Executive Stock Option Grants Research Articles

THE VALUE OF BEING LUCKY: OPTION BACKDATING AND NONDIVERSIFIABLE RISK

The practice of executives influencing their option compensation by setting a grant date retrospectively is known as backdating. Since executive stock options are usually granted at-the-money, selecting an advantageous grant date to coincide with a low stock price will be valuable to an executive. Empirical evidence shows that backdating of executive stock option grants was prevalent, particularly at firms with highly volatile stock prices. Executives who have the opportunity to backdate should take this into account in their valuation. We quantify the value to a risk averse executive of a lucky option grant with strike chosen to coincide with the lowest stock price of the month. We show the ex ante gain to risk averse executives from the ability to backdate increases with both risk aversion and with volatility, and is significant in magnitude. Our model involves valuing the embedded partial American lookback option in a utility indifference setting with key features of risk aversion, inability to diversify and early exercise.

Easy money? Managerial power and the option backdating game revisited

Abstract This paper presents a model of a firm that backdates executive stock option grants in order to maximize actual compensation for a given level of reported compensation. The model is used to estimate the magnitude of the difference between the actual and reported values of option grants. Although the Sarbanes–Oxley Act has reduced the likelihood of very large differentials, it has had a relatively minor impact on the average differential. Misreporting has a greater magnitude, on average, when the share price is more volatile, the options vest earlier or have shorter lifetimes, or there is a longer window in which to grant the options. We analyze more than 36,000 option grants between 2003 and 2019 and find that when recipients have more to gain from strategic backdating, or when there is likely to be less monitoring from independent directors, firms are more likely to exhibit behavior consistent with strategic backdating.

The Value of Being Lucky: Option Backdating and Non-Diversifiable Risk

Empirical evidence shows that backdating of executive stock option grants was prevalent, particularly at firms with highly volatile stock prices. Yet extant Black-Scholes style models used for empirical estimates of gains to executives from backdating suggest that this benefit is not only modest but is greatest for low volatility firms. In this paper we take the stance that, ex ante, executives who have the opportunity to backdate should take this into account in their valuation and we quantify the value to a risk averse executive of a "lucky" option grant with strike chosen to coincide with the lowest stock price of the month. This enables us to reconcile theory with empirics - we show the ex ante gain to risk averse executives is significant and increases with volatility. Our explanation hinges on valuing the embedded lookback option, and key features of risk aversion, inability to diversify and American early exercise.

Earnings Manipulation, Corporate Governance and Executive Stock Option Grants: Evidence from Taiwan*

AbstractExecutive stock options (ESOs), serving as a compensation mechanism, are widely used in business administration. ESOs link managerial wealth to firm performance and shareholder wealth. The intrinsic value of ESOs is determined by the difference between the stock price and the strike price. Executives, as a result of self‐interested incentives, would therefore manipulate firms’ reported earnings for influencing stock prices. Such conduct may boost the value of ESOs and then benefit managers greatly. This study attempts to explore if earnings had been manipulated before the ESO award date to satisfy some self‐interested managers. In addition, the paper attempts to reveal the cause and effect relationship between executive incentives and earnings management when compensations are linked to stock prices. The empirical results show that there is a significant downward earnings management phenomenon before the ESO award date. Furthermore, quarterly earnings management occurs frequently around the ESO grant date.

Cashing In on Managerial Malfeasance: A Trading Strategy around Forecasted Executive Stock Option Grants

This study examined the profitability of a trading strategy that exploits the manipulation of stock prices around the grant date of executive stock options. The strategy generates annualized abnormal returns of 1.4–5.2 percent net of transaction costs and is relatively unaffected by the Sarbanes–Oxley Act of 2002.

Incentives and Opportunities to Manage Earnings around Option Grants*

This study examines discretionary accruals imbedded in quarterly earnings announcements that precede executive stock option grants. Prior research indicates that managers attempt to increase the value of their option pay (by depressing the option’s exercise price) through a variety of strategies including timing voluntary disclosures, influencing option grant dates, or managing accruals. This study extends the research by jointly examining managerial incentives and opportunities to pursue an accruals-based strategy. We find evidence that discretionary accruals are lower when option pay is high and when concurrent firm performance is poor (incentive factors), but only when firms issue grants following earnings announcements relatively infrequently (opportunity factor). For firms that follow a predictable grant schedule, managers behave as if they believe that investors will discount earnings-based signals preceding the grant. Our results suggest that the decision to pursue an option-related strategy is influenced by economic tradeoffs. From a policy perspective, our results have relevance for the ongoing debate over option compensation practices, appropriate disclosure to investors, and the quality of corporate earnings. JEL Classifications: J33, M40

Is There a Firm-Size Effect in CEO Stock Option Grants?

Schaefer (1998) and Baker and Hall (2004) posit a firm size effect for regular executive compensation but not specifically for executive stock option grants. They propose an inverse relation between pay-performance sensitivity and firm size along with a positive relation between the marginal productivity of executive effort and firm size. The product of pay-performance sensitivity and executive productivity is 'incentive strength'. They find a weakly positive association between incentive strength and firm size. We substitute Hall and Murphy's (2002) pay-performance sensitivity metric to detect a firm size effect in CEO stock option grants. After adjusting for small-firm risk aversion and private diversification 'clienteles', we document evidence of a residual small-firm effect impacting on incentive strength principally through grant size. Given lower small-firm deltas, grant size appears to have been increased by compensation committees to ensure small-firm CEOs are not under-compensated relative to their large-firm counterparts. We also find that firm complexity influences pay-performance sensitivity as well, but not labor productivity (proxying for CEO productivity). No evidence is found that firm smallness and complexity impact on labor productivity. However, we empirically confirm a negative relation between pay-performance sensitivity and firm smallness and, by implication, firm complexity.

Backdating Executive Stock Option Grants: An Agency Problem or Just Efficient Contracting?

It is widely documented that managers tend to backdate their stock option grants so that a past date on which the stock price was particularly low is picked to be the grant date. Almost all of the current literature attributes the option backdating behavior exclusively to the agency problem which states that managers manipulate the terms of their option awards at the expense of shareholders. Our paper challenges this idea and demonstrates an alternative explanation for backdating. We show that backdating could be the consequence of efficient contracting that solves executive compensation problems. We first empirically document a rather strong but surprising evidence that better corporate governance is associated with more backdating. We then establish a theoretical model to explain this finding. The model predicts that managerial backdating benefits shareholders by (1) reducing the management compensation cost and (2) increasing managerial incentive. Using a large dataset, we provide strong empirical evidence supporting the model's predictions. Overall, our evidence supports the efficient contracting view of optionbackdating, and contradicts the prevalent agency explanation.

Is it Timing of the Date, of the News or is it Backdating of Option Grants?

This study investigates executive stock option grants at the Amsterdam stock exchange. The motive for this study is to examine the timing of the date and the news around option grants, and whether the option grant date is backdated. The empirical results provide evidence that that there are no significant abnormal cumulative returns in the period before the option grant date. However, we find significant abnormal cumulative returns during a period of 30 trading days after the option grant date, even for scheduled options granted before September 1, 2002. In addition, we have formed four different sub-samples: scheduled and unscheduled option grants, and, accounting for a change of the rulings as of September 1st, 2002 options granted before and after the latter date. Significant differences in the means of abnormal returns of the various sub samples are observed. These disappear for scheduled option grants after September 2002, but not for unscheduled option grants. The regression estimates for the periods before and after the introduction of stricter rulings in 2002 are consistent with our findings from the t-tests. The regressions run provide not only evidence that the option grants are timed, but also that the option grants are retroactively backdated. In addition, our findings show that earnings news releases around option grant dates are managed. Our findings are consistent with timing of news being a substitute for backdating and timing of the option grant date. Although after September 2002 stricter rulings regarding the option grant date reduce the opportunities to exploit private information, they do not disappear completely, notwithstanding the requirement of immediately publishing the option grants.

Is there a firm-size effect in CEO stock option grants?

Schaefer (1998) and Baker and Hall (2004) posit a firm size effect for regular executive compensation but not specifically for executive stock option grants. They propose an inverse relation between pay-performance sensitivity and firm size along with a positive relation between the marginal productivity of executive effort and firm size. The product of pay-performance sensitivity and executive productivity is „incentive strength‟. They find a weakly positive association between incentive strength and firm size. We substitute Hall and Murphy‟s (2002) pay-performance sensitivity metric to detect a firm size effect in CEO stock option grants. After adjusting for small-firm risk aversion and private diversification „clienteles‟, we document evidence of a residual small-firm effect impacting on incentive strength principally through grant size. Given lower small-firm deltas, grant size appears to have been increased by compensation committees to ensure small-firm CEOs are not under-compensated relative to their large-firm counterparts. We also find that firm complexity influences pay-performance sensitivity as well, but not labor productivity (proxying for CEO productivity). No evidence is found that firm smallness and complexity impact on labor productivity. However, we empirically confirm a negative relation between pay-performance sensitivity and firm smallness and, by implication, firm complexity.

Just Lucky? A Statistical Test for Option Backdating

The literature in financial economics provides convincing evidence of retroactive timing of executive stock option grants (option “backdating”). However, the literature does not yet contain a methodology for detecting backdating at individual companies. The present paper seeks to fill this gap. Specifically, it describes a rigorous statistical test for backdating based on publicly available data. In addition, it identifies a flaw in the methodology employed by the Wall Street Journal (Forelle and Bandler, 2006) to calculate the odds that the timing of executive stock option grants was purely random, and it provides experimental evidence that this flaw could in practice distort the assessment of odds.

Executive stock options and dynamic risk‐taking incentives

PurposeThe purpose of this study is to present theory and empirical evidence on whether changes in leverage are systematically associated with changes in the CEO's risk incentives over time.Design/methodology/approach – A model is developed to explain the dynamic relationship between leverage and managers’ risk incentives, and empirically tested with data on executive stock option grants. The model relies on the observation that the risk sensitivity of a call option does not monotonically increase or decrease in the value of the underlying stock.Findings – It is found that changes in the CEO's risk incentives are not systematically correlated with changes in the firm's leverage over time.Research limitations/implications – The near‐universal practice of setting option exercise prices near the prevailing stock price at the date of grant effectively undoes most of the effects of financial leverage, and therefore executives’ incentives to take equity risk are not correlated with firm leverage.Practical implications – For reasonable parameter values, this risk incentive‐maximizing stock price lies very close to the option's exercise price. This finding provides evidence that stock options plans granted approximately at‐the‐money encourage maximum risk‐taking by managers in a dynamic setting.Originality/value – This paper develops theory and evidence to explain why executive stock options are usually granted at‐the‐money.

Does backdating explain the stock price pattern around executive stock option grants?

Extant studies show that stock returns are abnormally negative before executive option grants and abnormally positive afterward. We find that this return pattern is much weaker since August 29, 2002, when the Securities and Exchange Commission requirement that option grants must be reported within two business days took effect. Furthermore, in those cases in which grants are reported within one day of the grant date, the pattern has completely vanished, but it continues to exist for grants reported with longer lags, and its magnitude tends to increase with the reporting delay. We interpret these findings as evidence that most of the abnormal return pattern around option grants is attributable to backdating of option grant dates.

Some Observations on the Stock Option Backdating Scandal of 2006

The corporate stock option backdating scandal has dominated business page headlines during the summer of 2006. The SEC is currently investigating more than seventy-five companies with respect to the timing and pricing of stock options granted during the boom years of the late 1990s and early 2000s, and the number of firms caught up in the scandal seems to increase every day. This essay contributes to our understanding of the backdating phenomenon by analyzing the economics of backdating and the characteristics of the firms under investigation. Its main points are the following: First, given the high volatilities of the stocks of the technology companies that dominate the list of firms under investigation and the fact that options granted to executives and employees typically may not be exercised for several years, press reports that focus on the size of the strike price discounts achieved by backdating significantly overstate the value of backdating. In some cases, reducing the strike price by a dollar per share by backdating increased the Black-Scholes value of the option by less than twenty cents per share. Second, completely unnoticed in the discussion so far is the fact that in many cases backdating dramatically reduced the apparent value of options. Because the size of executive stock option grants often is determined first by establishing the value to be delivered and then by calculating the number of shares to be covered by the option, reducing the apparent value of option shares may have substantially increased the size and true economic value of backdated executive option grants. Third, comparison of semiconductor firms under investigation for backdating with peer companies that are not suggests an association between backdating and the use of options in compensating non-executive employees. This essay considers several explanations for backdating non-executive options, including share limitations, minimizing apparent rank and file compensation, and cognitive biases. Finally, this essay argues that the backdating phenomenon is really not an accounting scandal. Backdating has accounting consequences, but it is unlikely to have been accounting driven.

Do executive stock option grants have value implications for firm performance?

Consistent with predictions of agency theory, we find direct evidence that executive stock option grants have value implications for firm performance. This inference is drawn from evaluation of various motivations for the use of such grants in executive compensation: value enhancement, risk taking, tax benefit, signaling and cash conservation. We find consistent evidence for the value enhancement motivation to reduce agency costs. As well, they signal for positive price sensitive information. Our results reject the tax benefit and cash conservation motivations. This finding is robust after controlling for the endogenous character of executive stock option grants and other equity-based grants.

The Effect of the Sarbanes-Oxley Act on the Timing Manipulation of CEO Stock Option Awards

Section 403 of the Sarbanes-Oxley Act accelerates the reporting deadline of executive stock option grants to be within two business days after the grants. This study investigates the effect of Section 403 on the extent of CEO influence over grant date stock prices aimed at enhancing the value of executive stock option awards. Prior studies find that executives affect the exercise price of options by influencing the timing of option awards, manipulating the timing of value-relevant information around option awards, or backdating the award in an attempt to lower the grant date stock price, thereby increasing the value of their options. We find that the accelerated reporting requirement of SOX 403 significantly reduces CEO influence over grant date stock prices in the post-SOX period. Specifically, we find that the accelerated reporting requirement (1) deters the opportunistic granting of unscheduled awards after bad news announcements and reduces, but does not eliminate, the opportunistic granting of unscheduled awards before good news announcements; (2) deters the delaying of good news announcements after scheduled option awards; and (3) greatly reduces the apparent use of backdating of option grants to lower the strike price. Thus, we provide important new evidence on the economic impact of SOX on mitigating executive opportunistic behavior associated with stock option grants.

Options with Constant Underlying Elasticity in Strikes

Closed-form solutions are derived and interpreted for European options, with stochastic strike prices, that maintain constant elasticity of the strike with respect to the price of the underlying asset. We refer to such options as CUES. CUES preserve the relative shares of exercise price risk for both the buyer and writer of the option, regardless of whether the price of the underlying asset moves up or down. The relevance of the CUES concept is established through applications in two distinct fields. First, it is established that CUES-like options are embedded in private equity investments. This concept is then used in a novel application to determine the equity share of a private company corresponding to a given level of investment. Secondly, the advantages that CUES would provide over traditional executive stock option grants are considered and it is shown that CUES can provide enhanced incentive-alignment without increasing options expense to the company.

Executive Stock Option Valuation Under Multiple Severance Risks

Executive stock option (ESO) grants have a number of important features that do not conform with the Black-Scholes model. This paper presents a risk-neutral model for valuing such options where the holder is exposed to multiple severance risks (e.g. termination with cause, without cause, mortality) with varying cause-contingent ex-severance payoffs and stock holding restrictions. We find that Black-Scholes significantly overestimates the cost of ESOs to the firm (e.g. 28-39% for a severance rate of 5%) and the bias is inversely related to volatility. For valuation, we construct a multi-severance binomial ESO (MSB-ESO) model and identify the corresponding multi-severance partial differential equation. The severance event is modeled using a flexible doubly stochastic Poisson process which permits rich information structures between state variables and the severance event to be endogenously captured in the valuation.

Are Executive Stock Options Associated with Future Earnings?

We estimate the relation between top 5 executive stock option (ESO) grants and future earnings to examine whether incentive alignment or rent extraction by top managers explains option granting behavior. The future operating income associated with a dollar of Black-Scholes value of an ESO grant is $3.82. To understand the source of these positive payoffs, we parse out ESO grant value into components predicted by economic determinants of option grants, governance quality, and a residual grant value. The payoffs to ESOs appear to be driven predominantly by the economic determinants of ESO grants and not poor governance quality. Thus we find little evidence in support of rent extraction.

Stock price decreases prior to executive stock option grants

This study examines abnormal stock price changes prior to executive stock option grants. Executives have the incentive and opportunity to manage the timing of their communications of inside information to the market during the period just prior to the date of their stock-option grant so as to reduce the exercise price of their options. Executives benefit from temporary stock price decreases before the grant date and by stock price increases after the grant date. Executive stock option grants create a unique opportunity for insiders to profit by manipulating the timing of information flowing to the market without engaging in insider trading. Using data on 783 stock-option grants to chief executive officers, we find a statistically significant abnormal decrease in stock prices during the 10-day period immediately preceding the grant date.