When is Enough, Enough? Market Reaction to Highly Dilutive Stock Option Plans and the Subsequent Impact on CEO Compensation

Abstract

Early studies of market reaction to stock option plans have found positive increases in stock prices upon the announcement of these plans. However, since in the mid-1990's, shareholders have become increasingly critical of stock option plans, and voted against them in growing numbers. Are shareholders fed up with the continued growth in option compensation, and if so, what are boards of directors doing in response to these concerns? In this paper, we use data from the 1998 proxy season to reevaluate market reaction to management-sponsored proposals for stock option plans, the level of opposition to these plans, and the effect of this opposition on corporate boards' awards of CEO compensation in subsequent years. In the first half of the paper, we conduct an event study similar to those done for early stock option plans from the 1980's and early 1990's. However, we expect to find that the market will react differently to plans that exhibit the high levels of potential dilution of ownership and certain shareholder unfriendly aspects of the plans that make shareholders more likely to vote against such plans. Our findings support part of our hypothesis: we find that higher levels of potential dilution in executive-only plans result in significantly negative cumulative market adjusted returns in the 3-day period surrounding the proxy date, but that plans that include repricing provisions, permit executives to borrow money from the firm in order to exercise options, or that allow the issuance of restricted stock, do not experience significantly negative returns. In the second part of the paper, we present evidence regarding the factors that affect voting opposition to stock option plans and the impact of this opposition on subsequent CEO compensation. In cross-sectional regressions, we find a significantly negative relationship between the percentage vote against the option proposal and the percentage change in salary and in total pay from the 1999 to 1998 compensation years. We interpret this finding to support the idea that boards of directors respond to concerns about CEO option awards by reducing executive pay in the year after a high level of opposition.