ETHAN YALE, Georgetown University - Law Center
Email: edy@law.georgetown.edu

Deferred compensation is thought to generate significant tax savings compared to current compensation in certain circumstances. The standard model used to support this conclusion does not consider investment risk and therefore overstates the tax benefit of deferred compensation significantly. This paper describes three alternative, risk-neutral approaches to measuring the tax benefit of deferred compensation. Each of these approaches avoids misclassifying increases in expected value attributable to increases in investment risk as a tax preference.

NEIL BRISLEY, University of Western Ontario - Richard Ivey School of Business
Email: nbrisley@ivey.uwo.ca
CHRIS K. ANDERSON, affiliation not provided to SSRN
Email: cka9@cornell.edu

Many companies are recognizing that the Black-Scholes formula is inappropriate for employee stock options (ESOs) and are moving toward lattice models for accounting or decision-making purposes. In the most influential of these models, the assumption is that employees exercise voluntarily when the stock price reaches a fixed multiple of the strike price, effectively introducing a "horizontal" exercise boundary into the lattice. In practice, however, employees make a trade-off between intrinsic value captured and the opportunity cost of time value forgone. The model proposed here explicitly recognizes and accounts for this reality and is intuitively appealing, easily implemented, and compliant with U.S. accounting standards.Editor's Note: The paper on which this article is based won the Second Annual "Best Conference Research Paper Award" from the Canadian Finance Executives Research Foundation at the 2008 Financial Executives International (FEI) Canada conference.

TEODORA PALIGOROVA, Bank of Canada
Email: tpaligorova@bankofcanada.ca

According to the rent-extraction hypothesis, weak corporate governance allows entrenched CEOs to capture the pay-setting process and benefit from events outside of their control - get paid for luck. In this paper, I find that the independence requirement imposed on boards of directors by the Sarbanes-Oxley Act of 2002 (SOX), together with the governance regulations subsequently introduced by stock exchanges, affects CEO pay structure. In firms whose corporate boards were originally less independent, and thus more affected by these provisions, CEO pay for performance strengthened while pay for luck decreased after adopting SOX. In contrast, those firms that exhibited strong board independence prior to SOX showed little evidence of pay for luck and little change in pay for performance following the adoption of SOX. The results are consistent with the rent-extraction hypothesis and robust to alternative explanations such as asymmetric benchmarks, market structure, and managerial talent.

TIM LEUNG, Johns Hopkins University, Dept of Applied Math & Statistics, Princeton University - Dept of Operations Research & Financial Engineering
Email: timleung@jhu.edu

Employee stock options (ESOs) have become an integral component of compensation in the U.S. In view of their significant cost to firms, the Financial Accounting Standards Board (FASB) has mandated expensing ESOs since 2004. The main difficulty of ESO valuation lies in the uncertain timing of exercises, and a number of contractual restrictions of ESOs further complicate the problem.

We present a valuation framework that captures the main characteristics of ESOs. Specifically, we incorporate the holder's risk aversion, and hedging strategies that include both dynamic trading of a correlated asset and static positions in market-traded options. Their combined effect on ESO exercises and costs are evaluated along with common features like vesting periods, job termination risk and multiple exercises. This leads to the study of a joint stochastic control and optimal stopping problem. We find that ESO values are much less than the corresponding Black-Scholes prices due to early exercises, which arise from risk aversion and job termination risk; whereas static hedges induce holders to delay exercises and increase ESO costs.

DAVID I. WALKER, Boston University School of Law
Email: diwalker@bu.edu

Contemporaneous grants of both stock and at-the-money options to individual employees of U.S. public companies indicates demand for equity compensation packages that are in the money, i.e., packages of equity pay instruments that in aggregate have payoff profiles and incentive properties that are similar to explicit in-the-money employee stock options. However, several tax rules (and formerly accounting rules) strongly discourage grants of explicit in-the-money options, including recently enacted IRC subsection 409A, which essentially precludes the use of explicitly discounted options by taxing these instruments at vesting, rather than at exercise. This article explores whether the tax and accounting distinction between discounted and non-discounted options makes sense.

The stated legislative rationales for rules discriminating against explicit in-the-money options are weak, reflecting a dichotomous view of equity compensation divided between discounted and non-discounted options, when, in fact, option design is a continuum. However, there is a tax policy rationale for forcing firms to bifurcate in-the-money pay packages into discrete grants of stock and at-the-money options, a combination that I refer to as a synthetic in-the-money option. In short, doing so precludes the unwarranted expansion of preferential option tax treatment to instruments resembling restricted stock. But there is a cost if firms are forced to utilize suboptimal compensation schemes. The extent of the cost depends in large part on how close a substitute synthetic in-the-money options are for the real thing. This article argues that the two are close, but not perfect, substitutes. Thus, at this stage of the investigation, this article identifies opposing benefits and costs to rules discriminating against discounted options, yielding indeterminacy, rather than a clear policy prescription.

KONSTANTINOS STATHOPOULOS, Manchester Business School
Email: k.stathopoulos@mbs.ac.uk
GEORGIOS VOULGARIS, University of Manchester - Manchester Business School
Email: georgios.voulgaris@postgrad.mbs.ac.uk
MARTIN WALKER, University of Manchester - Manchester Business School
Email: martin.walker@man.ac.uk

This paper provides evidence on the effect of compensation consultants on executive pay in the UK. As in previous studies, we find that compensation consultants have an increasing effect on the levels of total managerial compensation, a result apparently consistent with the managerial power hypothesis. However, we also show that compensation consultants have a decreasing effect on the salary portion of compensation and an increasing effect on the equity based part of compensation. This result shows that compensation consultants have a positive effect on the structure of executive pay since they encourage incentive based compensation. Moreover, we also find that in larger and better governed firms compensation consultants are viewed by shareholders as a control mechanism for managers' executive pay packages. These results suggest that pay consultants contribute to the solution of the executive pay determination problem and are not part of the problem; our results cast doubts on the conclusions of the managerial power approach regarding the role of compensation consultants.

NALINAKSHA BHATTACHARYYA, University of Alaska Anchorage
Email: nalinaksha@gmail.com
AMIN MAWANI, York University - Department of Accounting
Email: AMAWANI@SSB.YORKU.CA
CAMERON K.J. MORRILL, University of Manitoba - Department of Accounting and Finance
Email: CAMERON_MORRILL@UMANITOBA.CA

Bhattacharyya (2007) develops a model in which compensation contracts motivate high-quality managers to retain and invest firm earnings, while low-quality managers are motivated to distribute income to shareholders. In equilibrium, the model shows that there is a positive (negative) relationship between the earnings retention ratio (dividend payout ratio) and managerial compensation. Results of tests of US data show that executive compensation is positively (negatively) associated with earnings retention (dividend payout). Our results indicate that corporate dividend policy is perhaps best understood by considering the payout ratio (dividends divided by earnings), rather than the level of cash dividends alone.