On the Timing of CEO Stock Option Awards GROUP 1 Celestine Walter Jun Yue (Presenter)

Outline Stock option – What is it, How it works Opportunistic behaviour How did some CEO profit from the stock options? What are the statistical evidences (opportunistic behaviour)? Take Home Message!

Stock Option – What is it A stock option is a privilege that gives the buyer the power, but not the obligation, to buy or sell a stock at an agreed-upon price within a certain period of time Generally granted with a fixed exercise price equal to the stock price on the award date definition from http://www.investopedia.com/terms/c/calloption.asp

Stock Option Plan – How it works Past awards and/or industry norms usually influence the number of options awarded Stock option plan controls the number of options that can be awarded Stockholders loathe the potential dilutive effect generated by a large number of outstanding options Accounting rules require a charge to earnings for grants that are issued in-the money For scheduled award dates, executives would try to manipulate the release of information to the capital market, to depress the price on the date (WHY??)

Rise of Opportunistic Behaviour Option values: The value that is placed on private willingness to pay for maintaining or preserving a public asset or service even if there is little or no likelihood of the individual actually ever using it. Decreases with the exercise price Therefore, executives prefer for the stock price to be as low as possible on the award date to increase the value of their compensation definition from http://www.uio.no/studier/emner/sv/oekonomi/ECON4910/v16/lectures/lecture_6_slides.pdf

Opportunistic Behaviour Company adopted a stock option plan  Administration of the plan assigned to compensation committee, who officially determines the size and timing of stock option grants  Decisions influenced by several reasons Executives propose the framework of the stock option grant, compensation committee merely ratifies (backdating) Close friendships with individual committee members Influence the timings of the compensation committee meetings, which regularly coincide with the award date Self-serving behaviour by executives results in decrease in stock price before stock option grants and/or increase afterwards

some studies describing an opportunistic timing Yermack (1997): Around 620 stock option awards between 1992 and 1994. Awards were opportunistically timed to occur before anticipated stock price increases Aboody and Kasznik (2000): 2,039 scheduled option awards between 1992 and 1996. Release of information were opportunistically timed to occur around fixed option awards Chauvin and Shenoy (2001): Found evidence of negative abnormal returns before 783 option grants before 1981 and 1992, but little evidence of positive abnormal returns following the awards (WHY??)

Manipulating award dates to their advantage Unscheduled award date: Executives use their influence to time the awards on a date when the stock prices are particularly low; granting stock options retroactively i.e. taking the low point in a recent period to fix a low exercise price for the benefit of the executives (backdating transactions) Push back the award date if they think that the prices will fall in the near future (either think that current prices are higher than fundamental value, or expect prices to fall soon) Promote immediate awards when it is cheap, and unwarranted price drop should increase price as the capital market realises that the stock is undervalued Advocate immediate awards if expecting future prices to increase, irrespective of past price performance

Scheduled vs Unscheduled Award Date Any stock price effect is likely to be weaker around scheduled awards Inflation in value: Manipulate award dates (scheduled) VS control information flow (unscheduled) Scheduled awards are partially predictable by the capital market, thus creating trading opportunities that, when exploited, will tend to remove any price effect

Statistical Evidences 1992 through 2002: Negative abnormal stock returns are negative before award dates and positive afterward. Evident around both scheduled and unscheduled awards, but much more pronounced around unscheduled awards Although retroactive timing of executive stock option awards seems dishonest, it is unsettled that it contravenes the stipulations in the stock option plans

Intensified return patterns around unscheduled awards  Executives gradually learned how to better time awards to their advantage or become more aggressive in their timing efforts  Explains the absence of both negative abnormal returns leading up to the awards Scheduled award date: Official grant date must have been set retroactively. Else, the executives have an informational advantage, giving them exceptional predictions regarding the future market movements

Do not buy stocks unless you have insider knowledge! Take Home Message! Do not buy stocks unless you have insider knowledge!