Forum: "Insider Luck"
How stock-option grants were gamed — and what to do about it
by Lucian A. Bebchuk
The compensation of top American corporate executives has soared during the past 15 years. Measured in 2005 dollars, the average annual compensation of the CEOs of the large companies in the Standard & Poor’s 500 almost tripled from 1992 to 2005, growing from $3.7 million to $10.5 million. This growth in executive pay has been accompanied by a parallel increase in public interest in the subject, and has prompted heated debate about executive compensation—its appropriateness and effectiveness—and corporate governance.
In this context, the opportunistic timing of executive stock-option grants, via backdating or otherwise, has attracted a great deal of news coverage, regulator attention, and public debate since the media first focused on it in the spring of 2006. The U.S. Senate’s banking and finance committees held hearings on the subject. The Securities and Exchange Commission and a small army of private law firms hired by companies themselves have been intensively investigating past grant practices in many companies. More than 150 firms have thus far come under scrutiny, dozens of executives and directors have been forced to resign, and many companies have announced that they will have to revise their past financial statements.
But our understanding of option-grants manipulation remains incomplete. What circumstances and factors led to opportunistic timing of grants in some companies but not in others? To what extent has such timing resulted from systemic problems in corporate governance? What lessons should investors and firms draw? In two recent studies, Yaniv Grinstein from Cornell, Urs Peyer from the INSEAD business school, and I explored these questions by investigating empirically the incidence, causes, and consequences of option-timing practices.
In the debate over executive pay, I have sided with those critical of existing arrangements. In Pay without Performance: The Unfulfilled Promise of Executive Compensation, Jesse Fried of Berkeley and I offered a detailed account of the flaws in pay arrangements—in particular, the decoupling of executive compensation from corporate performance and the lack of transparency about both the amount of such compensation and the extent to which it is sensitive to performance. We also argued that the flaws have resulted from the absence of true arm’s-length contracting between boards and executives, and that such flaws are likely to remain unless we adopt governance reforms that improve directors’ incentives to focus on shareholders’ interests. The evidence about backdating reinforces these concerns.
Lucky CEOs
During the past 15 years, the most important component of executive pay packages, and the one most responsible for the large increase in the level of such compensation, has been stock-option grants. The increased use of option grants was justified as a way to align executives’ interests with shareholders’. For various tax, accounting, and regulatory reasons, stock-option grants have largely comprised “at-the-money options”: rights to purchase shares at an “exercise price” equal to the company’s stock price on the grant date. In such at-the-money options, the selection of the grant date for awarding options determines the options’ exercise price and thus can have a significant effect on their value.
Earlier research by financial economists on backdating practices focused on the extent to which the company’s stock price went up abnormally after the grant date. My colleagues and I focused instead on how a grant-date’s price ranked in the distribution of stock prices during the month of the grant. Studying the universe of about 19,000 at-the-money, unscheduled grants awarded to public companies’ CEOs during the decade 1996-2005, we found a clear relation between the likelihood of a day’s being selected as a grant date for awarding options, and the rank of the day’s stock price within the price distribution of the month: a day was most likely to be chosen if the stock price was at the lowest level of the month, second most likely to be chosen if the price was at the second-lowest level, and so forth. There is an especially large incidence of “lucky grants” (defined as grants awarded on days on which the stock price was at the lowest level of the month): 12 percent of all CEO option grants were lucky grants, while only 4 percent were awarded at the highest price of the month.
The passage of the Sarbanes-Oxley Act in August 2002 required firms to report grants within two days of any award. Most firms complied with this requirement, but more than 20 percent of grants continued to be reported after a long delay. Thus, the legislation could be expected to reduce but not eliminate backdating. The patterns of CEO luck are consistent with this expectation: the percentage of grants that were lucky was a high 15 percent before enactment of the law, and declined to a lower, but still abnormally high, level of 8 percent afterwards.
Altogether, we estimate that about 1,150 CEO stock-option grants owed their financially advantageous status to opportunistic timing rather than to mere luck. This practice was spread over a significant number of CEOs and firms: we estimate that about 850 CEOs (about 10 percent) and about 720 firms (about 12 percent) received or provided such lucky grants. In addition, we estimate that about 550 additional grants at the second-lowest or third-lowest price of the month owed their status to opportunistic timing.
The cases that have come under scrutiny thus far have led to a widespread impression that opportunistic timing has been primarily concentrated in “new economy” firms. But while the frequency of lucky grants has been somewhat higher in such firms, more than 80 percent of the opportunistically timed grants have been awarded in other sectors. Indeed, there is a significantly higher-than-normal incidence of lucky grants in each of the economy’s 12 industries.
1 | 2 | 3 | continued >
