Rewarding Poor Performance: Why Do Boards of Directors Increase New Options in Response to CEO Underwater Options?

Abstract

AbstractManuscript TypeEmpiricalResearch Question/IssueWhen the stock options granted to CEOs go underwater, boards of directors tend to award additional stock options to their CEOs. Drawing on agency theory and attribution theory, this study explores social psychological mechanisms that explain why boards of directors increase new option grants to CEOs in response to underwater options.Research Findings/InsightsUsing the compensation data of CEOs at 966 US firms, we found that contextual factors such as market conditions and industry performance affected boards of directors' decisions to grant new stock options. Consistent with our hypotheses, boards of directors granted a greater number of new options to CEOs in response to CEOs' underwater options during the recession period than the recovery period, and they granted fewer new options when the firm's industry performance was high rather than low.Theoretical/Academic ImplicationsThis study incorporates attribution theory in understanding boards of directors' causal attribution of firm performance and its impact on executive compensation. It complements earlier studies on causal attribution by exploring the role of contextual factors. It also contributes to the research by examining the attribution process of boards of directors rather than that of top management, as well as the consequences of the causal attribution in terms of ex‐post adjustment in executive option compensation.Practitioner/Policy ImplicationsThis study provides up‐to‐date and improved evidence on boards' decision making about executive stock options. Practitioners and policy makers can benefit from the study's findings that board members rely on contextual information about the market and the competition when they make causal attribution of firm performance changes, which tends to affect their decisions about executive compensation.