Option Grants Research Articles

Lessons of the HealthSouth Fraud: An Insider's View

T he night was December 6, 2005. I could not go to sleep. As I tossed and turned, my entire life replayed in my mind. How did I get to where I was? I went all the way back to my childhood. I was raised in a middle-income home with an older brother and sister and two loving parents. We were far from rich, but had what we needed. I was a normal kid. I loved riding my bike and being with friends. I never got into any real trouble. My thoughts on December 6 moved forward to college. I made good grades and was extremely involved in extracurricular activities. Lying in bed, my thoughts drifted forward. When I graduated from college, I had a job waiting at Ernst & Young. I passed the CPA exam, and for the next five years served as an auditor and specialized in the healthcare industry. I was surrounded by a lot of smart, hardworking people. As is so common with staff within CPA firms, with five years’ experience, my phone began ringing with various job offers. Then one day, a former colleague called and wanted to have lunch. An opportunity had opened at a small startup company named HealthSouth Rehabilitation Corporation. The next day, I interviewed with HealthSouth’s CEO and Founder, Richard Scrushy. He was extremely engaging and had a strong vision for the growth of the company. He also talked a lot about making money. I believed it was a great opportunity and accepted the position. The years rolled by and the company became enormously successful. During those years, HealthSouth grew from a dozen locations to over two thousand, located in all 50 states and five countries. I had risen from a middle-management position to become the company’s CFO. With a large salary, bonuses, and stock options, I had become financially successful. From the outside looking in, it was a dream come true. But why was I thinking about all of this on December 6? Let me tell you where I was. I was not at home in my comfortable bed that night. I was on the top rack of a bunk bed in a federal prison camp, looking at spending the next two years of my life there. All because I had become involved in a $3 billion accounting fraud at HealthSouth. Never in a million years would I have imagined being in prison. After all, I had always done all the ‘‘right things.’’ How on earth had I become a convicted felon? Simple. I crossed the line. In business and in our personal lives, we are constantly faced with situations of crossing the line. I am not writing about $3 billion frauds, I am talking about everyday life—the small temptations to cross the line are always there. Therein lies the danger. Facing a new line will create trepidation, but may be answered with the simple rationalizations, ‘‘It’s not that big of a deal,’’ ‘‘Everyone does it,’’ ‘‘It is

Corporate Investment and Changes in CEO Stock Option Grants

We study changes in CEO stock option grants. Unlike most of the literature, we focus on the number rather than the value of options granted. We first provide a detailed description of the main aggregate trends in CEO stock option grants. We then consider the cross-sectional heterogeneity in option-granting activity. We find that CEOs who either overinvest or underinvest subsequently receive fewer stock options as part of their compensation packages. CEOs who hold exercisable deeply-in-the-money options (overconfident CEOs) also receive fewer stock options in subsequent periods. Our findings provide insights into the dynamics of CEO compensation contracts.

Seemingly opportunistic management earnings guidance before stock option grants: does it misrepresent firms’ underlying performance?

The exercise price of stock options is typically the closing stock price on the option grant dates, so managers can potentially benefit from low stock prices on those dates. Prior studies find that on average, managers issue more pessimistic guidance before than after grant dates. They interpret this asymmetric pattern as representing managers’ opportunistic behavior. Nevertheless, it is not clear whether this pattern reflects managers’ selective timing of bad news disclosures or a deliberate misrepresentation of underlying firm performance. This paper extends the literature by examining the effects of managerial stock option incentives on the accuracy and the information content of firms’ voluntary earnings guidance. We find that pre-grant guidance significantly improves existing consensus earnings forecasts, and is similar in bias and accuracy to post-grant guidance. Moreover, investors and analysts react similarly to pre-grant vs. post-grant guidance, suggesting that the main consumers of earnings guidance view these two types of guidance to be equally informative. Our results are consistent with the notion that managers may opportunistically select the type or the timing of disclosures, but when they opt to disclose, they do not misrepresent the underlying firm performance. On the contrary, the seemingly opportunistic guidance before option grants improves overall firms’ information environment, because it is at least as truthful and informative as post-grant guidance, and is issued more frequently than by managers who do not have incentives to report bad news before earnings announcements.

Are Stock Option Grants to Directors of State-Controlled Chinese Firms Listed in Hong Kong Genuine Compensation?

ABSTRACT:We examine the determinants and consequences of stock option compensation to directors of state-controlled Chinese firms that are incorporated outside China and listed in Hong Kong, referred to as state-controlled Red Chip firms, over the period 1990–2005. We find that state-controlled Red Chip firms granted directors a significant number of stock options in response to the demand of foreign investors. However, state-controlled Red Chip firms forced the directors to forfeit a significant percentage of their vested in-the-money stock options due to a conflict between the high-powered stock option compensation and state-controlled Red Chip firms' unique managerial labor market. We find little evidence that directors' stock option compensation changed the behavior of state-controlled Red Chip firms. Overall, our results are consistent with the media's allegation that the stock options granted to directors of many, if not all, state-controlled Red Chip firms are not genuine compensation.JEL Classifications: D21, G32, J33, M40, N25Data Availability: Data used in this study are publicly available from the sources identified in the paper.

Meeting or Missing Earnings Benchmarks: The Role of CEO Integrity

AbstractThis paper examines the role of CEO integrity in determining whether a company's earnings benchmarks will be met, beaten or missed. Prior literature provides evidence that managers have incentives for meeting or beating earnings benchmarks and are rewarded by the market for doing so (Lopez and Rees, 2002; and Skinner and Sloan, 2002). Managers also have incentives to miss their earnings targets for the benefit of a lower strike price on subsequent option grants (McAnally et al., 2008). A CEO's involvement in backdating is taken here as a measure of his or her integrity. This paper shows that CEO integrity significantly influences whether benchmarks are met or beaten. In other words, backdating CEOs are more likely to meet or narrowly beat all three earnings benchmarks examined in the paper: positive earnings, last year's earnings and analysts’ forecasts. At the same time, they are also less likely to narrowly miss a zero‐earnings benchmark. The results presented in this paper further validate the use of benchmark meeting/beating as a measure of earnings manipulation.

Swinging for the Fences: Executive Reactions to Quasi-Random Option Grants

We examine how an increase in stock option grants affects CEO risk-taking. The overall net effect of option grants is theoretically ambiguous for risk-averse CEOs. To overcome the endogeneity of option grants, we exploit institutional features of multi- year compensation plans, which generate two distinct types of variation in the timing of when large increases in new at-the-money options are granted. We find that, given average grant levels during our sample period, a 10 percent increase in new options granted leads to a 2.8–4.2 percent increase in equity volatility. This increase in risk is driven largely by increased leverage.

Risk Aversion, Indivisible Timing Options, and Gambling

In this paper we model the behavior of a risk-averse agent who seeks to maximize expected utility and who has an indivisible asset and a timing option over when to sell this asset. Our main contribution is to show that, contrary to intuition, optimal behavior for such a risk-averse agent can include risk-increasing gambles. For example, a manager with a choice over when to disinvest from a project, a private homeowner with a property to sell, or an employee with a grant of American-style stock options may be better off taking positions in other assets with zero Sharpe ratio that are uncorrelated with the underlying project, house, or stock price risk. The results have wider implications for the modeling and interpretation of portfolio optimization problems involving American-style timing decisions.

Corporate Social Responsibility (CSR) and CEO Luck: Are Lucky CEOs Socially Responsible?

“Lucky” CEOs are given stock option grants on days when the stock price is the lowest in the month of the grant, implying opportunistic timing, severe agency problems, and poor corporate governance (Bebchuk, Grinstein, Peyer, 2010). We find that lucky (opportunistic) CEOs invest significantly less in CSR. The evidence thus does not support the notion that CSR is primarily used to enhance managers’ private benefits at the expense of shareholders. Rather, lucky CEOs appear to view CSR investments as depriving them of the free cash flow they could otherwise exploit.

Long-term Incentive Effects of Executive Stock Options

Although stock options have been widely used as part of firms’ long-term incentive plans, rarely has any study examined whether stock options indeed achieved the intended long-term incentive effect. This study for the first time examines whether stock options have motivated executives to take a long-term perspective of the firms. This question is addressed by examining how executives perceive the value of underwater options, which is revealed by the changes in firms’ new option grants that followed the deep stock price decline in the most recent financial crisis of 2008. It draws on prospect theory and complements rational option valuation methods by incorporating behavioral perspectives in executives’ stock option valuation. Contrasting hypotheses regarding firms’ new option grants in response to the losses from underwater options are developed under three assumptions: (1) “short-term view of executives”, (2) “long-term view of executives” and (3) “behavioral view of executives”. The results of the regre...

Stock option fraud detection and an analysis for its reasons: Arabic Republic of Egypt case

This paper investigates how stock option turned from an incentive for good management to a tool of management fraud. The objective of this paper is accomplished through studying the stock option phenomenon in the Arab Republic of Egypt (ARE). Stock option grants data are obtained from all firms that have stock option grants and listed in the Egyptian stock market. The empirical study covers the period from 2006 through 2009. Detecting stock option fraud and distinguishing between control and fraud firms was done through calculating the cumulative abnormal returns before and after stock option grants. Results of this research reveal that the incidence of stock option fraud is higher in unscheduled option grants compared to scheduled ones. These results strongly support that the reason of stock option fraud in ARE is dating games rather than news announcements manipulation.

Are CEO stock option grants optimal? Evidence from family firms and non-family firms around the Sarbanes–Oxley Act

This paper investigates the optimality of stock option grants to Chief Executive Officers (CEOs) by examining a set of S&P 500 companies around the passage of the Sarbanes–Oxley Act (SOX). I find that stock option grants to non-founding-family CEOs decreased dramatically after the passage of SOX. In addition, non-family firms granted significantly more stock options than family firms before the SOX, but not after its passage. These findings are consistent with the interpretation that CEOs use stock option grants as tools to extract rents from shareholders. This interpretation is further supported by evidence that the large decrease in stock option grants after the SOX was passed is not detrimental to firm performance, and by evidence from a test of the trade-off between option and non-option compensation.

The Effect of Social Interactions on Executive Compensation

We investigate whether and how executives’ social interactions affect their compensation. Using the social networks among 2,936 chief executive officers (CEOs) during 1999-2008, we report that socially connected CEOs receive significantly more similar compensation than non-connected CEOs. This result is robust to the inclusion of executive- and firm-fixed effects. We further find that CEO compensation responds to a peer’s change in pay caused by industry performance, especially if that change in pay is positive and the firm is suffering from weak corporate governance. We interpret these results as consistent with the notion that relative earnings concerns within social networks affect negotiations about compensation. Finally, we find that the past practice of backdating stock option grants spread across social networks, suggesting that social networks serve as a conduit for interpersonal information flow about compensation practices. Overall, our evidence suggests that peer effects in CEO compensation is due to both sharing of compensation matters and efforts to “keep up with the Joneses” within the network.

Australian evidence on CEO option grants

We test the option incentive models of Hall and Murphy (2000, 2002) and Choe (2003). Hall and Murphy (2000, 2002) posit optimal grant size and exercise price contingent on the executive’s levels of risk aversion and private diversification. Choe (2003) relates these choices to firm characteristics, principally the target risk level and financial leverage. A unique hand-collected data set of Australian grants is employed, wherein exercises prices and grant sizes are unconstrained by taxation and accounting practices. The Hall and Murphy (2000, 2002) model is found to explain observed exercise prices while neither model satisfactorily explains grant sizes. However, there is some evidence that CEO influence is associated with larger grants than posited by these optimal incentive models, but does not impact on exercise prices.

Executive turnover in the stock option backdating wave: The impact of social context

While boards are known to react to corporate misconduct by removing the executives responsible, little is known about whether the board's response is shaped by the firm's social context. Using the 2006 stock option backdating scandal, in which firms manipulated stock option grant dates, we examine the impact of two dimensions of social context—the pervasiveness of the misconduct and the media attention to the misconduct. We find that firms implicated later in the backdating scandal are less likely to experience executive turnover than those implicated earlier. We also find that the amount of media attention to backdating at the time a firm is implicated in the scandal increases the likelihood that the firm experiences executive turnover.Copyright © 2012 John Wiley & Sons, Ltd.

Stock option grant vesting terms: economic and financial reporting determinants

Option grant vesting terms are a contractual provision that is shaped by accounting standards and other economic factors. We examine the effect of accounting standards, specifically SFAS 123(R), on the vesting terms of stock option grants while also modeling other economic determinants of this contract feature. We document significant variation in stock option grant vesting periods and patterns suggesting that firms actively choose vesting terms. Consistent with financial reporting incentives influencing contract design, we find that firms simultaneously lengthen vesting periods and alter vesting patterns after the adoption of SFAS 123(R). The changes in vesting patterns are consistent with firms trying to defer recognition of the option expense, while limiting the incremental risk imposed on the CEO. In addition, we find that vesting schedules are longer in growth firms where lengthening the executive’s investment horizon is more important and that firms with more powerful CEOs and weaker governance grant options with shorter vesting periods.

Does Compensation Structure Alleviate Personal CEO Risks?

Abstract: Are CEO compensation packages designed to alleviate some of the personal risks that they bear? We employ a unified framework to test the relationship between the four major components of executive pay; salary, bonuses, option grants and restricted stock grants, and four factors that increase CEOs’ personal risks; the real value of their pay, the riskiness of firm equity, the value of their equity portfolios, and the delta of these equity holdings. We show that personal risks that CEOs face have significant effects on the design of their compensation contracts. Our results suggest that the portion of salary compensation decreases many of the personal risks that they face. There are intriguing differences between salary and bonuses on one hand, and option and restricted stock grants on the other. As predicted, we find that the delta of CEOs’ equity portfolios have strong nonlinear relationships with the different forms of compensation; especially with option grants.

Ironing out the kinks in executive compensation: Linking incentive pay to average stock prices

Traditional stock option grant is the most common form of incentive pay in executive compensation. Applying a principal-agent analysis, we find this common practice suboptimal and firms are better off linking incentive pay to average stock prices. Among other benefits, averaging reduces volatility by about 42%, making the incentive pay more attractive to risk-averse executives. Holding the cost of the option grant to the firm constant, Asian stock options are more cost effective than traditional stock options and provide stronger incentives to increase stock price. More importantly, the improvement is achieved with little impact on the option grant’s risk incentives (after adjusting for option cost). Finally, averaging also improves the value and incentive effects of indexed stock options.

Meeting or Missing Earnings Benchmarks: The Role of CEO Integrity

This paper examines the role of CEO integrity in determining whether a company’s earnings benchmarks will be met, beaten or missed. Prior literature has provided evidence that managers have incentives for meeting or beating earnings benchmarks and are rewarded by the market for doing so (Lopez and Rees 2002; Skinner and Sloan 2002). Managers also have incentives to miss their earnings targets for the benefit of a lower strike price on subsequent option grants (McAnally et al. 2008). A CEO’s involvement in backdating is taken here as a measure of his/her integrity. This paper shows that CEO integrity significantly influences benchmark meeting/beating behavior. In other words, backdating CEOs are more likely to meet or narrowly beat all three earnings benchmarks examined in the paper: positive earnings, last year’s earnings and analysts’ forecasts. At the same time, they are also less likely to just miss a zero earnings benchmark. The results presented in this paper further validate the use of benchmark meeting/beating as a measure of earnings manipulation.

Ironing Out the Wrinkles in Executive Compensation: Linking Incentive Pay to Average Stock Prices

Traditional stock option grant is the most common form of incentive pay in executive compensation. Applying a principal-agent analysis, we find this common practice suboptimal and firms are better off linking incentive pay to average stock prices. Among other benefits, averaging reduces volatility by about 42%, making the incentive pay more attractive to risk-averse executives. Holding the cost of the option grant to the firm constant, Asian stock options are more cost effective than traditional stock options and provide stronger incentives to increase stock price. More importantly, the improvement is achieved with little impact on the option grant’s risk incentives (after adjusting for option cost). Finally, averaging also improves the value and incentive effects of indexed stock options.

Stock option fraud prevention in Islamic country: does corporate governance matter?

PurposeThis paper aims to investigate the extent to which companies in one of the Islamic culture countries, Egypt, are complying with the Islamic implementation of the Anglo‐Saxon model of corporate governance and testing the impact, if any, of such compliance on mitigating of stock option fraud incentives.Design/methodology/approachA logistic regression model is used to examine the effects of board of directors, audit committee, ownership structure and other firm characteristics on the likelihood of stock option fraud. The analysis is based on the data for stock option grants obtained during the period from 2006 to 2009.FindingsThe results suggest that the rate of compliance with the Islamic implementation of the Anglo‐Saxon model of corporate governance in Egyptian public‐held companies is low. Weak corporate governance allows executives to exercise greater influence over the board of directors and audit committee decisions. Furthermore, a low level of disclosure, duality of CEO, high percentage of insiders in board of directors, auditor turnover, and management ownership are among the factors that increase the likelihood of stock option fraud in the Egyptian setting.Research limitations/implicationsThe results are constrained by the proxies used to define stock option fraud. Additionally, the limited number of companies with stock option grants in Egypt might affect the results.Originality/valueThis paper provides insights into exposing stock option fraud by Egyptian public‐held companies and sheds light on the effective role of corporate governance mechanisms to mitigate this phenomenon. This would help policy setters to enhance compliance with the Anglo‐Saxon model of corporate governance and develop a comprehensive Shari'ah model of corporate governance that reduces stock option fraud.