The influence of firm and executive characteristics on performance-vested stock option grants

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Abstract

Motivated by the considerable changes over the last two decades in the form and composition of executive remuneration schemes and the increasing use of performance-vested stock options (PVSOs), this study examines the determinants of PVSO grants. Using data on 4193 executive-year observations of 1373 executive directors in 243 FTSE 350 non-financial companies from 1999 to 2004, I examine the factors that influence PVSO grants at both the firm and the executive level. While controlling for unobservable industry, firm, and executive level fixed effects, the evidence shows that the PVSO grants awarded to individual executives are associated with observable features of corporate governance and indicators of managerial power. More specifically, the results support the following statements: (1) good corporate governance structures facilitate the use of PVSO plans; (2) the proportion of PVSO grants in the total compensation package is smaller for top mangers with more controlling power; (3) PVSO plans are less frequently used to compensate managers who are approaching their retirement and/or have a large equity stake in the firm; (4) relative to non-CEO executives, CEOs are more likely to be rewarded with PVSOs.

Highlights

► Performance-vested stock options (PVSOs) are designed to reward manager for real economic performance. ► Good corporate governance structures facilitate the use of PVSO plans. ► The proportion of PVSO grants in the total compensation package is smaller for top mangers with more controlling power. ► PVSO plans are less frequently used to compensate managers who are approaching their retirement and/or have a large equity stake in the firm. ► Relative to non-CEO executives, CEOs are more likely to be rewarded with PVSO plans.

Introduction

Both the form and composition of the executive remuneration schemes have been subject to considerable changes over the last two decades (Bebchuk & Fried, 2003). In addition, the weak link between managerial wealth and shareholder value has been intensively criticized by commentators, activist shareholders and academic researchers (Gerakos, Ittner & Larcker, 2007). One major concern is about the vesting feature of traditional stock options (hereafter TSOs), where option vesting is solely conditional upon time lapse (Bettis, Bizjak, Coles, & Swaminathan, 2010). Opponents argue that the vesting feature of TSOs may be an example of managerial self-serving behaviour. For instance, in a bull market, managers’ benefits from TSOs might merely be a reflection of the general market price improvement, enabling managers to receive windfall gains, even if they underperform relative to the market average or their peers (Bertrand & Mullainathan, 2001).

In the UK, the aforementioned concerns were voiced in a number of influential corporate governance codes (e.g. the Cadbury Report, 1992; the Greenbury Report, 1995; the Hampel Report, 1998; the Combined Code, 2003). These codes have resulted in a series of reforms. The most prominent innovation in the area of stock option plans is aimed at linking accounting-based (e.g. earnings per share growth) and/or market-based (e.g. total shareholder return) performance targets to option vesting, so that managers can only benefit from stock options after having achieved the pre-determined targets. This is called ‘performance-vested stock options’ (hereafter PVSOs). This incentive mechanism has been considered the result of a “decades-long effort to tighten the link between top executives’ bank balances and their employers’ success”,1 which is why PVSOs have been largely promoted by both regulators and activist shareholders.

The performance targets attached to the option vesting are set to reward managers for real economic performance. The most widely adopted target in this context is growth of earnings per share (EPS) (Conyon and Murphy, 2000, Conyon et al., 2000). Vodafone is an example of a firm using EPS growth as its performance target. In its annual report of the fiscal year ending March 31, 2007, Vodafone declared the following as regards the performance targets attached to the stock options rewarded to its executives:

“…For the award made in the 2007 financial year, one quarter of the option award will vest for achievement of EPS growth of 5% p.a., rising to full vesting for achievement of EPS growth of 10% p.a. over the performance period. In setting this target, the Remuneration Committee has taken the internal long range plan and market expectations into account. The Remuneration Committee has decided that for the 2008 financial year grants, the performance range will be 5–8% p.a. As in previous years, 25% vests at threshold (5% p.a.) with a straight line up to 100% vesting at maximum (8% p.a.).”2

Another very frequently used performance condition is total shareholder return (TSR) (Carter, Ittner, & Zechman, 2009). Here the option vesting usually depends on a firm's market return relative to the performance of a peer group. Cable and Wireless is an example of a company using TSR as its performance target. The firm attached TSR performance targets to the stock options awarded to its executives during the fiscal year ending March 31, 2004:

“…The vesting of share options awarded to the Executive Directors is subject to relative TSR performance conditions. Full vesting occurs only if the TSR performance of the Company meets or exceeds the upper quartile (of FTSE 100) on the third anniversary of the date of grant. Where TSR performance meets the median, 50% of the initial award vests. A sliding scale operates between median and upper quartile, and nothing vests for TSR performance below the median.”3

PVSOs were designed to make managers increase their efforts by more closely aligning their interests with the shareholders’ wealth. In the UK, the first wave of PVSO adoption took place around 1997, after the publication of the Greenbury Report (1995) which promoted the linkage of performance targets to equity compensation. While in 1997 almost 60% of the 200 largest UK firms using stock option compensation schemes had included performance criteria in their directors’ remuneration policies (Conyon et al., 2000), by 2003 this number had grown to 90% of the FTSE 250 non-financial companies (Kuang & Suijs, 2006). In the US, activist shareholders have argued that firms attach their company-specific performance targets to equity compensation and that they condition option vesting on the achievement of performance targets.4 As reported by Mercer Human Resource Consulting, in 2005, 30 of 100 major US corporations based a portion of the equity granted to their executives on performance targets, while this number increased to 50 in 2006.

Despite the increasing use of the PVSO compensation, the current study has documented a significant variance in the PVSO grants rewarded to individual executives. Of the 94% of the firms from a sample of 243 FTSE 350 non-financial companies which made use of PVSO plans in 2004, around 60% of the top managers did not receive a PVSO reward in the same year. On average, only 34% of the executives were granted PVSOs from 1999 until 2004. This considerable variance in PVSO grants has raised the question by what factors the board's decisions are triggered with respect to the allocation of PVSOs to individual executives. Therefore, the determinants of PVSO grants have formed the objective of this study.

Clearly, the design of executive compensation has been influenced by a variety of firm policies, such as measures aimed at sustaining an edge in the executive markets, the realization of tax efficiency,5 and building governance-enhancing models of pay. Prior research (Fee and Hadlock, 2004, Hopwood, 1974; among others) has demonstrated fixed firm level effects resulting from compensation policies. Firms have a tendency to apply one fixed compensation policy to all of their top managers, with the result that all of their executive compensation schemes are alike. In a similar vein, an industry level fixed effect enables firms operating in the same industry to adopt comparable strategies of executive pay. In addition, the determinants of the executive pay may be largely based on the characteristics of the top managers. Bertrand and Schoar (2003) find that executive fixed effects apply to a wide range of corporate decisions, including remuneration design. The current study has taken industry, firm, and executive level fixed effects on PVSOs grants into account. To test for the significance of these fixed effects, I have first built an intercept-only model which includes industry, firm, and executive fixed effects and excludes all the independent variables. The results show that the fixed effects at the industry, firm, and executive levels explain 8%, 58%, and 34% of the total variance of PVSO grants, respectively.

From a sample of 4193 executive-year observations I used data on 1373 executive directors in 243 FTSE 350 non-financial companies from 1999 to 2004, and examined the factors which influenced the performance-vested stock option grants at both the firm and the executive levels. Controlling for the unobservable industry, firm, and executive level fixed effects, I found that the PVSO grants were associated with a number of observable features of corporate governance and managerial power. More specifically, the results support the following notions: (1) good corporate governance structures measured by the proportion of outside directors sitting on the board and/or blockholder ownership facilitate the use of PVSOs; (2) the proportion of PVSOs in the total compensation package is smaller for top managers with more controlling power, measured by their tenure on the board and/or personal network links; (3) PVSOs are used less frequently for compensating managers who are approaching their retirement and/or have a large equity stake in the firm; (4) relative to non-CEO executives, CEOs are more likely to receive PVSOs.

Not surprisingly, the findings of the current study are fairly comparable with those based on US data, given the similar governance codes and institutional structures on both sides of the Atlantic. Using a data set from 1996 to 1997 of 290 randomly selected US firms, Harvey and Shrieves (2001) provide evidence of a facilitating role for outsider blockholders in the use of incentive compensation. They also observe that incentive pay is systematically lower for older CEOs, which can be explained by managerial risk aversion and employment horizon arguments. Whereas the authors categorize all sorts of stock grants, stock options, and payouts into long-term incentive plans, the current study has specifically concentrated on PVSOs, while controlling for executive equity holdings.

With regard to the relationship between PVSO grants and executive controlling power (especially as measured by external network links), the present study is at variance with Cordeiro (2005), in whose research the superior external network ties of a 1997 sample of Fortune 500 firms seem to lead to a higher proportion of risky incentive compensation. The current study's results are, however in line with those of Geletkanycz, Boyd, & Finkelstein (2001), who establish that higher CEO compensation levels accompany CEO external ties and with Hallock's (1997) evidence that CEO compensation is significantly higher in firms with interlocked outside directors.6

The contribution of this study to the compensation literature is threefold. Firstly, it has employed a unique data set that has enabled the examination of the determinants of PVSO grants at the individual executive level in the UK's largest companies. Prior studies (Bettis et al., 2010, Gerakos et al., 2007; among others) have mainly used US data, while examining PVSO grants at the firm level. This study investigates executive characteristics in detail, including some distinctive demographic data that have as yet hardly been addressed by prior research, such as the individual executive's network ties. Secondly, this study has been based on multi-level modelling, which means that in investigating the fixed effects on PVSO grants three levels have simultaneously been taken into account: the industry, firm, and executive levels. Only little research has as yet examined the fixed effects concurrently at all three levels, while the results of this paper indicate that on all three levels these fixed effects are significant. Any form of neglect in this respect could lead to biased estimates, because fixed effects may to some extent pick up omitted correlated variables (Verbeek, 2004). Also prior studies have shown that the use of fixed effects estimation reduces endogeneity bias and produces consistent results (Nikolaev and van Lent, 2005). Thirdly, with the aim of exploring the determinants of PVSO grants in a broader manner, the current study has been built on multiple theories and perspectives in the compensation literature. Although some of these perspectives may lead to contradictory hypotheses in addressing the research question, excluding these approaches from our research would only confine our way of thinking about this research topic.

The rest of the paper is organized as follows. In Section 2 the hypotheses are developed, followed by a description of the research methods in Section 3. The data sources and sample selection are presented in Section 4. In Section 5 I discuss the empirical findings of this study. Section 6 shows the results of the sensitivity tests. Finally, in Section 7 the conclusions of this study are discussed.

Section snippets

Hypothesis development

The perspective most commonly used in the investigation of the relationship between executive pay and corporate governance is the agency theory. The management of the firm acts as the contractor (agent) of the shareholders to pursue value creation. However, with the separation between ownership and management, some managers may have become too focused on self-enrichment or pursuing their own personal agendas. It is in this context that the board and other corporate stakeholders are responsible

Measurement

Table 2 lists the variables included in the analyses. The dependent variable contains three variants to measure the PVSO grants. A dummy variable (DummyPVSO) indicates the presence of new PVSO grants in an individual executive's compensation package (1 = yes; 0 = no). The intensity of the PVSO grants is captured by two proxies: %PVSO1 represents the proportion of the Black-Scholes value of the PVSOs in an individual executive's total annual compensation16

Sample selection and data sources

The sample used in this study contains FTSE 350 non-financial20 firms in the UK, based on the market capitalization at the end of 2004. This study focused on a UK setting because compared to US firms British listed companies disclose detailed information on issues such as managerial compensation in general and

Descriptive statistics

Table 4 presents the summary statistics of the sample. The mean DummyPVSO is 0.340. On average, around one-third of the executives were rewarded PVSOs from 1999 until 2004. The mean proportion of PVSO grants in terms of total annual compensation and total wealth is 10.6% and 4.7%, respectively. Fig. 1 depicts the trends of PVSO grants over time. The PVSO incidence (DummyPVSO) and intensity (%PVSO) have both been increasing since 1999 and peaked in the year 2003, while 2004 witnessed a decline

Robustness tests

Because of the potential disparity between CEO and non-CEO executives in compensation structures, tow sub-samples with CEO and non-CEO observations, respectively were constructed. With both subsamples all of the logit, tobit, and HLM regressions were re-run. Table 8, Table 9 show the results of these analyses. Although slight differences can be detected in the significance level of the coefficients, the main results are qualitatively consistent and robust. The HLM accounted for the fixed

Conclusions and final remarks

Already for decades the design of executive compensation has formed a major issue of debate among the general public, academics, and regulators. As a recent development, performance targets have been attached to stock option vesting, while managerial benefits gained from equity compensation have been made conditional upon the achievement of pre-specified performance targets. Especially through the influence of regulators and activist shareholders, the performance-vested stock options have been

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    I thank two anonymous reviewers and Pervez Ghauri (Editor-in-Chief) for their constructive comments and suggestions. An earlier version of this paper benefited from comments made by Wayne Landsman, Christian Leuz, David Cooper, Steven Balsam, Jeltje van der Meer-Kooistra, Arjen van Witteloostuijn, Tom Groot, Abe de Jong, Padma Rao Sahib, Henk ter Bogt, Dirk Swagerman, Hans van Ees, Yu Flora Kuang, and workshop participants at the 2007 European Accounting Association Doctoral Colloquium and University of Groningen. I am grateful to Jessica Bakker for her assistance.

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