The Impact of Directors' Option Compensation on Their Independence

Abstract

This study examines how the use of option-based compensation for directors affects their independence in their decisions on CEOs' option-grant dates. Firms typically grant CEOs at-the-money options, i.e., with the strike price set equal to the grant-day stock price. This practice creates a unique opportunity for CEOs to benefit from Timing Opportunism, whereby CEOs lower the grant-day stock price in order to increase the value of their option grants. Prior evidence indicates the existence of timing opportunism, because CEOs tend to receive options before (after) good news (bad news). Since directors frequently receive options at the same time as CEOs, directors also benefit from timing opportunism, so they may not have an incentive to constrain CEOs' timing opportunism. We hypothesize that, ceteris paribus, directors are more likely to constrain CEOs' timing opportunism when these directors receive a lower proportion of their compensation from stock options. We find evidence consistent with our hypothesis in a large sample from 1992 to 2002. Our results indicate that, when used as a common component of CEOs' and directors' compensation, stock options can compromise director independence in this particular setting.

Keywords: Corporate governance, stock option grants, directors' option grants, director independence

JEL Classification: G34, M41, M52, J33