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Abstract:
Stock and option compensation and the level of managerial equity incentives are aspects of corporate governance that are especially controversial to shareholders, institutional activists, and governmental regulators. Similar to much of the corporate finance and corporate governance literature, research on stock-based compensation and incentives has generated not only useful insights, but also has produced many contradictory findings. However, not surprisingly, many fundamental questions remain to be answered. In this survey, we synthesize the broad literature on equity compensation and executive incentives, and highlight topics that seem especially appropriate for future research.

Executive compensation; Stock options; Equity incentives; Corporate governance

Abstract:
Healy and Palepu (2001) provide a broad review of the empirical disclosure literature. This discussion expands on their survey of the empirical voluntary disclosure literature, and offers more specific suggestions for future research.

Abstract:
Healy and Palepu (2001) provide a broad review of the empirical disclosure literature. This discussion expands on their survey of the empirical voluntary disclosure literature, and offers more specific suggestions for future research.

Abstract:
We find mixed support for the hypothesis that a "New Economy" subperiod occurred in the late 1990s in which the relation between equity value and traditional financial variables differs from previous periods. We examine a regression model of equity value on financial variables over 25 years for a broad firm sample and for firm subsamples thought to be emblematic of the New Economy. We find the regression model's explanatory power declined in the New Economy subperiod for all firm subsamples. However, for all subsamples, the regression model's structure during the New Economy subperiod is not unusual compared to other subperiods.

capital markets, equity valuation, New Economy

Abstract:
The acceleration of globalization combined with rapid advances in technology and the growing importance of the Internet have led many researchers and practitioners to suggest that a "New Economy" has evolved in which equity valuation is different than in previous periods. We examine the explanatory power and stability of a regression model of equity value on traditional financial variables for a broad sample of firms over the past 25 years and investigate how equity valuation has changed in the recent New Economy sub-period. We also examine subsamples of high-technology firms, young firms, and young firms with losses that are thought to be emblematic of the New Economy. We find that the explanatory power of the regression model declined in recent years for all subsamples of firms. However, for all subsamples of firms, we find that the structure of the regression model is quite stable during the New Economy sub-period, as compared to other sub-periods. Together, these results suggest that traditional explanatory variables of equity value remain applicable to firms in the New Economy sub-period, but that there is greater variation remaining to be explained by uncorrelated omitted factors.

Abstract:
The costs associated with compiling data on employee stock
option portfolios is a substantial obstacle in investigating
the impact of stock options on managerial incentives,
accounting choice, financing decisions, and the valuation of
equity. We present an accurate method of estimating option
portfolio value and the sensitivities of option portfolio
value to stock price and stock-return volatility that is
easily implemented using data from only the current year's
proxy statement or annual report. This method can be applied
to either executive stock option portfolios or to firm-wide
option plans. In broad samples of actual and simulated CEO
option portfolios, we show that these proxies capture more
than 99% of the variation in option portfolio value and
sensitivities. Sensitivity analysis indicates that the degree
of bias in these proxies varies with option portfolio
characteristics, and is most severe in samples of CEOs
with a large proportion of out-of-the-money options. However,
the proxies' explanatory power remains above 95% in all
subsamples.

Employee stock options; Incentives; Executive compensation

Abstract:
The costs associated with compiling data on employee stock option portfolios is a substantial obstacle in investigating the impact of stock options on managerial incentives, accounting choice, financing decisions, and the valuation of equity. We present an accurate method of estimating option portfolio value and the sensitivities of option portfolio value to stock price and stock-return volatility that is easily implemented using data from only the current year?s proxy statement or annual report. This method can be applied to either executive stock option portfolios or to firm-wide option plans. In broad samples of actual and simulated CEO option portfolios, we show that these proxies capture more than 99% of the variation in option portfolio value and sensitivities. Sensitivity analysis indicates that the degree of bias in these proxies varies with option portfolio characteristics, and is most severe in samples of CEOs with a large proportion of out-of-the-money options. However, the proxies' explanatory power remains above 95% in all subsamples.

Abstract:
In this paper, we derive a measure of diluted EPS that incorporates the economic implications of the dilutive effects of employee stock options. We show that the existing FASB treasury-stock method of accounting for the dilutive effects of outstanding options systematically understates the options' dilutive effect, and thus overstates reported EPS. Using firm-wide data on 731 employee stock option plans, our proposed measure suggests that economic dilution from options is, on average, 100 percent greater than dilution in reported diluted EPS using the FASB treasury-stock method.

We examine the implications of our analysis for stock price valuation, the price-earnings relation, and the return-earnings relation. We demonstrate analytically that when firms have options outstanding, empirical applications of equity valuation models that use reported per-share earnings as an input (e.g., Ohlson 1995) yield upwardly-biased estimates of the market value of common stock. We predict that when the difference between our measure of economic dilution from options and the FASB treasury-stock method dilution from options is greater, the observed return-earnings and price-earnings coefficients will be smaller, and we provide some (albeit weak) empirical support for this prediction.

Employee stock options, Dilution, Diluted earnings per share, Earnings response coefficients, Equity valuation

Abstract:
We derive a measure of diluted EPS that incorporates economic implications of the dilutive effects of employee stock options. We show that the existing FASB treasury-stock method of accounting for the dilutive effects of outstanding options systematically understates the dilutive effect of stock options, and thereby overstates reported EPS. Using firm-wide data on 731 employee stock option plans, we find that economic dilution from options in our proposed measure of options-diluted EPS is, on average, 100% greater than dilution in reported diluted EPS using the FASB treasury-stock method.

We examine the implications of our analysis for stock price valuation, the price-earnings relation, and the return-earnings relation. We demonstrate analytically that when firms have options outstanding, empirical applications of equity valuation models that use reported per share earnings as an input (e.g., Ohlson, 1995), yield upwardly biased estimates of the market value of common stock. We predict that observed return-earnings and price-earnings coefficients are expected to be smaller the greater the difference between our measure of economic dilution from options and FASB treasury-stock method dilution from options, and provide weak empirical support for this prediction.

Abstract:
We investigate Gompers, Ishii, and Metrick's (2003) finding that firms with weak shareholder rights exhibit significant stock market underperformance. If the relation between poor governance and poor returns is causal, we expect that the market is negatively surprised by the poor operating performance of weak governance firms. We find that firms with weak shareholder rights exhibit significant operating underperformance. However, analysts' forecast errors and earnings announcement returns show no evidence that this underperformance surprises the market. Our results are robust to controls for takeover activity. Overall, our results do not support the hypothesis that weak governance causes poor stock returns.

Corporate governance, market efficiency, analysts

Abstract:
We investigate Gompers, Ishii, and Metrick's (2003) finding that firms with weak shareholder rights exhibit significant stock market underperformance. If the relation between poor governance and poor returns is causal, we expect that the market is negatively surprised by the poor operating performance of weak governance firms. We find that firms with weak shareholder rights exhibit significant operating underperformance. However, analysts' forecast errors and earnings announcement returns show no evidence that this underperformance surprises the market. Our results are robust to controls for takeover activity. Overall, our results do not support the hypothesis that weak governance causes poor stock returns.

This is a revised version of a paper previously titled 'Does Weak Governance Cause Weak Stock Returns? An Examination of Firm Operating Performance and Analysts' Expectations' that was originally posted on April 21, 2004.

Corporate Governance, Market Efficiency, Analysts

Abstract:
We examine whether managers' trading decisions (both at a firm and personal level) are correlated with trading strategies suggested by the operating accruals and the post-earnings announcement drift (SUE) anomalies. We discuss advantages and disadvantages of the use of managerial trading activity to infer managers' private valuation about their own securities. Our results provide corroborative evidence for the accruals anomaly, i.e., managers' repurchase and insider trading behavior varies consistently with the information underlying the operating accruals trading strategy. On the other hand, we do not find corroborative evidence for the SUE anomaly.

Accruals, SUE, share repurchases, insider trading

Abstract:
We examine whether managers' trading decisions (both at a firm and personal level) are correlated with trading strategies suggested by the operating accruals and the post-earnings announcement drift (SUE) anomalies. We discuss advantages and disadvantages of the use of managerial trading activity to infer managers' private valuation about their own securities. Our results provide corroborative evidence for the accruals anomaly, i.e., managers' repurchase and insider trading behavior varies consistently with the information underlying the operating accruals trading strategy. On the other hand, we do not find corroborative evidence for the SUE anomaly.

Accruals, SUE, share repurchases, insider trading

Abstract:
In this paper, we review Pay Without Performance by Professors Lucian Bebchuk and Jesse Fried. The book develops and summarizes the leading critiques of current executive compensation practices in the U.S., and offers a negative, if mainstream, assessment of the state of U.S. executive compensation: U.S. executive compensation practices are failing, and systemic reform is needed. This review summarizes the book in some detail and offers some counter-arguments.

The book's thesis is that executive compensation practices are bad for shareholders (not "optimal") because they are the product of "managerial power." Managerial power arises because boards of directors at public companies are not independent of executives. Weak compensation committees thus do little to protect the firm in its pay negotiations with the CEO, leading to levels of executive pay that are both inappropriately high and have inappropriately low levels of incentives.

The authors offer a four part analysis of CEO pay. First, they describe and critique optimal contracting theory, which posits that executive compensation arrangements are designed to benefit shareholders. Second, they explain managerial power theory, in part through an in-depth analysis of current executive compensation practices. They assert the managerial power theory provides a superior explanation of current practices to the optimal contracting perspective. They also draw the strong implication that if managerial power exists, it means that something is wrong with the contracting process. Third, they claim that CEO compensation does not vary sufficiently with firm performance. They conclude with policy recommendations for changing compensation plans and improving corporate governance, for example by requiring that directors be more independent.

We agree that it is useful to consider the effect of managerial power on compensation, but we disagree with their interpretation of the consequences of this power. It is true that contract structures reflect CEO power, and that CEOs with more power get more pay, but this does not necessarily lead to the conclusion that CEO pay is not optimized for shareholders, nor does it imply that CEO pay needs reform. We show that in many settings where managerial power exists, observed contracts anticipate and try to minimize the costs of this power, and therefore may in fact be written optimally. As a result, the optimal contracting and managerial power perspectives are complementary, and not competing, explanations.

We next examine Bebchuk and Fried's claim that U.S. compensation is inefficient "pay without performance." Their analysis focuses on whether CEO annual pay varies with firm performance. While the book conducts an extensive analysis of the incentives provided by annual grants of stock options and equity it largely ignores the main source of CEO incentives: Large holdings of stock and options. These large equity holdings provide powerful performance incentives and ensure that the wealth of most CEOs varies strongly with their firm's stock price. The books' claim that CEO compensation is "pay without performance" does not appear correct once one considers this main source of CEO incentives. U.S. executives have very large pay-performance incentives, and their overall pay levels do not seem inappropriate.

We conclude by examining some of Bebchuk and Fried's policy recommendations. Bebchuk and Fried have missed some important aspects of executive pay and incentives. They have not shown that there are systematic failures with U.S. CEO compensation, and therefore have not shown that reform is needed.

CEO compensation, stock options, equity incentives, corporate governance

Abstract:
Stock and option compensation and the level of managerial equity incentives are aspects of corporate governance that are especially controversial to shareholders, institutional activists, and governmental regulators. Similar to much of the corporate finance and corporate governance literature, research on stock-based compensation and incentives has generated not only useful insights, but also has produced many contradictory findings. Not surprisingly, many fundamental questions remain unanswered. In this article, the authors synthesize the broad literature on equity-based compensation and executive incentives, and highlight topics that seem especially appropriate for future research.

Executive compensation, stock options, equity incentives, corporate governance

Abstract:
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.

Abstract:
We examine the press' role in monitoring and influencing executive compensation practice using more than 11,000 press articles about CEO compensation from 1994 to 2002. Negative press coverage is more strongly related to excess annual pay than to raw annual pay, suggesting a sophisticated approach by the media in selecting CEOs to cover. However, negative coverage is also greater for CEOs with more option exercises, suggesting the press engages in some degree of "sensationalism." We find little evidence that firms respond to negative press coverage by decreasing excess CEO compensation or increasing CEO turnover.

press, media, executive compensation, corporate governance

Abstract:
We examine the press' role in monitoring and influencing executive compensation practice using more than 11,000 press articles about CEO compensation from 1994 to 2002. Negative press coverage is more strongly related to excess annual pay than to raw annual pay, suggesting a sophisticated approach by the media in selecting CEOs to cover. However, negative coverage is also greater for CEOs with more option exercises, suggesting the press engages in some degree of "sensationalism." We find little evidence that firms respond to negative press coverage by decreasing excess CEO compensation or increasing CEO turnover.

press, media, executive compensation, corporate governance

Abstract:
In a recent and influential empirical paper, Francis, LaFond, Olsson, and Schipper (2005) conclude that accruals quality (AQ) is a priced risk factor. We explain that FLOS' regressions examining a contemporaneous relation between excess returns and factor returns do not test the hypothesis that AQ is a priced risk factor. We conduct appropriate asset-pricing tests for determining whether a potential risk factor explains expected returns, and find no evidence that AQ is a priced risk factor.

Asset-pricing tests, Accruals quality, Information risk, Portfolio theory and diversification

Abstract:
In a recent and influential empirical paper, Francis, LaFond, Olsson, and Schipper (2005) conclude that accruals quality (AQ) is a priced risk factor. We explain that FLOS' regressions examining a contemporaneous relation between excess returns and factor returns do not test the hypothesis that AQ is a priced risk factor. We conduct appropriate asset-pricing tests for determining whether a potential risk factor explains expected returns, and find no evidence that AQ is a priced risk factor.

Asset pricing tests, Accruals quality, Information risk, Portfolio theory and diversification

Abstract:
We examine the determinants of options outstanding, grants, and exercises by non-executive employees. Using hand-collected data on options outstanding, grants, and exercises for a broad cross-section of 795 large firms for the years 1994 to 1997, we create measures of option values and incentives for both executive (top 5) employees and non-executive employees. We find that firms have committed large fractions of firm value to option plans, that a majority of these options are distributed to non-executives, and that substantial cross-sectional variation exists with respect to the fraction of the option plan that is distributed to non-executives.

We provide strong evidence that firms use options to a greater extent when they face capital requirements and financing constraints. This finding is consistent with cash constrained firms using stock option compensation in lieu of cash compensation. Our empirical results are also broadly consistent with the hypothesis that options held by non-executives vary as predicted by theory relating the distribution of equity incentives to firm characteristics. However, we find little evidence that firms manage the level of option plan incentives through the annual grant of options, suggesting that the corporate use of non-executive option plans is still evolving. In our cross-sectional regressions of annual exercises, we find strong evidence that the psychological reference point bias documented by Heath, Huddart, and Lang (1999) is valid in a broad sample of large corporations.

Abstract:
In contrast to a body of research starting with Demsetz and Lehn (1985) that predict and find a strong positive association between firm percent return variance and incentives, Aggarwal and Samwick (1999) predict and find a strong negative association between firm dollar return variance and incentives. A key assumption of Aggarwal and Samwick's analysis is that firm risk is the sole determinant of the pay-performance sensitivity, and that expected dollar return variance (the product of expected percent return variance and firm market value) is the correct proxy for risk. We demonstrate that dollar return variance is a noisy measure of firm market value and argue that A&S re-documents a size effect that is already well-known from prior literature. Because dollar return variance is shown to be a noisy proxy for firm size, the A&S empirical specification does not include an appropriate proxy for firm risk. The data consistently show that it is important to examine market value and percent return variance as separate determinants of the effects of size and risk on CEO incentives, as is done in the managerial ownership literature. In a model of CEO incentives that includes market value and risk as separate explanatory variables, we find that, contrary to the results in A&S, percent return variance is positively associated with incentives. The A&S empirical work cannot be interpreted as evidence of a negative relation between risk and incentives.

incentives, risk, uncertainty, standard agency model, managerial ownership

Abstract:
We examine the determinants of the stock and flow of CEO equity incentives. We define equity incentives as the total incentives provided by the CEO's holdings of stock and options, and we assume that firms have a target level of equity incentives for their CEOs. We model target incentive levels and use residuals from this model as a measure of the deviation between the CEO's existing level of incentives and the target level. Consistent with our hypothesis that firms use the flow of new incentives to correct deviations in the stock of incentives, we find that grants of new equity incentives to CEOs are negatively related to this residual. Grants of new equity incentives are positively associated with firm performance and average incentive grants are larger for firms with greater growth opportunities. Cash compensation is lower when firms make incentive grants to adjust CEOs? portfolio incentives back to the target level. This finding is consistent with our hypothesis that firms substitute cash compensation for equity compensation when equity compensation is used to adjust portfolio incentive levels. Overall, we find that firms effectively use grants of equity incentives to reward past performance and to re-optimize incentives for future performance.

Abstract:
We examine determinants of non-executive employee stock options outstanding, grants, and exercises for 756 firms during 1994 to 1997. We find that firms use greater stock option compensation when facing capital requirements and financing constraints. Our results are also consistent with firms using options to attract certain types of employees, provide retention incentives, and create incentives to increase firm value. After controlling for economic determinants and stock returns, option exercises are greater (less) when the firm's stock price hits 52-week highs (lows), which confirms in a broad sample the psychological bias documented by Heath, Huddart, and Lang (1999).

Employee stock options, Compensation, Equity incentives

Abstract:
We examine determinants of non-executive employee stock options outstanding, grants, and exercises for 756 firms during 1994 to 1997. We find that firms use greater stock option compensation when facing capital requirements and financing constraints. Our results are also consistent with firms using options to attract certain types of employees, provide retention incentives, and create incentives to increase firm value. After controlling for economic determinants and stock returns, option exercises are greater (less) when the firm's stock price hits 52-week highs (lows), which confirms in a broad sample the psychological bias documented by Heath, Huddart, and Lang (1999).

Employee stock options, Compensation, Equity incentives

Abstract:
Using a sample of D&O premiums gathered from the proxy statements of Canadian companies, this article examines the D&O premium as a measure of ex ante litigation risk. I find a significant association between D&O premiums and variables that proxy for the quality of firms' governance structures. The association between the proxies for governance structure quality and D&O premiums is robust to a number of alternative specifications. This article provides confirmatory evidence that the D&O premium reflects the quality of the firm's corporate governance by showing that measures of weak governance implied by the D&O premium are positively related to excess CEO compensation. The overall results suggest that D&O premiums contain useful information about the quality of firms' governance.

Abstract:
Using a sample of D&O premiums gathered from the proxy statements of Canadian companies, this article examines the D&O premium as a measure of ex ante litigation risk. I find a significant association between D&O premiums and variables that proxy for the quality of firms' governance structures. The association between the proxies for governance structure quality and D&O premiums is robust to a number of alternative specifications. This article provides confirmatory evidence that the D&O premium reflects the quality of the firm's corporate governance by showing that measures of weak governance implied by the D&O premium are positively related to excess CEO compensation. The overall results suggest that D&O premiums contain useful information about the quality of firms' governance.

Abstract:
We examine a sample of firms that adopt "target ownership plans," under which managers are required to own a minimum amount of stock. We find that prior to plan adoption, such firms exhibit low managerial equity ownership and low stock price performance. Managerial equity ownership increases significantly in the two years following plan adoption. We also observe that excess accounting returns and stock returns are higher after the plan is adopted. Thus, for our sample of firms, the required increases in the level of managerial equity ownership result in improvements in firm performance.

Managerial ownership; Corporate governance; Financial performance

Abstract:
We examine a sample of firms that adopt "target ownership plans," under which managers are required to own a minimum amount of stock. We find that prior to plan adoption, such firms exhibit low managerial equity ownership and low stock price performance. Managerial equity ownership increases significantly in the two years following plan adoption. We also observe that excess accounting returns and stock returns are higher after the plan is adopted. Thus, for our sample of firms, the required increases in the level of managerial equity ownership result in improvements in firm performance.

Managerial ownership; Corporate governance; Financial performance

Abstract:
We empirically examine standard agency predictions about how performance measures are optimally weighted to provide CEO incentives. Consistent with prior empirical research, we document that the relative weight on price and non-price performance measures in CEO cash pay is a decreasing function of the relative variances. Agency theory speaks to the weights in total compensation (annual total pay and changes in the CEO's equity portfolio value), however, and we document that very little of CEOs' total incentives come from cash pay. We also document that variation in the relative weight on price and non-price performance measures in CEO total compensation is an increasing function of the relative variances. The conflicting results using total compensation indicate that existing findings on cash pay cannot be interpreted as evidence supporting standard agency predictions. Based on our results, we suggest approaches for future research on performance measure use in CEO total compensation.

agency theory, cash pay, total compensation, equity incentives

Abstract:
We empirically examine standard agency predictions about how performance measures are optimally weighted to provide CEO incentives. Consistent with prior empirical research, we document that the relative weight on price and non-price performance measures in CEO cash pay is a decreasing function of the relative variances. Agency theory speaks to the weights in total compensation (annual total pay and changes in the CEO's equity portfolio value), however, and we document that very little of CEOs' total incentives comes from cash pay. We also document that variation in the relative weight on price and non-price performance measures in CEO total compensation is an increasing function of the relative variances. The conflicting results using total compensation indicate that existing findings on cash pay cannot be interpreted as evidence supporting standard agency predictions. Based on our results, we suggest approaches for future research on performance measure use in CEO total compensation.

agency theory, cash pay, total compensation, equity incentives

Abstract:
We model how a firm motivates a risk-averse CEO not only to exert productive effort but also to evaluate and to adopt new projects. Evaluation effort produces better information on risky projects, but the agent may reject a good project in order to avoid risk. Productive effort increases the mean of firm value but the agent faces uncertainty in his productivity due to the externality created by the new project. We examine the effect of uncertainty about the success of the new project on contract slope and convexity. The convexity in the contract protects the agent from uncertainty about the success of the new project, and the contract is more convex when uncertainty is greater. The contract slope encourages the agent to work on both tasks and to make the right project choice. We show conditions under which increases in uncertainty about the success of the new project cause increases in the contract slope. This positive relation between contract slope and uncertainty contrasts with the standard agency model's prediction of a decreasing relation. The features of the optimal contract are broadly consistent with prior empirical evidence on cross-sectional variation in CEO incentives. In addition our model suggests that there can be two groups of firms. The first group of firms has high uncertainty, and there is an increasing relation between risk and CEO incentives. The second group of firms has lower uncertainty, and there is the traditional decreasing relation between risk and CEO incentives.

Risk and uncertainty; Project selection; Multi-task principal-agent problem; Optimal contract; Contract slope and convexity

Abstract:
A growing body of literature suggests that because an executive is risk-averse and undiversified, he values equity compensation and incentives at less than market value. This discount on valuation is driven by the assumption that the executive is constrained from rebalancing his portfolio following an equity grant, and as such, the payment of equity compensation permanently increases the risk and incentives borne by the executive. We relax this exogenous assumption, and assume that firms contract with their executives and agree upon a specified level of risk. Firms expect and require that executives rebalance their portfolios when equity risk rises above or falls below the contracted level. Under these assumptions, we show that the executive does not discount the value of equity compensation or changes in the value of his equity portfolio.

The notion that firms write contracts that require executives to hold equity also suggests that executive contracts are more consistent with relative performance evaluation than has been found in prior empirical research. Specifically, this type of contract requires executives to reduce the fraction of their total wealth held in a well-diversified portfolio and to increase their investment in firm equity.

Stock options, Option valuation, Contracting, Equity incentives, Managerial compensation, Managerial ownership

Abstract:
We compute and compare risk-adjusted pay for US and UK CEOs, where the adjustment is based on estimated risk premiums stemming from the equity incentives borne by CEOs. Controlling for firm and industry characteristics, we find that US CEOs have higher pay, but also bear much higher stock and option incentives than UK CEOs. Using reasonable estimates of risk premiums, we find that risk-adjusted US CEO pay does not appear large compared to that of UK CEOs. We also examine differences in pay and equity incentives between a sample of non-UK European CEOs and a matched sample of US CEOs, and find that risk-adjusting pay may explain about half of the apparent higher pay for US CEOs.

CEO compensation, equity incentives, corporate governance, international comparisons

Abstract:
A growing body of literature suggests that because risk-averse executives are undiversified, they value equity compensation at significantly less (over 30%) than market value. This valuation discount is driven by the assumptions that the firm ignores existing incentives when it grants equity, and does not allow executives to buy or sell firm stock for a multi-year period following a grant. We instead assume that firms contract efficiently, which means that contracts require executives to hold precise amounts of incentives (e.g., Holmstrom, 1979). Under this efficient contracting assumption, we show that executive discounts to the value of equity compensation are small (less than 6%). Finally, when firms write efficient contracts over executive wealth, these contracts are consistent with relative performance evaluation: they require executives to increase their exposure to firm-specific risk by reducing (increasing) the amount of wealth they hold in diversified portfolios (firm equity).

stock options, option valuation, contracting, equity incentives, managerial compensation, managerial ownership

Abstract:
Critics of U.S. executive pay practices have raised four major concerns: (1) executive pay is too high; (2) CEO contracts do not provide strong enough incentives to increase value (i.e., there is too little pay-for-performance); (3) options and other equity-based pay provide windfalls, large payoffs that reflect good luck more than good performance; and (4) CEOs have too much freedom to unwind their incentives. This negative, and increasingly mainstream, assessment of the state of U.S. executive compensation has led many observers to conclude that executive pay practices are fundamentally flawed and that systemic reform is needed. We shed light on these perceived problems with executive pay and, in so doing, provide some balance to what we find to be an increasingly one-sided debate. Our key points are that: (1) CEOs' stock and option holdings provide powerful incentives to increase value, and this is true regardless of whether or not annual pay varies with firm performance; (2) recent growth in annual pay may well be appropriate to compensate CEOs for recent growth in incentive risk borne through their stock and option holdings, and due to the increasing size and complexity of U.S. firms; (3) when viewed as a combination of market risk and firm-specific risk, conventional (that is, unindexed) stock and options may provide a simultaneous solution to shareholders' demand for executive rewards tied to company performance, and executives' preference to diversify their wealth; (4) U.S. CEOs show little evidence of widespread unwinding of incentives, and in cases where CEOs have too much incentives, it is appropriate to allow and encourage the CEO to exercise options and sell stock to rebalance her portfolio.

CEO, compensation, corporate governance, incentives

Abstract:
We model how firms motivate their risk-averse managers to evaluate new investment projects as well as to manage assets-in-place. We first consider a two-agent model: an Innovator in charge of project adoption and a Producer in charge of production. The Innovator's effort produces better information on risky projects, but he may reject a good project in order to avoid risk. The Producer's effort increases the mean of firm value but he faces uncertainty in his productivity, due to the externality created by the new project. We examine the two agents' roles in the firm separately and also combine them in a Nash game. We derive optimal contracts for them and show that under mild conditions they exhibit convexity. We next demonstrate that when a single agent is assigned both tasks, his contract is in general convex, with the degree of convexity increasing in the agent's importance in managing the new project. We interpret the convexity in the optimal contracts as "option-like" compensation.

Abstract:
We examine three alternative explanations for excess endowments in not-for-profit firms: (1) growth opportunities, (2) monitoring, or (3) agency problems. Inconsistent with growth opportunities, we find that most excess endowments are persistent over time, and that firms with persistent excess endowments do not exhibit higher growth in program expenses or investments. Inconsistent with better monitoring, program expenditures toward the charitable good are lower for firms with excess endowments, and CEO pay and total officer and director pay are greater for firms with excess endowments. Overall, we find that excess endowments are associated with greater agency problems.

Corporate governance, Not-for-profit, Cash holdings, Endowment, Agency problems

Abstract:
We examine three alternative explanations for excess endowments in not-for-profit firms: (1) growth opportunities, (2) monitoring, or (3) agency problems. Inconsistent with growth opportunities, we find that most excess endowments are persistent over time, and that firms with persistent excess endowments do not exhibit higher growth in program expenses or investments. Inconsistent with better monitoring, program expenditures toward the charitable good are lower for firms with excess endowments, and CEO pay and total officer and director pay are greater for firms with excess endowments. Overall, we find that excess endowments are associated with greater agency problems.

Corporate governance, not-for-profit, non-profit, executive compensation, cash holdings, endowment, agency problems

Abstract:
This paper investigates whether the business press serves as an information intermediary. The press potentially shapes firms’ information environments by packaging and disseminating information, as well as by creating new information through journalism activities. We find that greater press coverage reduces information asymmetry (i.e., lower spreads and greater depth) around earnings announcements, with broad dissemination of information having a bigger impact than the quantity or quality of press-generated information. These results are robust to controlling for firm-initiated disclosures, market reactions to the announcement, and other information intermediaries. Our findings suggest that the press helps reduce information problems around earnings announcements.

Business Press, Information Asymmetry, Information Intermediaries, Earnings Announcements

Abstract:
We re-examine the “underleverage puzzle,” which argues many corporations fail to take full advantage of debt tax shields. We show that prior results suggesting underleverage stem from biased estimates of tax benefits from interest deductions. We develop improved estimates of marginal tax rates using a non-parametric procedure that produces largely unbiased estimates of the distribution of future taxable income. We show that additional debt would provide firms with much smaller tax benefits than previously thought, and when distress costs, non-debt tax shields, and the benefits of financial flexibility are also considered, it appears plausible that most firms have tax-efficient capital structures.

capital structure, debt, marginal tax rates, corporate taxes

Abstract:
We use an option pricing framework to model equity valuation when debtholders have the right to take action against a firm that violates an accounting-based covenant prior to debt maturity. The model predicts that the expected value of equity depends on two factors: the economic value of the firm and the probability that the firm violates an accounting-based covenant. Earnings innovations are one example of information that can simultaneously affect both of these factors so we focus on the role of earnings in stock valuation. First, as documented in prior literature, earnings provides a signal of the value of expected future cash flows. Second and unique to our model, earnings changes the equity option value by changing the probability that the firm violates an accounting-based covenant. Our pricing model shows that this "covenant" effect of earnings is greatest for firms near the point of violation. We test for the covenant effect of earnings using a sample of thrift institutions that are bound by regulatory net worth covenants. We document that earnings response coefficients increase as firms approach covenant violation. As more direct evidence of a covenant effect, we find that stock price responses to losses and transitory earnings (earnings that are less informative about future cash flows) are significant only for thrifts that are near covenant violation.

Abstract:
Using data on directors' and officers' insurance policies gathered from a sample of Canadian firms, this article examines the determinants of firms' demand for D&O insurance. Firms with greater litigation risk are more likely to purchase insurance and carry higher limits and deductibles. The data do not support the hypothesis that director cash compensation substitutes for D&O insurance. Consistent with the hypotheses of Mayers and Smith (1982, 1987), firms with greater distress probability and utilities are more likely to purchase insurance and carry higher limits. However, firms with greater inside shareownership are less likely to purchase insurance and carry lower limits. Firms with greater inside voting control are more likely to purchase insurance and carry higher limits.

Abstract:
We examine whether board and ownership structure variables explain the level of chief executive officer (CEO) compensation. After controlling for standard economic determinants (i.e., the firm's demand for a high-quality CEO, firm performance, and risk), we find that board and ownership structure variables explain a significant amount of cross-sectional variation in CEO compensation. We also find that the predicted component of compensation arising from these board and ownership structure characteristics has a significant negative relation with subsequent firm accounting performance. Overall, our analysis indicates that unusually large CEO compensation levels reflect managerial entrenchment or poor governance mechanisms, and that firms with more entrenched managers or poorer governance systems perform worse.