Restricted Stock Grants Research Articles

CEO Compensation and Firm Performance

This paper provides empirical validation of the theoretical relationship between firm performance and CEO compensation. The rational behavior hypothesis is that the “CEO that is paid more works harder (and succeeds) to improve the financial performance of the corporation that he/she leads. To test this relationship as our hypothesis, we collected information of firms and CEO compensation from the COMPUSTAT and EXECUCOMP data bases. Of the SP500 firms, we selected 276 firms with complete data in the 10-year period from 1995 to 2004. We estimate three measures/indicators of firm performance: Return On Equity (ROE), Return On Equity Average (ROE_AVG), and Economic Value Added (EVA). CEO compensation is measured by six categories: CEO Salary, Restricted Stock Grants, Options Awarded, Bonus, Long-Term Incentive Payouts (LTIP), and Total CEO Compensation. There are over 40,000 observations of both CEO compensation and corporate profit returns in the important large corporations in a period when media, analysts, and university research community were calling for CEOs to get with it. After controlling for fixed effects (macroeconomic and specific industry conditions) of the six types of CEO compensation, we find that only cash bonus has had a significant positive effect on firm performance. A one million dollar increase in bonus—an increase of 83.68% (based on the sample average of 1.195 million dollars) - was associated with a 1.15% increase in Average ROE in the fixed effects model or 1.03% increase in the random effects model. However, once we control for endogeneity of CEO compensation, i.e. that it was simultaneously determined with performance, none of the six payment types had significant effects on firms’ performance. This finding suggests a rethinking of the role of the CEO compensation as an incentive for improving corporate performance, i.e. can the CEO actually affect the annual profit of firms of this scale. The finding, interpretations and conclusions expressed herein are those of the authors. We greatly appreciate the comments and feedback provided by our colleagues at Yale School of Management (especially Professor Paul MacAvoy and Dean Ira Millstein) and Brown University All remaining errors are our own. Email addresses: dennisWmichaud@gmail.com (Dennis Michaud), ygai@babson.edu (Yunwei Gai). Dedication: This paper is dedicated to Professor Paul W. MacAvoy. Throughout this project his suggestions, comments, advice, and encouragement have been tireless. Paul is the former dean of the Simon and Yale Schools of Management and in our opinion, the dean of corporate governance research. As a teacher, scholar, and corporate director, Paul has been a strong advocate for enhanced corporate governance and shareholder rights. We are all in his debt.

The Valuation Differences Between Stock Option and Restricted Stock Grants for U.S. Firms

The Valuation Differences Between Stock Option and Restricted Stock Grants for U.S. Firms

Stock Options and Incentives: Employee-Level Evidence from Google

We examine whether stock option and restricted stock grants motivate higher performance using employee-level data from Google. Employees who received more equity grants than peers hired at the same time and job grade perform slightly better in the future across a variety of measures. To attempt to determine the direction of causality in this relationship, we exploit the fact that employees' option strike prices, and thus their exposure to Google stock, depend on Google's stock price the week they start work. Employees who start work when the stock price is lower than surrounding weeks, and who thus receive more equity exposure from their options, do not perform significantly better than their peers. Even if the correlation between equity grants and performance is interpreted causally, the incentive effects of stock options are still small relative to those from being eligible for promotion. On the other hand, we do find evidence that unvested equity encourages retention and that employees may jointly make retention and performance decisions.

Stock Option Repricing and its Alternatives: an Empirical Examination

Studies on determinants of stock option repricing contrast repricers with firms that do not conduct repricings. In practice, firms resort to other alternatives to retain managers and to restore incentives. We examine a broad array of alternatives that includes repricings, stock option grants, restricted stock grants, and the neutral alternative of doing nothing. Multinomial logit results suggest that firms reprice CEO stock options in response to economic factors. We address the debate on whether agency conflicts between managers and shareholders are severe in repricing firms, and do not find evidence that repricers are characterized by weak boards or entrenched managers.

Governance Effects of LBO Events

We examine the effects of leveraged buyouts (LBOs) on the industry rivals of the firms that undertake the LBO. Specifically, we are interested in determining whether or not the rivals that remain public take steps to change their governance mechanisms to emulate the firms that go private. Specifically, we examine CEO compensation, and the compensation and composition of the board of directors. We document an increase in the number of options awarded to CEOs following LBO activity in an industry, and a decrease in annual bonuses and restricted stock grants as LBO activity slows down. Our results also indicate the likelihood of changing the CEO is positively correlated with LBO activity. We also demonstrate significant changes in the pay for directors and the structure of the board after LBOs occur in an industry. Overall, our examination yields results that indicate firms effectuate significant corporate governance changes following an LBO event in their industry.

Pay Without Performance: The Unfulfilled Promise of Executive Compensation

This book provides a detailed account of how structural flaws in corporate governance have enabled managers to influence their own pay and produced widespread distortions in pay arrangements. The book also examines how these flaws and distortions can best be addressed. Part I of the book (titled The Official View and its Limits) critically examines the arm's length contracting view, which underlies much of the academic research on executive compensation as well as the law's approach to it. We show that boards have not been operating at arm's length from the executives whose pay they set. While recent reforms can improve matters, they cannot be expected to eliminate significant deviations from arm's length contracting. We also show that the constraints imposed by market forces and shareholders' power to intervene are not tight enough to prevent such deviations. Part II of the book (titled Power and Pay) shows how an understanding of the role of managerial power can help explain executive compensation practices. We provide a framework for assessing whether pay arrangements are a product of managerial influence. We discuss managers' interest in camouflaging the amount and the performance-insensitivity of their pay. Applying our framework, we discuss how managerial influence can help explain, among other things, the evidence on the relationship between managerial pay and managerial power; the use of retirement benefits and other compensation arrangements to provide stealth compensation; and the ability of departing managers to obtain more than their contractual entitlement.Part III of the book (titled Decoupling Pay from Performance) examines how managerial influence has operated to reduce the performance-sensitivity of executive pay. Among other things, we examine the structure of non-equity compensation, the design of conventional option plans, the use of restricted stock grants, and managers' freedom to unload options and shares.Part IV of the book (titled Going Forward) discusses how executive compensation - and corporate governance more generally - can be improved. We examine the extent to which pay arrangements can be improved by adopting board process rules, imposing shareholder approval requirements, and making pay more transparent. We conclude that problems with compensation arrangements cannot be fully addressed without ensuring that directors focus on shareholder interests and operate at arm's length from the executives whose compensation they set. To achieve this result, we argue, it is not sufficient to make directors independent of executives as recent reforms has sought to do; it is also necessary to make directors dependent on shareholders by changing the legal arrangements that insulate boards from shareholders.The preface and introduction are available to download at the bottom of this page. Also available for downloading from SSRN are three papers on which the book partly draws:- Lucian Bebchuk and Jesse Fried, Stealth Compensation via Retirement Benefits, http://ssrn.com/abstract=583861- Lucian Bebchuk and Jesse Fried, Compensation as an Agency Problem, Journal of Economic Perspectives, Vol. 17, pp. 71-92, 2003, http://ssrn.com/abstract=364220- Lucian Bebchuk, Jesse Fried, and David Walker, Managerial Power and Rent Extraction in the Design of Executive Compensation, University of Chicago Law Review, Vol. 69, pp. 751-846, 2002, http://ssrn.com/abstract=316590

Optimal Incentive Contracts for Loss‐Averse Managers: Stock Options versus Restricted Stock Grants

AbstractThis paper provides an explanation for the widespread use of stock option grants in executive compensation. It shows that the optimal incentive contract for loss‐averse managers must contain a substantial portion of stock options even when it should consist exclusively of stock grants for “classical” risk‐averse managers. The paper also provides an explanation for the drastic increase in the risk‐adjusted level of CEO compensations over the past two decades and argues that more option‐based compensation should be used in firms with higher cash flow volatility and in industries with a higher degree of heterogeneity among firms.

Accounting, Governance, and Broad-Based Stock Option Grants

We estimate the costs of broad-based stock option programs relative to cash compensation and restricted stock grants. Using detailed data on stock-option grants to middle managers, we rst compute the cost of option grants under the assumption that grants are driven solely by the dierence between their accounting and economic costs. Under this assumption, the median rm in our sample incurs $0.64 in real costs in order to increase reported pre-tax net income by $1. This cost is reduced, but is still quite substantial, if accounting considerations drive rms to grant stock options when grants of restricted stock would capture similar economic benets. Finally, we examine the possible sources of economic benets of broad-based option programs if observed grants are more protable than restricted stock grants. We nd that the choice of options over restricted stock is consistent with rms using equity grants to attract and retain

Pay without performance: the unfulfilled promise of executive compensation

This book provides a detailed account of how structural flaws in corporate governance have enabled managers to influence their own pay and produced widespread distortions in pay arrangements. The book also examines how these flaws and distortions can best be addressed. Part I of the book (titled The Official View and its Limits) critically examines the arm's length contracting view, which underlies much of the academic research on executive compensation as well as the law's approach to it. We show that boards have not been operating at arm's length from the executives whose pay they set. While recent reforms can improve matters, they cannot be expected to eliminate significant deviations from arm's length contracting. We also show that the constraints imposed by market forces and shareholders' power to intervene are not tight enough to prevent such deviations. Part II of the book (titled Power and Pay) shows how an understanding of the role of managerial power can help explain executive compensation practices. We provide a framework for assessing whether pay arrangements are a product of managerial influence. We discuss managers' interest in camouflaging the amount and the performance-insensitivity of their pay. Applying our framework, we discuss how managerial influence can help explain, among other things, the evidence on the relationship between managerial pay and managerial power; the use of retirement benefits and other compensation arrangements to provide stealth compensation; and the ability of departing managers to obtain more than their contractual entitlement. Part III of the book (titled Decoupling Pay from Performance) examines how managerial influence has operated to reduce the performance-sensitivity of executive pay. Among other things, we examine the structure of non-equity compensation, the design of conventional option plans, the use of restricted stock grants, and managers' freedom to unload options and shares. Part IV of the book (titled Going Forward) discusses how executive compensation - and corporate governance more generally - can be improved. We examine the extent to which pay arrangements can be improved by adopting board process rules, imposing shareholder approval requirements, and making pay more transparent. We conclude that problems with compensation arrangements cannot be fully addressed without ensuring that directors focus on shareholder interests and operate at arm's length from the executives whose compensation they set. To achieve this result, we argue, it is not sufficient to make directors independent of executives as recent reforms has sought to do; it is also necessary to make directors dependent on shareholders by changing the legal arrangements that insulate boards from shareholders.

How do Managers Value Stock Options and Restricted Stock?

We gather data from 77 current mid-level managers and 111 future entry-level managers, to investigate how they value stock options and restricted stock. We refer to our current and future manager groups collectively as managers. We supplement our manager data with a dozen field interviews with senior executives. We find that managers, on average, systematically overvalue stock options relative to both the Black-Scholes (B-S) value and fair-value equivalent restricted stock grants. Thus, contrary to conventional economic thinking, many risk-averse agents do not appear to discount B-S values of options. Further, in valuing options, managers value quick vesting and extended expiration. Managers also extrapolate recently rising stock price trends to arrive at their subjective valuations of both options and restricted stock. In general, our results suggest that a combination of economic, behavioral and demographic factors explain managers' subjective valuations of options and restricted stock.

The Impact of Personal Income Taxation on Executive Compensation

This paper analyzes the effect of personal income taxation on the sensitivity of executive compensation to company performance and the use of stock option and restricted stock grants underlying this sensitivity. The theoretical model predicts that, if a single tax rate applies to the entire compensation package, an increase in the tax rate weakly diminishes the equilibrium level of managerial effort and the after-tax pay-to-performance sensitivity, with the effect on the pre-tax pay-to-performance sensitivity being ambiguous. When salary and option gains are taxed at a higher rate than stock gains, tax changes also induce shifting among the individual compensation instruments. Interestingly, this differential taxation leads to a positive amount of stocks in the compensation contract even in the absence of any desire to incentivize the manager. In addition, an increase in the tax rate applied to salary and option gains may increase the level of managerial effort in equilibrium. On the other hand, an increase in the tax rate applied to stock gains weakly decreases the equilibrium level of managerial effort and strictly decreases the amount of after-tax pay-to-performance sensitivity generated by stock grants. The second part of the paper exploits the variation in the U.S. federal personal income tax rate generated by the Omnibus Budget Reconciliation Act of 1993, as well as variation in the combined federal and state income tax rates during the period 1992-1996 to empirically evaluate the impact of personal income taxation on the pay-to-stock-price sensitivity generated by stock-option and restricted stock grants. The results show that an increase in the ordinary income tax rate decreases the pay-to-stock-price sensitivity generated by option grants when time series variation in the marginal tax rate is utilized in the identification, with the estimates retaining the same sign but being statistically insignificant when only the variation in the marginal tax rate originating from cross-sectional variation in the federal income tax rate and/or state tax rate changes is used in the estimation. On the other hand, stock grant sensitivity is found to be unresponsive to changes in the ordinary income tax rate.

Stock-Based Compensation in Teams

This paper considers the role of stock-based compensation, such as restricted stock grants and stock options, in mitigating the moral hazard problem in teams in which agents who face the possibility of turnover must choose a level of effort or investment within working relationships with the other agents. We formally derive results in which stock-based compensation is a component of an optimal compensation contract, and in particular, in which stock-based compensation is superior to cash-based compensation such as bonuses and severance payments. We also show that stock-based compensation is not optimal in individual production. The results also provide new empirical and practical implications for stock-based compensation from the viewpoint of team incentives and job turnover.

Modern Financial Engineering and Discounts: The Collar Message

An abundance of literature addresses the appropriate marketability discount to be applied to a block of publicly traded securities that cannot be immediately liquidated. Typically, the discounts are based upon inferences drawn from measuring discounts indirectly. Here, we take a different approach. We ask the specific question: What is the direct cost of providing full marketability to a less than liquid financial asset? Our findings indicate that marketability discounts for restricted stock and stock option grants, as well as large blocks of publicly traded securities that can be converted to publicly traded securities at some future date, can be determined with reasonable accuracy. This direct approach is superior to that of relying on observed discounts of restricted stock prices in private placements relative to their publicly traded counterparts. Liquidity or marketability is comprised of two components. The elimination of price risk is the first component. Price risk represents the risk that one may not receive the current market value of the underlying freely traded asset due to price fluctuations in the marketplace. The second component of marketability is the ability to convert an asset to cash in a timely fashion. Restricted stock units received as part of a compensation package may not convert to a freely traded stock for periods ranging from a few months to several years. The cost of restoring liquidity to an illiquid asset represents the appropriate marketability discount. We show that an at-the-money equity collar, engineered by buying and selling options on the underlying publicly traded stock creates a perfect hedge that removes all price risk at a point in time. In addition, borrowing against this hedged position will provide funds and restore full liquidity. In the absence of transaction costs, the return on the collar portfolio will be equal to the risk free rate. In practice this return is reduced by transactions costs and interest costs that are incurred. Therefore, the net transaction cost and net interest cost in creating the equity collar represents an appropriate marketability discount. This direct cost approach is the best tool available for calculating the size of the marketability discount. We demonstrate the application of this strategy to blockage discounts and discounts applied to restricted stock units. This approach cannot be directly applied to situations where an equity collar cannot be engineered. However, even where a perfect hedge cannot be directly created we can develop a sense of the appropriate marketability discount that should be applied in a given situation. We begin by looking at previous work dealing with the measurement of liquidity discounts for blockage and restricted stock. Next we apply the collar strategy to determine the appropriate discount to both restricted stock and stock subject to blockage discounts. Blockage Discount Literature Moore (1992) presents a checklist of 22 factors to consider when determining the appropriate blockage discount. The weighting of the factors is based upon the judgment of the valuation professional. Several of the factors he suggests are useful for determining whether a blockage discount is warranted. For example, The share size of the block – especially as compared to the number of shares outstanding of that

Executive Pay, Earnings Manipulation and Shareholder Litigation

The paper examines the role of executive compensation in inducing management behavior that triggers private securities litigation. Incentive pay in the form of options is found to increase the probability of securities class action lawsuits, holding constant a wide range of other firm characteristics. In contrast, base pay levels and restricted stock grants do not have a significant impact on lawsuit incidence. Firms whose executives hold restricted stock only, and no options, induce less shareholder litigation. Our results suggest that option-based compensation may give executives too strong an incentive to target the short term share price, which may be harmful to long term shareholder value. We further identify earnings manipulation as an important channel linking compensation and litigation: incentive pay has a significant impact on earnings manipulation, which in turn significantly affects the probability of litigation. However, our accrual-based measure of manipulation does not capture the full impact of compensation on litigation, suggesting other channels are important.

Understanding High-Powered Incentives

This paper analyzes the effect of restricted stock options and restricted stock grants on managerial effort incentives. The combination of low managerial valuations of options and inefficient incentive creation makes options inferior means of inducing managerial effort incentives. The negative covariance of the option delta or pay-for-performance with marginal utility reduces ex-ante effort incentives substantially, and the more so the higher the volatility of stock returns. Pay-for-performance is shown to be a biased measure of managerial incentives. It systematically understates the incentives generated by equity holdings relative to the incentives generated by option grants. The bias is again increasing in the volatility of stock returns, offering a potential explanation for the empirical finding that pay-for-performance does not decrease with volatility as predicted by the optimal contracting framework. The private trading behavior of managers is shown to be crucial for the optimal design of compensation contracts. Assuming that managers invests only into the riskless asset makes option compensation look considerably more effective than it is: The cost of compensating the executive is underestimated, and incentive effects are overestimated. The benefit of indexing compensation schemes to market or industry returns is reduced or even eliminated when the manager is able to freely trade the index through her private account.

CEO Stock‐Based Compensation: An Empirical Analysis of Incentive‐Intensity, Relative Mix, and Economic Determinants

The use of stock-based compensation for U.S. CEOs has increased significantly throughout the 1990s. Research interest, in particular on stock option compensation, has similarly increased, yet contradictory results create questions about the theoretical underpinnings. Therefore, we revisit the controversy surrounding stock option awards, and we further the understanding of restricted stock grants, which have escaped similar research focus. Using a recent data set, we obtain convincing empirical support for most theoretical predictions about stock option awards. We also find that restricted stock, due to its linear payoffs, is relatively inefficient in inducing risk-averse CEOs to accept risky, value-increasing investment projects. Copyright 2000 by University of Chicago Press.

Are Performance Measures Other Than Price Important to CEO Incentives?

We examine whether publicly available performance measures other than stock price are economically significant in explaining changes in CEOs' firm-specific wealth. Similar to Antle and Smith [1986], we measure a CEO's firm-specific wealth changes as the sum of total annual pay and changes in the value of the CEO's portfolio of stock and option holdings. We examine the determinants of the variance of CEOs' wealth changes to infer the magnitude of their incentives. We decompose the variance of the wealth change into price-based and non-price-based components, and examine whether there is substantial variation in CEO wealth changes that is unexplained by price. Our results indicate that for most CEOs, stock return is the dominant component of their incentives. We find that for 65% of the CEOs in our sample, the variation in wealth changes that is explained by stock returns is at least 10 times greater than the variation that is unexplained by stock returns. This latter percentage is substantially larger when the CEOs are aggregated by industry to mitigate measurement error problems associated with computing by-CEO variances over a short time-series. Although there are some CEOs for which the non-price-based variation in annual total pay is significant, nearly all of this variation comes from non-cash pay, such as stock option and restricted stock grants. The variation in annual cash pay that is unexplained by price is greater than 1% of the total variation in CEO wealth changes for only 25% of the CEOs.

CEO Stock-Based Compensation: An Empirical Analysis of Incentive-Intensity, Relative Mix, and Economic Determinants

The use of stock-based compensation for U.S. CEOs has increased significantly throughout the 1990s. Research interest, in particular on stock option compensation, has similarly increased, yet contradictory results create questions about the theoretical underpinnings. Therefore, we revisit the controversy surrounding stock option awards, and we further the understanding of restricted stock grants, which have escaped similar research focus. Using a recent data set, we obtain convincing empirical support for most theoretical predictions about stock option awards. We also find that restricted stock, due to its linear payoffs, are relatively inefficient in inducing risk-averse CEOs to accept risky, value-increasing investment projects.

Compensation Policy and the Investment Opportunity Set

We analyze the proportions of executive pay derived from salary, bonus, long-term incentive compensation, and stock-based compensation for a sample of 321 Fortune 1,000 firms in 1992. We find that firms with abundant investment opportunities pay higher levels of total compensation to their executives. Executives of growth firms receive a larger portion of their compensation from long-term incentive compensation (such as performance awards, restricted stock grants, and stock option grants), while those of non-growth firms receive a larger portion of their pay from fixed salary. An implication is that long-term incentives contracts reduce agency costs associated with manager-shareholder information asymmetries in growth firms.

The Use and Misuse of Restricted Stock

Because they are not contingent on performance, restricted stock grants have their limitations as long-term incentives for executives—but such grants can be modified to build in performance incentives and risk elements.