Are CEOS Charged for Stock-Based Pay? An Instrumental Variable Analysis

Abstract

During recent years, one controversy related to CEO compensation has been a simultaneous increase in the popularity of the option grants and the dramatic increase in the total size of the CEO compensation packages. According to the current accounting standards, option grants are the only form of compensation that does not have to be reported on the income statement, which lead some to suggest that options may be used by the CEOs to take money out of the firm (e.g., Bertrand and Mullanaithan 2002).

While the existing literature mainly focuses on the use of stock-based compensation, the analysis of the other components of CEO compensation is relatively scarce. This paper attempts to investigate the efficiency of the use of the other components by studying the tradeoff between the level of stock-based pay and all other components of CEO compensation. The main findings are as follows. When a CEO receives new stock-based pay, the CEO also enjoys an increase in all other compensation. The result holds even after controlling for factors that may lead to an increase in the optimal CEO compensation, such as firm size and improvements in performance. While stock-based pay mainly consists of option grants, it also often includes restricted stock pay. I find that focusing on option grants only and removing restricted stock produces the same evaluation of the tradeoff. These findings are indicative of CEOs using stock-based pay to take money out of the firm. Additionally, they imply that options are not solely responsible for unjustified increases in CEO pay, and similar inefficiencies may be present in the use of the other components of CEO compensation.

Empirical analysis of the tradeoff between option grants to CEOs and the other components of CEO compensation is complicated by the endogeneity of the option grant policies and the policies on all other parts of the compensation package. I address endogeneity using an instrumental variables approach. In particular, I use the lagged value of CEO compensation and Tobin's Q, CEO share ownership, leverage, and dollar volatility of stock returns as instruments for option grants.

Keywords: option grants, tradeoff

JEL Classification: G3, G34, G38