Evolving Executive Equity Compensation and the Limits of Optimal Contracting

Abstract

Executive equity compensation in the United States is evolving. At the turn of the millennium, stock options dominated the equity pay landscape, accounting for over half of the aggregate ex ante value of senior executive pay at large public companies, while restricted stock and similar compensation accounted for only about ten percent. Beginning in 2006, stock grants have displaced options as the single largest component of senior executive compensation at these firms. Accompanying this shift has been increased variation among companies in their relative emphasis on stock and options in equity pay packages. Both phenomena provide an opportunity for a rich exploration of executive pay focusing specifically on equity pay design. Such an exploration is timely given the current focus in Washington on the relationship between equity compensation and corporate risk taking. This Article begins that exploration and has two primary aims. First, it describes the evolution in executive equity pay practices and the current equity compensation landscape. Second, it considers the extent to which this evolution and the current use of stock and option pay can be explained as a function of (and what efficient contracting means in this context). The analysis reveals several features of the executive equity pay landscape that suggest limitations on compensation contracting. First, although directionally consistent with changes in the conventional economic determinants of equity pay design, the dramatic shift over the last decade from very heavy reliance on options to a more balanced emphasis on stock and options suggests that option expensing, option taint, and/or increased perceptions of option risk played leading roles. Second, the trimodal distribution of the mix of stock and options being granted in recent years suggests that optimizing incentives is not the sole consideration of issuing firms. Third, the extent to which the same mix of stock and options is granted to the various member of the executive suite suggests that individual optimization is quite limited. INTRODUCTION 613 I. THEORY AND BACKGROUND 617 A. Using Equity Compensation to Align Managerial and Shareholder Interests 617 B. Conventional Economic Determinants of Optimal Equity Compensation Design 621 C. Optimal Equity Compensation in the Presence of Tax and Accounting Concerns and Transaction Costs 624 1. Accounting Rules 624 2. Tax Rules 626 3. Transaction Costs 627 4. Intangible Considerations 627 D. The Managerial Power View of the Executive Compensation Process 628 II. EMPIRICAL OBSERVATIONS 629 A. Equity Pay Instruments Actually Observed 630 B. Aggregate Increase in Stock and Decline in Option Compensation 632 1. Explaining the Shift from Option to Stock Compensation 634 a. Firm and Market Economic Determinants 634 b. The Burst of the Dot-Corn Bubble ..... 636 c. Rebalancing Equity Portfolios 636 d. Options-Related Scandals 637 e. Dividend Pressure 638 f. Stock Option Accounting 639 2. What Does the Shift from Option to Stock Compensation Tell Us About Efficient Contracting? …