Do managers alter the tone of their earnings announcements around equity compensation transactions? Isho Tama-Sweet Oregon State University October 19,

College of Business Research Why bother? –It is expensive and time consuming Production of new knowledge –We are social scientists –Business is more interesting (to us) than biology or nuclear physics –Consequential belief revision –Examples 1

What is my paper about? Do managers alter the tone of their earnings announcements around equity compensation transactions? Who are managers? What is tone? What is an earnings announcement? –How does it impact stock price? What are equity compensation transactions? 2

Contribution Investigate a specific strategy by which managers could potentially increase wealth Opportunism vs. truthfulness in disclosure Increase our understanding of how managers use narrative disclosure –More and more of it (i.e. annual report length) –How is it being used –Not audited 3

Prior literature: Credible Disclosure Tone captures (at least partially) the information content of narrative disclosure –Davis et al. (2008), Henry and Leone (2009), Henry (2008) –Davis and Tama-Sweet (2010) Credible disclosure can increase the value of managers’ human capital Managers use flexibility in disclosure to reduce information asymmetry –Stocken (2000) 4

Prior literature: stock option grants Option compensation Options value inputs Options grants are almost always ‘at the money’ Maximizing option value at the grant date –Timing the grant (i.e. disclosure date is fixed) –Yermack (1997) Backdating –Herron and Lie (2007), Narayanan and Seyhun (2007) –Timing of disclosures (i.e. grant date is fixed) –Aboody and Kasznik (2000) –Downward earnings management –Baker et al. (2008), McAnally et al. (2008) 5

Prior literature: insider equity sales Option exercises usually become insider sales Motivations for insider sales –Firm specific: information –Manager specific: taxes, liquidity, diversification Maximizing option value upon exercise –Exercise options after earnings management Bartov and Mohanram (2004) Bergstresser and Philipon (2006) –Sell more equity after just meet or beat Cheng and Warfield (2005) 6

Hypotheses H1a and H1b H1a: The optimistic tone in the earnings press release is lower when the CEO receives an option grant in the quarter following the press release. H1b: The optimistic tone in the earnings press release is greater when the CEO sells equity in the quarter following the press release. 7

Timeline QEnd t Press release t QEnd (t+1) Option grant or exercise

Research design: 9 OPTIMISM_PR it = a + b 1 GRANT it + b 2 SALE it + CONROLS + e (1) H1a predicts b 1 is negative H1b predicts b 2 is positive Data: , about 19,000 observations Financial data and press release

Control variables Controls based on NIRI guidelines –Current firm performance (ROA, LOSS, BEAT, SURP, LOGREV) –Prior period performance (SD_ROA, PCT_JMOB) –Length of press release (LOGWC) –QTR, YEAR and INDUSTRY indicators –Financial metrics: ACCR, SI_DUM, DA, MB 10

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Results of returns tests Linking unexpected optimistic tone to changes in CEO wealth –Estimate magnitude of relation between CAR_PR and UNEXP_OPT –Compute change in value of CEOs’ wealth for a 1 StdDev change in UNEXP_OPT Low wealth change compared to overall compensation 14

Sensitivity and robustness Scheduled option grants Pre/post SOX (backdating of options) Quarters in which CEO received grant and sold equity Sales of equity from option exercise only Litigation risk Alternative measure of HL_OPT Test by quarter Alternate model of expected OPTIMISM in returns tests 15

Conclusion I provide limited evidence to support the predictions that managers alter the tone of their earnings announcements around stock option transactions Contribution –Choices in narrative disclosure –Trade-off of credibility and opportunism –Litigation as constraint 16