"The Relation Between Corporate Governance and CEOs’ Equity Compensation" 

LAWRENCE D. BROWN, Georgia State University - School of Accountancy
Email: ldb@gsu.edu
YEN-JUNG LEE, National Taiwan University
Email: ylee@ntu.edu.tw

We investigate whether the firm's corporate governance affects the value of equity grants for its CEO. Consistent with the managerial power view, we find that firms with poorer corporate governance grant their CEOs higher values of equity compensation after controlling for the economic determinants of these grants. We show that the negative relation between governance strength and equity compensation cannot be attributed to either omitted economic factors or the substitution effect between governance strength and incentive compensation. As further evidence consistent with the managerial power view, we show that firms with poorer governance in the pre-Enron era cut back more on the use of employee stock options (ESOs) for their CEOs in the post-Enron era, a period when CEO compensation received intensified public scrutiny and when the transparency and accounting cost of ESOs increased. We show that the association between governance strength and abnormal equity compensation remains significantly negative even after controlling for the divergence between the subjective and fair values of equity compensation.

"Market Reaction on Limiting the Executive Compensation Evidence from the TARP Firms" 

WON YONG KIM, Drexel University - Department of Finance
Email: wk39@drexel.edu

Using 256 TARP recipients as a sample, I find that markets are mostly negatively reacting for the news on limiting the executive compensations. Although investors react quite positively for the initial announcement on the TARP on October 14, 2008, other announcements regarding compensation regulation including strict $500,000 salary cap are perceived as bad news in the market. The results is more supportive for the managerial talent hypothesis, which implies that investors concern for losing their talented executives due to the upper limit of the salary. Splitting the sample by various possible determinants for the CARs, I also find that firm size as well as financial performance is an important factor to decide the level of abnormal returns. In conclusion, shareholders for larger and better performed firms concern more for imposing the salary cap for the TARP firms, which is also the evidence of managerial talent hypothesis.

"Executive Stock-Based Compensation: A Case Study in Valuing Employee Stock Options and Restricted Stock Issues in a Breach of Contract Case" 

DWIGHT STEWARD, EmployStats
Email: dsteward@employstats.com

In this case study, the former CEO of a large telecommunication company filed a lawsuit against her former employer that alleged that the company’s contract breach resulted in the loss ESO grants and diminished the value of the vested ESOs that she held at the time of the alleged contract breach. The former company executive also alleges that the breach prevented her from receiving restricted company stock shares that she believes she was entitled to under her contract with the employer. In this paper, I present an application of the Shapiro and O’Connor (2001) modified Black-Scholes (B-S) and the Hull-White (2002) binomial lattice tree employee stock option (ESO) valuation models to the valuation of breach of employment contract damages. In addition to ESO valuation, this paper also illustrates the valuation of restricted company stock issues and provides a discussion of the approaches used to account for the unique valuation related issues that arise in litigation. The case study illustrates the importance of incorporating case specific factors, such as the plaintiff's historical ESO exercise rates and firm specific ESO forfeiture probabilities, into the valuation models.

"Executive Compensation and Earnings Management Under Moral Hazard" 

FRB International Finance Discussion Paper No. 985

BO SUN, Board of Governors of the Federal Reserve System - Division of International Finance - International Banking and Finance Section
Email: bo.sun@frb.gov

This paper analyzes executive compensation in a setting where managers may take a costly action to manipulate corporate performance, and whether managers do so is stochastic. We examine how the opportunity to manipulate affects the optimal pay contract, and establish necessary and sufficient conditions under which earnings management occurs. Our model provides a set of implications on the role earnings management plays in driving the time-series and cross-sectional variation of executive compensation. In addition, the model's predictions regarding the changes of earnings management and executive pay in response to corporate governance legislation are consistent with empirical observations.

"Executive Compensation in the Courts: Board Capture, Optimal Contracting and Officer Fiduciary Duties" 

Vanderbilt Law and Economics Research Paper No. 10-10

RANDALL S. THOMAS, Vanderbilt University - School of Law
Email: randall.thomas@law.vanderbilt.edu
HARWELL WELLS, Temple University Beasley School of Law
Email: harwell.wells@temple.edu

This Article proposes a new approach to monitoring executive compensation. While the public seems convinced that executives at public corporations are paid too much, scholars are sharply divided. Advocates of “Board Capture” theory believe officers so dominate their boards that they can negotiate their own employment agreements and set their own pay. “Optimal contracting” theorists doubt this, contending that, given legal and economic constraints, executive compensation agreements are likely to be pretty good and benefit shareholders. Disputes about which theory is correct have hampered efforts to reform executive compensation practices.

Recent developments in corporate law point to a way out of this theoretical impasse. Last year, in Gantler v. Stephens, Delaware’s Supreme Court resolved a major unanswered issue in corporation law when it held that a corporation’s officers owe the same fiduciary duty to the corporation and its shareholders as do its directors. Gantler opens the door for courts to scrutinize rigorously officers’ actions in negotiating their own compensation agreements. The Delaware Chancery Court has taken up this invitation by holding that corporate officers are bound by their duty of loyalty to negotiate employment contracts in an arm’s-length, adversarial manner. If the officers do not do so, but instead try to take advantage of the Board, they will open themselves up to shareholder lawsuits and give courts the opportunity to examine the compensation agreements and their negotiations. This will provide a new level of judicial scrutiny of executive compensation arrangements, and should go far to answer criticisms leveled by Board Capture theorists, who believe the present negotiating system is corrupt, while Optimal Contracting theorists will welcome judicial intervention that improves the present negotiating environment.