The Relation between Corporate Governance and CEOs’ Equity Grants
Lawrence D. Brown
Georgia State University
Email:
Yen-Jung Lee
National Taiwan University
Email: ylee@ ntu.edu.tw
September 2009
Abstract: We investigate whether the firm’s corporate governance affects the value of equity grants for its CEO. Consistent with the managerial power view, we find that more poorly governed firms grant higher values of stock options and restricted stock to their CEOs after controlling for the economic determinants of these grants. We show that the negative relation between governance strength and equity grants cannot be attributed to omitted economic factors, the substitution effect between governance strength and equity incentives, or the divergence between the subjective value and the fair value of equity grants. As further evidence consistent with the managerial power view, we show that firms with poorer governance in the pre-Enron era cut back more on the use of employee stock options (ESOs) for their CEOs in the post-Enron era, a period when CEO compensation received intensified public scrutiny and when the transparency and accounting cost of ESOs increased.
Key words: corporate governance, executive compensation, stock options, SFAS 123R
JEL Classifications: G30, G34, J31, J33
We thank Ashiq Ali, Eli Bartov, Dan Collins, Christi Gleason, Paul Healy, Tom Lys, Maria Nondorf, Shiva Rajgopal, Doug Skinner, Abbie Smith, Franco Wong, and workshop participants at the 2007 American Accounting Association Annual Meetings, 2007 Harvard University IMO conference, 2007 University of Okalahoma Accounting Research Conference, Georgia State University, National Taiwan University, University of Iowa, and the University of Texas at Dallas for helpful comments.
The Relation between Corporate Governance and CEOs’ Equity Grants
ABSTRACT
We investigate whether the firm’s corporate governance affects the value of equity grants for its CEO. Consistent with the managerial power view, we find that more poorly governed firms grant higher values of stock options and restricted stock to their CEOs after controlling for the economic determinants of these grants. We show that the negative relation between governance strength and equity grants cannot be attributed to omitted economic factors, the substitution effect between governance strength and equity incentives, or the divergence between the subjective value and the fair value of equity grants. As further evidence consistent with the managerial power view, we show that firms with poorer governance in the pre-Enron era cut back more on the use of employee stock options (ESOs) for their CEOs in the post-Enron era, a period when CEO compensation received intensified public scrutiny and when the transparency and accounting cost of ESOs increased.
Key words: corporate governance, executive compensation, stock options, SFAS 123R
JEL Classifications: G30, G34, J31, J33
1. Introduction
We investigate the effect of a firm’s corporate governance on its CEO’s equity grants, defined as employee stock options (ESOs) and restricted stock. Corporate governance is a set of mechanisms that helps mitigate agency problems between managers and shareholders. Theoretically, equity grants can be considered an aspect of corporate governance because it ties managers’ personal wealth to their firms’ stock price performance (Shleifer and Vishny 1997; Core et al. 2003), reducing the possibility that managers take suboptimal actions to harm shareholder value. However, a number of practitioners, institutional investors, shareholder activists, and academic researchers contend that instead of being an effective governance mechanism, the option granting practice is a manifestation of poor corporate governance (e.g., Biggs 2002; Gillan 2005; Guay et al. 2003; Coombes 2005).[1]
While there is evidence that poor governance is associated with excessive cash and total compensation (Core et al. 1999), empirical evidence on the relation between corporate governance and employee equity grants is limited.[2] Unlike cash, stock options and restricted stock are provided to employees for reasons besides just conveying compensation.[3] Both survey and archival evidence suggests that retaining existing employees and attracting new employees are the most important reasons for implementing equity grant programs (Ittner et al. 2003 and Oyer and Schaefer 2005). Moreover, researchers demonstrate that stock options and restricted stock are inefficient forms of compensation when compared to cash, raising the question about the relative importance of equity grants’ compensation versus their attracting, retaining and other economic roles.[4] Thus prior research’s cash compensation results cannot be readily generalized to equity grants. We fill this gap in the literature by examining how the CEO’s equity grants relates to the firm’s governance structure and exploring alternative explanations for the observed relation.
The extant executive compensation literature offers two distinct views on the relation between corporate governance and the CEO’s equity awards: efficient contracting and managerial power. The efficient contracting view contends that boards grant optimal equity incentives that maximize firm value (e.g., Himmelberg et al. 1999; and Core and Guay 1999). According to the efficient contracting view, there is no systematic relation between corporate governance and the value of equity grants for top executives after controlling for the economic determinants of equity grants. The managerial power view contends that CEOs exert substantial influence over corporate boards and structure compensation contracts to benefit themselves rather than outside shareholders (e.g., Shleifer and Vishny 1997; Murphy 1999; Bebchuk and Fried 2003). As such, weaker governance gives CEOs relatively more power vis-à-vis the board, allowing them to receive more compensation than justified economically. The managerial power view predicts a negative association between governance strength and the value of the CEO’s equity grants.
To determine which view is more descriptive of reality, we utilize 8,084 observations representing 1,719 firms from 1998 to 2006 with necessary compensation data from ExecuComp and governance data from RiskMetrics to examine the relation between firms’ corporate governance and the grant day fair values of new equity grants for their CEOs. Because governance mechanisms do not operate independently to resolve agency problems, we consider jointly the structuring of internal and external governance. We use Core et al.’s (1999) 12 board and ownership structure variables to measure internal monitoring and Gompers et al.’s (2003) G-index to capture external monitoring. We use two methods, an equally weighted sum of the standardized governance variables and a factor analysis on all governance measures, to collapse the 13 governance variables into one parsimonious measure of overall governance strength.
Consistent with the managerial power view, we find a negative relation between governance strength and the value of equity grants. This negative relation, however, is consistent with two alternative explanations: (1) omitted economic factors affecting equilibrium equity compensation (hereafter, omitted economic factors explanation); and (2) substitution effects between governance mechanisms and equity incentives (hereafter, substitution explanation). To test for validity of the omitted economic factors explanation, we examine how the portion of the CEO’s equity grants explained by governance variables affects future firm performance. Under the managerial power view, governance-motivated equity grants reflect unresolved agency conflicts, which should not have a favorable effect on future firm performance. In contrast, the omitted economic factors explanation suggests that the portion of equity grants explained by governance variables proxies for the demand for a higher level of equilibrium equity compensation, which should not impair future firm performance. Regressing accounting earnings and abnormal stock returns over the three subsequent years on governance- and economic-explained equity grant values, we find that governance-explained (economic-explained) equity grant value is negatively (positively) associated with future accounting and stock return performance, inconsistent with the omitted economic factors explanation.
Given that equity grants are used to align managers’ and shareholders’ interests, firms are likely to substitute equity incentives for active monitoring in cases where direct monitoring by outside directors is less cost-beneficial. To explore the substitution explanation, we sort all observations into 2´2=4 portfolios based on overall governance strength and abnormal equity grants, which we define as the component of equity grants not explained by economic determinants of these grants.[5] If the substitution explanation is valid, firms with weak governance and high abnormal equity grants should outperform firms with weak governance and low abnormal equity grants. We examine future accounting and stock return performance for each of the 4 portfolios and do not find evidence consistent with the substitution explanation.
One obstacle hindering the interpretation of our results is that both corporate governance and equity grants are endogenously determined by such factors as monitoring costs, firm performance, and growth opportunities. Comparing compensation decisions between firms with good and bad governance may capture the effects of differences in the environments wherein firms operate rather than the effects of their governance. However, finding a good instrument for governance that is exogenous in the equity grant decision is extremely difficult so we provide two other analyses to mitigate this endogeneity concern.
Our first approach follows Bebchuk et al. (2008) and Dittmar and Mahrt-Smith (2007) wherein we repeat our analysis retaining firms from the second half of our sample period (2003-2006) and replace the governance variables by their beginning-of-the-sample-period values (i.e., 1998 values). Our rationale is that since governance structure changes slowly over time, the initial value of governance structure is less affected by future business and operating environments, making it more exogenous to future compensation decisions than is contemporaneous governance structure.[6] Consistent with our primary analysis, the results reveal that past corporate governance has a significantly negative effect on future abnormal equity grants.
As a second way to address endogeneity concerns and to add validity to our managerial power interpretation, we examine changes in CEOs’ ESO grant values in the post-Enron era, a period characterized by an increased public attention to executive compensation, various regulatory actions such as the Sarbanes-Oxley Act of 2002 and listing requirements at the stock exchanges, and issuance of Statement of Financial Accounting Standards 123R (SFAS 123R) - Share-Based Payment (FASB 2004) that requires that ESOs be expensed on income statements.
Prior to SFAS 123R, firms were not required to record any ESO expense as long as the exercise price of their ESO was not below the grant day market price of the underlying stock. Not surprisingly, virtually all ESOs are granted “at-the-money”- that is, their exercise price is set to the grant-date market price (Murphy 1999). ESOs’ zero accounting cost provides firms with opportunities to extract excessive compensation via ESOs. Under the managerial power view, CEOs of more poorly-governed firms are more likely to take advantage of the lack of ESO expensing and award themselves more ESOs than could be justified by economic factors.
The mandatory expensing requirement along with the increased public scrutiny of executive compensation increased the outrage and accounting costs of ESOs, forcing firms that used “too many” ESOs in the pre-Enron period to scale back their ESO use in the post-Enron era.[7] We show that firms with weaker corporate governance in the pre-Enron period cut back more on the use of ESOs post-Enron after controlling for changes in governance structures and other economic determinants of equity grants during the period. This evidence is consistent with CEOs exercising power over poor governance structure to grant themselves excessive ESOs in the pre-Enron period, providing further evidence on the managerial power view.
We contribute to the literature along several important dimensions. First, we add to the literature examining the relation between corporate governance and agency problems. While prior studies show that managers exercise power to their own benefits (e.g., expropriating funds; empire building; consuming perquisites), direct evidence relating corporate governance to equity grants is limited. Using proprietary data for 205 firms from 1982-1984, Core et al. (1999) find that poorly-governed firms award their CEOs with more cash and total compensation. We complement and extend Core et al. (1999) by focusing on the equity component of the CEO compensation and by using a broader sample and data from a more recent period when ESOs become a major component of executive compensation.[8]
Second, we extend the literature examining substitution effects among governance mechanisms. Sundaramurthy et al. (1997) find that equity market investors react less negatively to antitakeover provisions adopted by firms whose CEOs do not chair their boards than to anti-takeover provisions adopted by firms whose CEOs do chair their boards, consistent with the market perceiving stronger board monitoring substitutes for weak monitoring from the takeover market. Gillan et al. (2006) find firms with more independent boards have a higher G-Index, suggesting that the market for corporate control plays a less important monitoring role when the firm has a more powerful board. We extend this literature by showing that firms do not use incentive compensation to substitute for weak governance. In fact, our evidence is inconsistent with incentive compensation serving as an effective governance mechanism.
Third, we contribute to the literature examining CEOs’ opportunistic behavior with respect to stock option grants. Yermack (1997), Aboody and Kasznik (2000), and Lie (2005) show that managers time corporate disclosures or information flows around ESO grants to increase the value of their stock option grants. Choudhary et al. (2009) reported that some firms accelerated the vesting of outstanding ESOs to reduce accounting expenses that would need to be reported under SFAS 123R. Our findings suggest weak corporate governance allowed CEOs to take advantage of opaque ESO accounting to enrich themselves via ESOs. The rest of our paper proceeds as follows. Section 2 presents our research design. Section 3 describes our data and reports the descriptive statistics. We show results of our multivariate analyses in section 4 and of additional analyses in section 5. Section 6 concludes.
2. Research Design
We estimate the following Tobit model on a pooled cross-sectional and time-series basis to assess the relation between governance strength and equity grants for the CEO:[9]
(1)
where EQUITY is the logarithm of (1 + new equity grants to the CEO for the year). New equity grants to the CEO is calculated as the sum of the grant day fair value of new ESOs as computed by Execucomp plus the grant day fair value of restricted stock.[10]
GOVSCORE and GOVFACTOR are measures of governance strength. Corporate governance mechanisms used to mitigate agency conflicts between shareholders and managers can be either internal (i.e., the board of directors, insider ownership, and blockholders) or external (e.g., the market for corporate control). We use takeover vulnerability, measured as a transformation of Gompers et al.’s (2003) G-Index, to proxy for external governance strength, and use board monitoring and ownership structure, measured following Core et al. (1999), to proxy for internal governance strength. G-Index is based on 24 anti-takeover provisions from RiskMetrics and is determined by adding one point for each anti-takeover provision the firm has in place and zero otherwise. A higher G-index imposes higher costs on takeover activities. We transform G-Index to takeover vulnerability using a linear transformation, denoted VULNERABILITY=24-G-Index so that a higher value of VULNERABILITY indicates stronger external governance.[11]