GEORGE RYAN HUSTON, Florida State University - Department of Accounting
Email: rhuston@cob.fsu.edu
THOMAS JOSEPH SMITH, Florida State University
Email: tomsmith2465@yahoo.com

This paper extends prior stock option literature by examining whether individual and corporate tax incentives are associated with the decision to hold shares acquired through option exercises. Aboody, Hughes, Liu, and Su (2008) refute the previously-held assumption that individuals immediately sell shares acquired through option exercise. We extend their work by focusing on the trade-off between tax incentives and the costs of holding, including liquidity constraints, opportunity costs, and future share price decline. We find that insiders hold shares for at least a year in 18.26 percent of exercises. Additionally, insiders are more likely to hold shares obtained through exercise of ISOs (specifically ISOs that are deeper in the money) relative to NQSOs, as ISOs allow for the transfer of pre-exercise gains from ordinary income to capital gain treatment. Finally, we find corporate tax incentives associated with employee stock sales mitigate insiders’ likeliness to hold.

LIU ZHENG, University of Hong Kong - Faculty of Business and Economics
Email: lzheng@business.hku.hk
XIANMING ZHOU, University of Hong Kong - School of Economics and Finance
Email: xianming.zhou@hku.hk

Existing studies have extensively examined how executive stock options are awarded, exploring various factors including manipulation. In this study we ask whether and how executive options affect shareholder value. We address this issue by examining stock-price performance surrounding chief executive officer (CEO) turnover, focusing on retiring CEOs. Retiring CEOs are often with high stock option holdings that are to expire shortly after their departure, and hence are expected to have strong option-induced incentives either to enhance or to manipulate the firm’s performance. We document evidence in support of managerial manipulations that cause a short-term valuation effect in favor of stock option exercises.

SUDARSHAN JAYARAMAN, Washington University, St. Louis - John M. Olin School of Business
Email: jayaraman@wustl.edu
TODD T. MILBOURN, Washington University, St. Louis - John M. Olin School of Business
Email: milbourn@olin.wustl.edu

Recent studies interpret a positive association between equity-based compensation and the probability of a lawsuit for financial statement misrepresentation or fraud as evidence that such pay plans lead to managerial impropriety. However, these associations do not consider the simultaneous relation between equity-based compensation and litigation risk. Consistent with recent theoretical models that predict that firms will grant more equity-based compensation when the probability of detection of misrepresentation is high, we find that firms that operate in ex ante high litigation risk environments grant more equity-based compensation to their CEOs. Controlling for this effect of litigation risk on equity-based compensation, we find no evidence that higher equity-based compensation causally affects the probability of a lawsuit. Further, while sued firms see more option exercises in the year before the lawsuit, these exercises as a percentage of annual option grants are not significantly different from those of firms that are not sued. Stock options may cause all sorts of bad behavior, but our results here do not support a causal link between equity-based incentives and the probability of a lawsuit.

MIRIAM A. CHERRY, University of the Pacific (UOP) - McGeorge School of Law, University of Georgia Law School
Email: macherry@samford.edu
JARROD WONG, University of the Pacific - McGeorge School of Law
Email: jwong@pacific.edu

In the spring of 2009, public outcry erupted over the multi-million dollar bonuses paid to AIG executives even as the company was receiving TARP funds. Various measures were proposed in response, including a 90% retroactive tax on the bonuses, which the media described as a "clawback." Separately, the term "clawback" was also used to refer to remedies potentially available to investors defrauded in the multi-billion dollar Ponzi scheme run by Bernard Madoff. While the media and legal commentators have used the term "clawback" reflexively, the concept has yet to be fully analyzed. In this article, we propose a doctrine of clawbacks that accounts for these seemingly variant usages. In the process, we distinguish between retroactive and prospective clawback provisions, and explore the implications of such provisions for contract law in general. Ultimately, we advocate writing prospective clawback terms into contracts directly, or implying them through default rules where possible, including via potential amendments to the law of securities regulation. We believe that such prospective clawbacks will result in more accountability for executive compensation, reduce inequities among investors in certain frauds, and overall have a salutary effect upon corporate governance.

RICHARD A. BOOTH, Villanova University School of Law
Email: booth@law.villanova.edu

Stock options are the primary form of compensation for CEOs because they are the best way to align the interests of CEOs with those of diversified stockholders. Nevertheless, critics argue that the use of stock options leads to excessive pay because there is no effective bargaining between the CEO and the board of directors about the number of options to award. They argue that the cost is underestimated by boards and hidden from stockholders and that options induce CEOs to undertake risky business strategies. None of these objections withstands scrutiny. First, there is little reason to believe that options have resulted in excessive CEO compensation. Although CEO pay has increased dramatically in absolute terms, data show that total executive pay as a percentage of corporate income – including gain from the exercise of options – has remained quite stable since 1982. This is true even though equity compensation grew from a negligible amount to as much as 75% of CEO pay by the year 2000. It would thus appear that equity compensation has been substituted for cash compensation and that a larger share of aggregate pay goes to those who succeed in increasing stock price. Second, options are subject to powerful market forces that effectively control their use. Using options as compensation effectively requires a corporation to repurchase shares to control for dilution. Because cash is scarce, there is a natural limit on the number of options that a corporation can grant. In addition, stock options confer significant benefits that are difficult to achieve with other forms of compensation. Aside from the fact that options induce corporations to distribute cash in the form of repurchases to control for dilution, options also convey significant information to the market about a company’s prospects, because the need to repurchase stock requires the company to estimate future cash flows in deciding how many options to grant. Finally, options provide an unbiased incentive for acquisitions when appropriate and for divestitures when appropriate. Thus, options make sense for both growing companies and mature companies. Although other forms of incentive compensation may provide some of the same benefits as stock options, they are ultimately inferior to options. For example, restricted stock rewards the CEO who increases stock price, but it may also induce the CEO to engage in conservative business strategies designed primarily to avoid losses rather than generate gains, contrary to the interests of diversified investors. And the traditional bonus based on earnings may induce CEOs to grow the business by retaining cash and investing it in new but suboptimal ventures. To be sure, stock options can be abused through such practices as timing and backdating. But these problems can be addressed by announcing option grants in advance of fixing the strike price. Moreover, it is quite easy to design an option that addresses the problem of overvalued equity and eliminates the incentive to maintain a stock price that is inappropriately high. By indexing exercise price downward, options can provide an incentive for CEOs to minimize losses in falling markets. In light of the numerous advantages of options as compared to other forms of incentive compensation, it appears that complaints about executive pay are based largely on ex post results. From an ex ante perspective, investors are not likely to object to options because with options the CEO gains only if and to the extent that stockholders gain. Indeed, as a result of the use of options as compensation, it is arguable that the model of the corporation as one owned by the stockholders has evolved into something more like a partnership between stockholders and officers in which the officers work for an ownership share of the business. Under this model, the board of directors may be seen primarily as an arbiter between these two groups for purposes of dividing up the gain rather than as an active manager of the business. But even under the prevailing stockholder ownership model, it is the supposed duty of the directors and officers to maximize stockholder value. In practice, there are few situations in which that duty is enforced as a matter of law. Options fill the gap.

KENNETH ROBERT DAVIS, Fordham University - College of Business Administration - Legal and Ethical Studies
Email: kedavis@fordham.edu

Executive compensation has come to mean corporate greed. CEO pay has soared to incomprehensible levels. Even during the current financial crisis, more CEOs saw pay increases than cuts. Public resentment to multi-million dollar paychecks swelled to outrage when AIG and Merrill Lynch used bailout funds to dispense enormous bonuses to executives. The looting of America’s corporations has led to numerous strategies to curb executive compensation. These strategies include heightened corporate disclosure requirements, tax incentives, say-on-pay, and shareholder input into the process for nominating directors. All these strategies have failed and will continue to fail to control executive pay because they do not grapple with the problem directly. This Article proposes a framework that will enable corporations to pass bylaws to establish Shareholder Compensation Committees. Such Committees would have the authority to review, and, if appropriate, to make counter proposals to the recommendations of the director compensation committee for compensation packages for the CEO, CFO, three next most highly paid executives, and the chairperson of the board. Both sets of proposals would appear on the company’s proxy materials. Shareholders would have a binding vote to decide between the competing proposals. This approach would prevent directors from supporting the greed of executives rather than the interests of the corporations they ostensibly serve. It would vest the decision to set pay levels where it belongs - with shareholders.

BO SUN, Board of Governors of the Federal Reserve System - Division of International Finance - International Banking and Finance Section
Email: bo.sun@frb.gov

The paper investigates the optimal structure of executive compensation with the possibility of financial data manipulation. We characterize the optimal compensation contract analytically, and establish necessary and sufficient conditions for earnings management to occur. The model shows that the optimal pay-performance sensitivity increases with the possibility of manipulation, and thus provides an explanation for the positive association between earnings management and incentive compensation observed in both time series and cross section. In addition, the model’s predictions regarding the changes of earnings management behavior and executive compensation structure in response to corporate governance legislations are consistent with empirical observations.