Ceo stock options

How stock options lead CEOs to put their own interests first.

(Stan HONDASTAN HONDA/AFP/Getty Images)

One of the fundamental questions about executive pay is how well the stock awards or options grants that boards of directors dole out actually do their intended job. Do they put senior managers' interests in line with shareholder interests? Or prompt CEOs to boost short-term results in lieu of making long-term investments?

New research would side with the latter. In a paper currently under review in the Journal of Financial Economics, three professors examined the investments CEOs made for their companies in the year before their option grants "vested." Options offer executives the right to buy stock in the future — the vesting date — at an earlier date's price (which is useful, of course, only if the share price goes up).

The researchers found that in the year prior to vesting dates for big option grants, CEOs spent significantly less on long-term investments: research and development in particular, as well as advertising and other capital expenditures. In other words, the pending dates were prompting CEOs to pump up short-term results while sacrificing long-term spending — moves that could, in theory, boost the share price and ultimately put their own interests above the company's.

"Managers actually behave myopically," says Katharina Lewellen, a professor at the Tuck School of Business at Dartmouth College who wrote the paper with collaborators from Wharton and the University of Minnesota's business school. "They’re more short-term oriented than shareholders would like."

The study looked at approximately 2,000 companies between 2006 and 2010, using data from the executive compensation research firm Equilar. They found that in the year ahead of the vesting date, R&D spending declined by an average of $1 million per year.

The researchers also found that when options were about to vest, executives were more likely to meet or just slightly beat the earnings forecasts of analysts. Coming so close to analysts' estimates, rather than producing big swings above or below the target, "s uggests it really has to do with vesting," Lewellen says. "The vesting actually affects manipulation."

Options are a compensation tool designed to retain executives and reward performance. And while they are increasingly being replaced by shares of restricted stock in executive pay, they still made up 31 percent of the average long-term incentive package in 2012, according to a 2013 analysis by James F. Reda & Associates, a compensation consulting firm.

Because options are not as "certain" as restricted stock grants (options can be worthless if the stock price on the vesting date is lower than the price at which they were granted), they've been falling out of favor in executive pay packages. They're also less popular after changes to accounting rules that began requiring stock option awards to be expensed . And they suffered image problems after a number of scandals involved companies using options inappropriately to create even more lucrative windfalls for executives.

But for academics, they remain something of a gold mine. Unlike with the sale of other equity, CEOs know when their options are scheduled to vest and expire, making it easier for researchers to link the actions leaders take at the firm with their potential for pocketbook profits. "The reason why vesting is an interesting experiment is that the vesting period was determined a while ago," Lewellen says. "We can make a good case that there's a cause and effect relationship."

The great irony, of course, is that while the ultimate goal of all this short-term thinking is to goose the stock price, it apparently doesn't. Lewellen and her collaborators found that share prices did not increase, on average, following the earnings reports associated with executives' vesting schedules. The reason, she says: Investors have wised up to spending cuts made in advance of earnings reports, and have priced such manipulation into the market.

"It's like a vicious cycle," she says. "Investors expect them to do it, so [CEOs] do it. At the same time, they are not fooling anyone."

The Completely Absurd (and Infuriating) Reason CEOs Get Paid So Much.

For years economists—not to mention everyday Americans hanging out on bar stools or on Twitter—have argued about why even mediocre CEOs get paid such ridiculous sums of money.

Of course, corporate bigwigs have always been handsomely rewarded. But in the past generation, average pay for CEOs at American’s largest companies has leaped nearly sixfold, from $2.8 million a year in 1989 to $16.3 million today, according the Economic Policy Institute. Exactly why this has happened is a matter of some debate, even among experts. Arguments range from corporate self-dealing to the just rewards for talent in a free-market system.

Now researchers from Dartmouth and the University of Chicago have examined years of pay data to offer up a new explanation: Boards have been handing CEOs bigger and bigger slugs of company stock because they don’t understand how stock options—a key component of CEO pay—work.

Options, which allow corporate executives to buy shares of their employers’ stock at preferential prices, were originally designed to constrain top executives’ pay, or at least make sure that pay is tied closely to company performance. It has long been understood that if a company’s stock rockets ahead, a rich grant of options can lead to big payday. Fair or not, that’s the way the system was engineered.

The new research shows that something different has been happening: Boards have been allowing CEO pay to climb ever higher by offering executives the same number of options year in and year out, regardless of company stock prices. The practice means that each new year’s grants tend to end up being potentially more valuable than the previous year’s, just because stock prices tend to drift higher over time.

Here is how it works: Corporate stock options (which are different from those that trade on exchanges) are typically issued “at the money.” That means they give executives the right to buy a number of the company’s shares at today’s prices, even if they appreciate in value in the near future.

The idea is that if the stock is flat or down, the CEO will make nothing. But if the value rises, he or she will be able to buy shares at what has become a discounted price. Once the options are exercised and the shares are purchased, the CEO can turn around and sell, pocketing the difference, essentially sharing in the wealth he or she created for shareholders.

The problem, according to the paper, is that boards don’t have a very strong grasp on options’ potential value, something that it typically takes a sophisticated computer algorithm (known as the Black-Scholes formula) to analyze.

Because option values can be difficult to understand, boards have tended to issue a certain number of options from year to year, regardless of the grant’s dollar value, rather than calculate a desired dollar value and vary the number of options. But since stock prices tend to drift upward over time, this can lead to what looks in retrospect like a boneheaded move. Option grants end up being worth more and more every year—simply because an option on a share with a high nominal value is more potentially lucrative than an option on a share with a low nominal value.

Author Kelly Shue, of the University of Chicago, says boards’ apparent mistake is a common one, highlighted by years of research in the field of behavioral economics, and much like the way workers get confused about the effect of inflation on the real value of their paychecks. “It’s called ‘the money illusion,'” she says. “People tend to think about nominal units, not real dollars.”

To understand, consider a simple example: In the first year, a board issues a CEO options to buy 10 shares at a price of $10. The stock climbs 10%, to $11. The CEO cashes in, paying $100 for shares worth $110, and making a $10 profit.

Now imagine it is 10 years later. The market is up generally, or the company has reduced the number of shares and increased their nominal value through a reverse stock split, so that each share now trades at $20. The board, however, is still in the habit of issuing options to buy 10 shares at the market price, in this case $20. Again the stock price climbs 10%, this time to $22. Now, however, the options give the CEO the chance to buy $220 worth of stock for $200. In other words the CEO’s reward for the same 10% stock bump has doubled.

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Could boards really be this knuckle-headed? The researchers collected a lot of evidence suggesting that they might. Looking at the number of options awarded by S&P 500 companies for the roughly two decades between 1992 and 2010, they found about 20% of the time boards simply kept the number of options they granted to their top executive the same from one year to the next. That might not sound like all that much. But it was by far the most common move boards made, occurring roughly four times more frequently than any other grant.

The researchers also found that when boards did vary the number of options granted to CEOs, they often picked round numbers, such as increasing the number of options by 10% or doubling it. Such behavior, the researchers argue, suggests that boards indeed tend to think about grants in terms of the number of options, not their dollar value.

There is some good news. In the past several years, it has gotten a lot harder for boards to give away the store. Starting in 2006 large companies have been required to figure out the dollar value of options—and disclose them to investors. The researchers concluded that since that time, boards appear to have become much more thoughtful about how they make grants to CEOs, and the growth rate of CEO pay has also tapered off.

But that doesn’t exactly mean boards have turned back the clock. According to the Economic Policy Institute, the typical CEO made about 58 times the average worker in 1989. By 2014 it had climbed to more than 300 times.

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Executive Stock Options.

CEOs of the largest U. S. companies now receive annual stock option awards that are larger on average than their salaries and bonuses combined. In contrast, in 1980 the average stock option grant represented less than 20 percent of direct pay and the median stock option grant was zero. The increase in these options holdings over time has solidified the link between executive pay -- broadly defined to include all direct pay plus stock and stock options revaluations -- and performance. However, the incentives created by stock options are complex. To the extent that even executives are confused by stock options, their usefulness as an incentive device is undermined.

In The Pay to Performance Incentives of Executive Stock Options (NBER Working Paper No. 6674) , author Brian Hall takes what he calls a "slightly unusual" approach to studying stock options. He uses data from stock options contracts to investigate the pay-to-performance incentives that would be created by executive stock options if they were well understood. However, interviews with company directors, CEO pay consultants, and CEOs, summarized in the paper, suggest that the incentives are often not well understood - either by the boards that grant them or by the executives who are supposed to be motivated by them.

Hall addresses two main issues: first, the pay-to-performance incentives created by the revaluation of stock option holdings; and second, the pay-to-performance incentives created by various stock option grant policies. He initially characterizes the incentives facing the "typical" CEO (with typical holding of stock options) of the "typical" company (in terms of dividend policy and volatility, both of which affect an option's value). He uses data on the compensation of CEOs of 478 of the largest publicly traded US companies over 15 years, the most important detail being the characteristics of their stock options and stock option holdings.

His first question concerns the pay-to-performance incentives created by existing stock option holdings. Yearly stock option grants build up over time, in many cases giving CEOs large stock-option holdings. Changes in firm market values lead to revaluations - both positive and negative - of these stock options, which can create powerful, if sometimes confusing, incentives for CEOs to raise the market values of their companies.

Hall's results suggest that stock option holdings provide about twice the pay-to-performance sensitivity of stock. This means that if CEO stock holdings were replaced with the same ex ante value of stock options, the pay-to-performance sensitivity for the typical CEO would approximately double.

Moreover, if the current policy of granting at-the-money options were replaced by an ex ante value-neutral policy of granting out-of-the-money options (where the exercise price is set equal to 1.5 times the current stock price), then performance sensitivity would increase by a moderate amount - approximately 27 percent. However, the sensitivity of stock options is greater on the upside than on the downside.

Hall's second question is how the pay-to-performance sensitivity of yearly option grants is affected by the specific option granting policy. Just as stock price performance affects current and future salary and bonus, it also affects the value of current and future stock option grants. Independent of how stock prices affect the revaluation of old, existing options, changes in the stock price can affect the value of future option grants, creating a pay-to-performance link from option grants that is analogous to the pay-to-performance link from salary and bonus.

Stock option plans are multi-year plans. Thus different option-granting policies have significantly different pay-to-performance incentives built in, since changes in current stock prices affect the value of future option grants in different ways. Hall compares four options-granting policies. These create dramatically different pay-to-performance incentives at grant date. Ranked from most to least high-powered, they are: up-front option grants (instead of annual grants); fixed number policies (the number of options is fixed through time); fixed value policies (the Black-Scholes value of options is fixed); and (unofficial) "back door re-pricing," where bad performance this year can be made up for by a larger grant next year, and vice-versa.

Hall notes that because of the possibility of back-door repricing, the relationship between yearly option awards and past performance can be positive, negative or zero. His evidence, however, suggests a very strong, positive relationship in the aggregate. In fact, Hall finds that (even ignoring the revaluation of past options grants) the pay-to-performance relationship in practice is much stronger for stock option grants than for salary and bonus. Moreover, consistent with expectations, he finds that fixed number plans create a stronger pay-to-performance link than fixed value policies. In sum, multi-year grant policies appear to magnify, rather than reduce, the usual pay-to-performance incentives that result from CEO holdings of past options.

The Digest is not copyrighted and may be reproduced freely with appropriate attribution of source.

Rethinking CEO Stock Options.

With the stock market in a possibly record-setting swoon, one of the first things boards of directors and senior executives are thinking about is: How soon can they reprice their stock options? Ironically, it may well be the prevalence of stock options that has contributed to the current economic mess. What's that, you say? How could anyone speak ill of stock options, the engine of growth in Silicon Valley and a ready path to wealth for millions of executives?

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