has
dominated business page headlines during the summer of 2006. The
SEC is currently investigating more than seventy-five companies
with respect to the timing and pricing of stock options granted
during the boom years of the late 1990s and early 2000s, and the
number of firms caught up in the scandal seems to increase every
day. This essay contributes to our understanding of the
backdating phenomenon by analyzing the economics of backdating
and the characteristics of the firms under investigation. Its
main points are the following: First, given the high volatilities
of the stocks of the technology companies that dominate the list
of firms under investigation and the fact that options granted to
executives and employees typically may not be exercised for
several years, press reports that focus on the size of the strike
price "discounts" achieved by backdating significantly overstate
the value of backdating. In some cases, reducing the strike price
by a dollar per share by backdating increased the Black-Scholes
value of the option by less than twenty cents per share. Second,
completely unnoticed in the discussion so far is the fact that in
many cases backdating dramatically reduced the apparent value of
options. Because the size of executive stock option grants often
is determined first by establishing the value to be delivered and
then by calculating the number of shares to be covered by the
option, reducing the apparent value of option shares may have
substantially increased the size and true economic value of
backdated executive option grants. Third, comparison of
semiconductor firms under investigation for backdating with peer
companies that are not suggests an association between backdating
and the use of options in compensating non-executive employees.
This essay considers several explanations for backdating
non-executive options, including share limitations, minimizing
apparent rank and file compensation, and cognitive biases.
Finally, this essay argues that the backdating phenomenon is
really not an accounting scandal. Backdating has accounting
consequences, but it is unlikely to have been accounting driven.
______________________________
"Pay without Performance: Overview of the Issues"
Journal of Corporation Law, Vol. 30, No. 4, pp. 647-673,
2005
Journal of Applied Corporate Finance, Vol. 17, No. 4,
pp. 8-22, 2005
Academy of Management Perspectives, pp. 5-24, February
2006
Contact: LUCIAN ARYE BEBCHUK
Harvard Law School, National Bureau of Economic
Research (NBER)
Email: bebchuk@law.harvard.edu
Auth-Page: http://ssrn.com/author=17037
Co-Author: JESSE M. FRIED
University of California, Berkeley - School of Law
Email: FRIEDJ@MAIL.LAW.BERKELEY.EDU
Auth-Page: http://ssrn.com/author=1465
Full Text: http://ssrn.com/abstract=761970
ABSTRACT: In a recent book, Pay without Performance: The
Unfulfilled Promise of executive Compensation, we critique
existing executive pay arrangements and the corporate governance
processes producing them, and put forward proposals for improving
both executive pay and corporate governance. This paper provides
an overview of the main elements of our critique and proposals.
We show that, under current legal arrangements, boards cannot be
expected to contract at arm's length with the executives whose
pay they set. We discuss how managers' influence can explain many
features of the executive compensation landscape, including ones
that researchers subscribing to the arm's length contracting view
have long viewed as puzzling. We also explain how managerial
influence can lead to inefficient arrangements that generate weak
or even perverse incentives, as well as to arrangements that make
the amount and performance-insensitivity of pay less transparent.
Finally, we outline our proposals for improving the transparency
of executive pay, the connection between pay and performance, and
the accountability of corporate boards.
______________________________
"Do Executive Stock Option Grants Have Value Implications for
Firm Performance?"
Review of Quantitative Finance and Accounting, Vol. 26, pp.
249-274, 2006
Contact: SWEE SUM LAM
National University of Singapore - NUS Business
School
Email: bizlamss@nus.edu.sg
Auth-Page: http://ssrn.com/author=457480
Co-Author: BEY FEN CHNG
ExxonMobil Asia Pacific Pte, Ltd.
Email: beyfen.chng@exxonmobil.com
Auth-Page: http://ssrn.com/author=686769
Abstract: http://ssrn.com/abstract=934480
ABSTRACT: Consistent with predictions of agency theory, we find
direct evidence that executive stock option grants have value
implications for firm performance. This inference is drawn from
evaluation of various motivations for the use of such grants in
executive compensation: value enhancement, risk taking, tax
benefit, signaling and cash conservation. We find consistent
evidence for the value enhancement motivation to reduce agency
costs. As well, they signal for positive price sensitive
information. Our results reject the tax benefit and cash
conservation motivations. This finding is robust after
controlling for the endogenous character of executive stock
option grants and other equity-based grants.
______________________________
"The Economic Impact of Backdating of Executive Stock Options"
Stephen M. Ross School of Business at the University of
Michigan Research Paper
Michigan Law Review, Forthcoming
Contact: M.P. NARAYANAN
University of Michigan - Stephen M. Ross School of
Business
Email: mpn@umich.edu
Auth-Page: http://ssrn.com/author=16755
Co-Author: CINDY A. SCHIPANI
University of Michigan - Stephen M. Ross School of
Business
Email: schipani@umich.edu
Auth-Page: http://ssrn.com/author=98249
Co-Author: HASAN NEJAT SEYHUN
University of Michigan at Ann Arbor - Finance
Email: nseyhun@umich.edu
Auth-Page: http://ssrn.com/author=16757
Full Text: http://ssrn.com/abstract=931889
ABSTRACT: The paper discusses the economic impact of legal,
corporate governance, tax, disclosure, and incentive issues
arising from revelation of dating games with regard to executive
option grant dates. It provides an estimate of the value loss
incurred by shareholders of firms implicated in backdating and
compares it to the potential gain that executives might have
obtained through backdating. Using a sample of firms that have
already been implicated in backdating, we find that the
revelation of backdating results in an average loss to
shareholders of about 8%. This translates to about $500 million
dollars per firm. By contrast, we estimate that the average
potential gain from backdating to all executives in these firms
is under $600,000 per firm annually. We suggest some remedies for
not only backdating, but also for other dubious practices such as
springloading.