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Undermining incentives: CEO reactions to compensation rebalancing

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Abstract

Directors commonly “punish” CEOs for overly risky behavior by rebalancing their compensation to include more restricted stock and fewer stock options. This paper extends the behavioral-agency model to describe how CEOs will manage their holdings of stock and stock options in response to this form of compensation rebalancing. In doing so, it finds that CEOs respond by selling existing stock holdings and accumulating option holdings. This behavior achieves the opposite incentive structure that such rebalancing intends to create, raising questions about the effectiveness of compensation rebalancing in reducing risky decision making.

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Notes

  1. Compensation packages can be rebalanced in any number of ways. Presumably, boards could redesign pay packages to increase risk-incentives, better link pay with performance, or better match industry norms. Within this study, we narrowly study the replacement of annual stock option grants with new annual restricted stock grants because our research question explores how CEOs can potentially undermine that specific type of compensation package rebalancing.

  2. Performance bonuses are a third significant mechanism that firms employ to align financial incentives, but because our research question regards the stock and option exercise behavior of executives, we limit the scope of our study to the asymmetry between stock and stock options.

  3. Stock options gifted to executives of U.S. companies typically vest in 3–5 years, expire at the end of 10 years, and have an exercise price set equal to the current stock price at the time of the award (Ofek and Yermack 2000).

  4. Formally, shares of stock and stock options do not exactly map to the constructs of current and prospective wealth as noted by Larraza-Kintana et al. (2007) and Martin et al. (2013). Shares of stock could rise in value—and that future increase would be prospective wealth. Old stock options could have a current value—which would be current wealth. However, a share of stock’s current wealth is typically far greater than its future potential gain in wealth. And typically the value in a stock option is in its potential for gain instead of its current value. As mentioned earlier, empirical work has similarly demonstrated that restricted stock deters risky behavior while stock options encourage it (e.g., Rajgopal and Shevlin 2002; Sanders 2001). Thus, we find the current wealth and prospective wealth constructs to be very useful for describing the dualistic risk effects of stock and stock options. Nonetheless, we do control for any current value of stock options in our analysis.

  5. Although new stock grants are typically restricted and unable to be sold immediately, prior researchers have found consistent evidence that executives simply sell unrestricted shares they already own on a one-for-one basis to nullify the effects of new restricted share grants (Jin and Kothari 2008; Ofek and Yermack 2000). Since overall risk-aversion will be based on the overall value of existing stock holdings, and not exclusively new grants, we find no reason to argue that this finding will not hold true in our case.

  6. It is worth noting that we do not necessarily expect that the accumulation of stock options will result in a greater preference for risk post-rebalancing versus pre-rebalancing. We only expect that the accumulation of options will be linked to more risky decisions vis-a-vis the non-accumulated case. Whether the accumulation of stock options leads to an increase or reduction in risky decisions relative to the pre-rebalancing case is not immediately clear and we leave for future empirical exploration.

  7. It is worth noting that to some extent the opposite behavior, including the increased exercise of stock options when faced with an increase in option grants, is likely and consistent with the mean-reversion behavior found by Ofek and Yermack (2000). However, we find it less convincing that an increase in annual option awards will result in a decrease in total option holdings or that acquisition-seeking CEOs will adjust their exercise behavior to reduce the incentives to pursue future acquisitions when faced with additional stock option grants.

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  1. College of Business, University of Mary Washington, 1301 College Avenue, Fredericksburg, VA, 22401, USA

    John S. Marsh & Rachel Graefe-Anderson

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  1. John S. Marsh
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Correspondence to John S. Marsh.

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Marsh, J.S., Graefe-Anderson, R. Undermining incentives: CEO reactions to compensation rebalancing. J Manag Gov 22, 365–391 (2018). https://doi.org/10.1007/s10997-017-9391-7

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