This master's dissertation investigates whether executive stock options incentivize managers to take on greater firm risk, drawing on three core theoretical frameworks: the principal-agent problem, moral hazard, and asymmetric information. A literature review surveys decades of academic debate on stock-based compensation and its alignment—or misalignment—with shareholder interests. Primary research consists of a Likert-scale survey administered to 30 financial executives in Norway, supplemented by qualitative analysis of open-ended responses. Findings indicate that while temptation to pursue self-interested risk-seeking behavior exists, most respondents believe managers ultimately act within the bounds of their fiduciary obligations, partly out of fear of job loss. The study concludes that stock-based compensation does influence risk-seeking behavior, though not uniformly across all economic conditions.
An issue arising within the public domain is that of executive compensation and its repercussions on society as a whole. Over the past three decades, executive compensation has ballooned while the average worker has continued to see only modest gains in income. This disproportionate disparity between executive compensation and that of the average American family provides a solid foundation for examining the merits of stock options.
The value of stock options now dwarfs the actual value returned to shareholders. In accordance with this growing executive demand for stock options, there has been a corresponding increase in academic literature on the subject. This literature presents interesting arguments both for and against stock options — arguments that are valid in regard to their overall claims. What is particularly interesting, in the context of prevailing economic conditions, is the question of whether stock options genuinely increase firm value, or whether they are simply a tool for the wealthy to accumulate more wealth without a corresponding increase in firm value.
This topic is of particular interest given the "Occupy Wall Street" movement and other anti-banking sentiments that developed over the preceding five years. Stock options have been at the forefront of these anti-banking sentiments as unemployment, wages, and home ownership decreased while large organizations continued to award stock options to their executives. This is particularly true of banking organizations, which the public perceived as having disproportionately caused the fiscal crisis of 2008. Others, however, believe stock options were needed precisely at that time so that executives had the incentive to correct the errors of their respective firms. These commentators believe that societal sentiments are misplaced and that more emphasis should be placed on individual decision-making regarding the crisis, rather than on stock options and compensation. Both arguments have merit and deserve consideration within the overall context of employee compensation.
This study evaluates whether stock options align with shareholder value. The fundamental argument here is that this alignment theory is flawed. In some respects, stock ownership does indeed align company goals with those of management and stockholders. In other instances, however, stock options encourage management to take excessive risks in order to temporarily inflate the value attributed to each share. This excessive behavior on the part of management is typically achieved through high-risk decisions at the firm level. Such higher risk, by virtue of the uncertainty inherent in it, can create the potential for devastating losses. When excessive leverage is added to the equation, companies once thought to be stable can instantly become insolvent — Bear Stearns, Long-Term Capital Management, Washington Mutual, and Lehman Brothers are prominent examples.
Numerous examples occurring primarily during the financial crisis support this argument. Bank of America's acquisition of Countrywide Financial was an extremely risky endeavor that cost shareholders nearly half the market valuation of their company. During the crisis, however, executives temporarily heightened the value of their stock. Long after their departure, shareholders were left with a significantly devalued company. Therefore, stock options that carry no potential for downside risk on the part of management encourage risky behavior that ultimately undermines shareholders' interests.
There is support in the research for the idea that corporations may not award stock options to executives in the most optimal fashion. New executives are likely to receive particularly large stock option awards, presumably because of the impact of executive decisions on firm value (Yermack, 1994). This is one of several variables that may influence the short-term orientation of executives toward their compensation. Another is that boards of directors are unlikely to pay substantive long-term compensation to executives as their retirement approaches (Yermack, 1994). Further, as firm size increases, it becomes more difficult for boards to monitor managerial performance directly, and fixed administrative costs for implementing compensation plans are generally incurred (Yermack, 1994). The relation between new stock option awards and the current performance of a firm is roughly zero, as the relevant coefficient is generally of very small magnitude (Yermack, 1994). At the time of Yermack's research in the early 1990s, the author concluded that "contingent pay instruments used in CEO compensation are not well designed to reduce agency costs and are not awarded with great sensitivity to firms' financial environments" (1994, p. 29).
Stock options, however, do have merit in regards to objective alignment when used appropriately. A stock option in a conservatively run company does indeed encourage value-enriching behavior, particularly if shareholders act as actual owners of the company and are therefore vulnerable to downside risk. Proper oversight in regards to acquisitions, mergers, and capital expenditures also increases the effectiveness of stock options.
Performance-oriented reward systems are most often directed at executive compensation and are used to align executive pay with the overall performance of a business unit or the firm. In performance-based systems, executive compensation in the form of salary adjustments, awards, and bonuses commonly shows a linear relationship to performance. Strong positive correlations between executive performance ratings and executive performance compensation in companies using a performance-based approach can typically be demonstrated through the Pearson correlation coefficient.
Stock options are used primarily to attract management talent when capital is not widely available. This is especially true for young, emerging companies that have little capital but wish to attract top talent. Through stock options, talented managers can be drawn to a company without requiring a large concrete salary. This is advantageous to both the firm and the individual manager. The firm obtains talent that can be used to grow the business, and the goals and objectives of the firm are aligned as the manager is compensated in stock options. The manager benefits as well, since if the role is conducted in a conservative manner, the value of his or her holdings can increase while the company is being built. In these scenarios, stock options provide a powerful tool for properly aligning the goals of management with those of the firm.
Options are not stock in physical form but rather a claim to stock at a predetermined price. Two key distinctions regarding this concept are important. First, stock options have an asymmetric payoff, and second, they do not pay dividends. Actual stock ownership does pay dividends. These two distinctions can create risk-taking behavior on the part of management because the value of options increases with the overall risk of the firm. The price of options also decreases with a large dividend increase. The more stable a company's performance, the less valuable the option will become. Performance-oriented rewards therefore provide incentive to increase firm risk while also producing a corresponding decrease in dividends. Overall dividends have decreased substantially relative to earnings in recent decades (Fama and French, 1999), though this may be a response to overall market risk rather than risk in any particular firm. Wayne Guay notes that firms with very high growth opportunities tend to increase the granting of stock options (Guay, 1999), and in turn, these option-holding managers take on more risk to increase the value of those options. This behavior, by virtue of the risk inherent in it, causes many smaller growth firms to become insolvent and eventually bankrupt.
Further complicating the question of performance-oriented rewards and their relevance to shareholders is the evidence regarding risk preferences. Is risk-taking on the part of management desirable or undesirable from a shareholder perspective? It is difficult to answer this question definitively when a shareholder population may consist of thousands of owners with differing preferences. Managers who shun risk may be overly conservative, taking fewer risks than are desired by shareholders (Lambert, Larcker, and Verrecchia, 1991). The principal-agent problem is compounded by managers who have strong incentive to avoid risk out of a desire to retain their positions. Conversely, there is also research providing strong incentive to encourage risk-taking through performance-oriented rewards. As such, it is difficult to determine unambiguously whether stock options encourage risky behavior, or whether such behavior is ultimately harmful to shareholders in the long run.
This dissertation examines the link between stock options and the inherent risk of a company. Share options and risk, as noted above, are a growing concern as the economic recovery continues. Shareholders are now more cognizant of the substantial wealth accumulation and subsequent risk-taking on the part of executives. Many contend that the pay received by top-level executives is not commensurate with the value they create for the company (Touryalai, 2012).
Over the years, stock options have become an integral aspect of an executive's overall compensation. What once was simply an added bonus has now become the standard by which executives are compensated. It is through these stock options that the propensity to incur additional risk is exacerbated. This is particularly true for executives in industries deemed essential to the proper functioning of the economy. Executives in industries such as financial services, automotive, and energy are more prone to increased risk-taking due to the concept of moral hazard.
A moral hazard occurs when there is an incentive for a person to take high or unusual risks in an attempt to capture a profit while still possible — for example, before a contract is settled. As executives in these critical industries incur additional risk, there is seemingly no incentive to protect against the adverse economic consequences of their behavior. Since their industries are necessary for the overall economy to function, these executives assume that a third party — usually the government, taxpayers, or private enterprise — will absorb the loss. There is, therefore, a clear link between stock options and the riskiness of a firm's activities.
If moral hazard is present because risk is embedded in a company's strategy, the possibility of profound consequences increases dramatically. The key themes within this dissertation are attributed primarily to risk-taking on the part of executives who hold vast amounts of stock options. In addition to moral hazard, higher leverage ratios, negative NPV projects, and principal-agent complications all contribute to this risky behavior.
Due to the wide and varied discussion around stock options and overall risk-taking behavior, this document focuses on three core principles: the principal-agent problem, moral hazard, and asymmetric market information. These principles, more than any others, provide insights into stock options and risk-taking on the part of management. Both sides of the debate have valid examples, figures, and knowledge to reinforce their arguments. The document begins with this introduction, providing an overall synopsis of stock options, their prevalence, their appeal, and the unintended consequences of providing them. The literature review in Chapter 2 provides insights into the risk-taking behavior of management with large amounts of stock-based incentive compensation. Chapters 3 and 4 focus on the methodology and findings. Chapter 5 provides a critical analysis and conclusion.
In regard to options and risk, three main themes emerge from the literature: the principal-agent problem, moral hazard, and asymmetric information. All three components relate directly to stock options and their subsequent risk. The first theme is the principal-agent problem — arguably the most dominant of the three. It is difficult to ascertain or prove whether management is acting in self-interest or being prudent stewards of shareholder capital. Furthermore, the actions of management can be framed in ways that appear consistent with shareholder mandates when, in actuality, that behavior is decidedly not aligned with shareholder interests.
Academics describe the principal-agent problem as one that constantly devalues shareholder wealth (Eisenhardt, 1989). This is consistent with prevailing principal-agent sentiments. The principal-agent problem has plagued society in the midst of the greatest financial crisis since the Great Depression. Conflicts of interest create a misalignment between the desires of management and the desires of shareholders, pertaining primarily to options and risk-taking behavior (Haubrich, 1994).
Executives cannot alter the exercise price or the time remaining to exercise their options. Executive stock options increase in value when the value of the underlying security increases. Management therefore has an incentive to increase stock valuations. The literature describes how managers can control dividend policy and the risk of the underlying security. Since call option values decrease with an increase in dividends, and the exercise prices of executive stock options are rarely adjusted for dividends, the manager's incentive is to reduce dividends as much as possible (Hall, 2000). The literature also suggests that executives who hold large option grants are more likely to substitute higher dividends with share repurchase programs (Jolls, 1998). It is particularly notable that management, due in part to larger option grants, is willing to change financial policy even when that policy is not in the best interest of shareholders. Stock repurchases at inflated levels actually subtract from shareholder value because the company pays more than what it is actually worth. Furthermore, dividends — particularly for income-oriented investors — are far more desirable than overpriced share repurchases.
Management can also affect risk within the firm. Options, as noted earlier, have an asymmetric payoff, giving management an incentive to increase risk as the standard deviation of the option changes. Evidence has shown that management has undertaken projects with negative NPV in order to increase firm risk (Esty, 1997). In regard to the principal-agent problem, management can destroy shareholder value and increase their option value in two distinct ways: by vastly increasing the leverage of the firm, and by undertaking risky projects. This is precisely what occurred during the financial crisis in firms levered as much as 200 to 1 (Lebaton, 2008). The stock options of management were highly valued, but the firms ultimately collapsed.
At the peak of stock option usage in 2001, over 50 percent of the compensation of CEOs in large U.S. firms could be attributed to stock options valued ex ante (Sanders & Hambrick, 2007). Four years later in 2005, the single largest component of pay for 41 percent of CEOs was still stock options (Sanders & Hambrick, 2007). The catalyst for this shift occurred in the late 1990s when Hall and Liebman (1998) called for the use of stock options as a motivational tool. In their words, "the most direct solution to [the] agency problem is to align the incentives of executives with the interests of shareholders by granting (or selling) stock and stock options to the CEO" (1998, p. 656).
Prior to 1990, management's duties and responsibilities were quite different. In the 1980s, management was seen primarily as a representative of the entire business entity, and stockholder and investor interests were subordinate to the needs of the overall business. Managers did not use assets in a manner that benefited stakeholders and were inclined to underuse capacity. Companies with competitive advantages such as economies of scale or distribution networks simply did not use them to their fullest extent. This benefited managers whose compensation packages were based on metrics that could be easily manipulated — metrics such as revenue, earnings per share, and sales growth (Kaplan, 2012). All management had to do was alter assumptions within the annual report to "create" earnings, since their compensation was not tied to stock. One commonly used method was manipulation of pension fund assumptions: by "expecting" a higher growth rate within the pension fund, a company could contribute fewer earnings to fund the pension, and these savings were then transferred to the bottom line as a profit increase when in reality the increase was an accounting gimmick (Shaw, 2012).
Throughout the 1980s, many companies used such gimmicks to manipulate financial information. To be fair, that decade and prior periods were marked by economic uncertainties that created a sense of caution among businesses, which can reasonably explain some underutilization of capacity. A wave of hostile takeovers and proxy fights eventually ensued in an effort to better align corporate goals with those of owners. Investors who found companies with underutilized assets would obtain a majority stake and either sell those assets or use them to generate profits. Companies began to take notice and started aligning corporate objectives with owner objectives through the issuance of stock options.
Since the demise of Enron, WorldCom, and other firms associated with excessive risk-seeking and large stock option grants, many companies have taken corrective positions. A noticeable shift from stock options to restricted stock grants has occurred, despite managerial concern that restricted stock does not efficaciously incentivize firm-value-increasing behavior (Reh, 2004). An important distinction has emerged between risk-averse investment behavior and loss-averse investment behavior. The literature suggests that managers tend to be loss-averse — avoiding losses of existing wealth — rather than consistently risk-averse (Tversky and Kahneman, 1986, 1991). In a loss context, managers will be more risk-seeking; in a gain context, they will be less so. The behavioral agency model of Wiseman and Gomez-Mejia (1998) stipulates that the more wealth at stake, the less risk-seeking behavior will manifest in both gain and loss decision contexts.
Fundamental to principal-agent theories is the idea that managerial risk-seeking, value-increasing behavior is induced by stock options, while risk-averse behavior is induced by restricted stock. Sawers et al. (2006) found that the relation between stock options and risky investment is not characterized by such a strictly linear interaction. In their research, the decision context — whether gain or loss — was pivotal to investment behavior. The study did not confirm that subjects assigned stock options engaged in risky investment projects more frequently than their peers with restricted stock. The study did find, however, that in a loss decision context, subjects with restricted stock chose risky projects more frequently than subjects with stock options. The researchers argue that their findings are consistent with the view that managers subjectively overvalue stock options relative to restricted stock.
These stock options contribute heavily to the income disparity between executives and the average worker. In many instances, executives gain at the expense of shareholders through the issuance of stock options. Furthermore, these options often encourage extreme risk-taking on the part of the executive, which ultimately increases executive wealth at the expense of the long-term-oriented shareholder. The average annual earnings of the top 1 percent of wage earners grew 156 percent from 1979 to 2007 (Emmanuel, 2012). This rise is even more pronounced for the top 0.1 percent, which grew 362 percent over the same period. In contrast, earners in the 90th to 95th percentiles had wage growth of 34 percent — less than a tenth as much as those in the top 0.1 percent. Workers in the bottom 90 percent had the weakest wage growth, at 17 percent from 1979 to 2007 (Shapiro, 2005). If an inflation rate of just 2 percent per year is assumed over this period, the overall real gains of bottom wage earners in America would be negative.
Further compounding this issue is the decrease in median household income. Since the onset of the financial crisis, the median household income decreased from $51,000 in 2007 to $48,000 in 2011 (Census, 2010), while executive compensation rose by 21 percent over the same period. The majority of these executive gains occurred through the exercise of stock options. Many lower-level managers and employees do not have equivalent access to equity ownership, and by virtue of holding options, executives have an incentive to increase firm value through excessive risk-taking. This temporarily inflates stock prices, which heightens the value of the options. In 2007, average annual incomes of the top 1 percent of households were 42 times greater than those of the bottom 90 percent, and incomes of the top 0.1 percent were 220 times greater — increases of approximately 1,400 percent and 4,700 percent, respectively, since 1979. Many analysts argue this is simply unsustainable (Lars, 2006).
These statistics matter for two primary reasons. First, stock options are issued by the very corporation in which the executive works — which is detrimental to the average shareholder, who is overwhelmingly an individual in the bottom 90 percent. When a company issues stock options to executives, it reduces the ownership stake of all remaining owners. More shares outstanding without a corresponding increase in earnings means less earnings per share for the average shareholder, ultimately increasing executive wealth at the expense of shareholders. Moreover, options are often granted to executives at a discount to market value. For example, if a share trades at $50, an executive might be given the option to purchase 100,000 shares at $20 per share — in essence, receiving a $5 million piece of the company for only $2 million. The existing shareholders ultimately pay the $3 million difference.
Shareholders have recently contested stock options aggressively in light of these events. Executives are being compensated without a corresponding increase in business value (Higgins, 2004). Shareholders are limiting or simply not approving executive compensation packages. Acting more like actual owners — through proxy votes and active engagement — is likely to produce sustainable change in executive compensation practices.
Many academics advocate that markets are "efficient" (Ederington & Lee, 1995; Higgins, 2004; Smithson & Smith, 1998), arguing that all stock and business information is embedded in the current price of an asset (Fama, 1970). As new information enters the market, asset prices immediately adjust to reflect the new market sentiment. As a result, investors can only hope to achieve the market rate of return given the amount of risk taken. It is the contention of this dissertation, however, that markets are inefficient in both valuations and subsequent reappraisals of assets and capital projects. Behavioral finance and the theories embedded within it provide evidence of market inefficiency (Shleifer, 1999). Through behavioral finance, companies can take advantage of extreme market pessimism to achieve higher rates of return without a subsequent increase in risk.
Management has partial control over the information provided to analysts and shareholders. Corporate finance, budgeting, and financial planning arguably have the greatest impact on the behavioral economics field. These methods alter public perception and can thereby heighten the value of option holdings. The behavioral economics field is broadly defined as the study of social, cognitive, and emotional factors embedded within a financial decision-making process (Hogarth, 1987). In regard to management, there is therefore an incentive to depict a rosier scenario in terms of corporate earnings. Because the market is primarily composed of human beings making financial decisions for themselves, their companies, or on behalf of others, emotions play a very important role in business decision-making on both the management and shareholder sides. Management can take advantage of this to artificially inflate prices.
Consider the financial services industry during the 2007–2008 fiscal crisis — arguably the greatest financial crisis of our lifetime. During that year, stock prices plummeted nearly 50 percent, unemployment reached record levels, foreclosures were at all-time highs, and the global economy was in turmoil ("Harvard Economists," 2009). Extreme pessimism was the dominant market sentiment. These overreactions are a primary cause of asymmetric information entering the market (Daniel, 1998). The prices of options during the height of the financial crisis were extremely elevated. Companies that were financially strong had opportunities to acquire other firms at distressed prices. JP Morgan acquired Washington Mutual and Bear Stearns for pennies on the dollar due to pessimistic market emotions (Sidel et al., 2012). Wells Fargo was able to acquire Wachovia as market sentiment depressed prices to bargain levels. Stocks of financially stable companies with strong balance sheets — such as Walmart, Procter & Gamble, and Nike — were all trading at very depressed prices (Rothbard, 2012). On the opposite end of the spectrum, Bank of America acquired Countrywide Financial under the guise of positive information regarding scale and synergy, and the acquisition proved enormously costly. Retail investors who bought stock in the depths of 2008 would have doubled their initial investment by 2012 due to prudent management oversight. Management with stock options took calculated risks that, in some cases, increased shareholder value, while others used asymmetric information to detract from it.
Mergers and acquisitions are also significantly impacted by asymmetric information. Management — particularly those holding a high degree of options — tend to acquire firms with their elevated stock prices (Bebchuk, 2003). By taking on increased risk, management can directly impact the standard deviation of returns, which in turn increases option prices. Once the option is exercised, management may own overvalued stock relative to intrinsic value and can then acquire smaller firms through all-stock acquisitions. This activity increases the earnings of the combined company, further elevating the stock price as profits are reported. This reporting further contributes to asymmetric information in the market, as many novice investors interpret earnings increases as a positive sign of business operations (Aharon, 2010), often overlooking how those earnings were generated. Eventually the cycle ceases, and shareholders again lose value.
Mergers and acquisitions often fail due to overoptimism on the part of management regarding asymmetric information. Sanders and Hambrick found that "option-loaded CEOs lay more bets" and "tend to take on more risk with each bet" (p. 36). Systematic differences were found between the acquisitions made by option-loaded CEOs and those made by other CEOs: option-loaded CEOs spent more aggregate money on acquisitions, made more acquisitions, acquired larger targets relative to their own firms, and paid larger premiums (Sanders & Hambrick, n.d., p. 36). Moreover, stock option-based compensation may not be economically efficient since options may "most create the illusion of stimulating constructively aggressive behavior, while diverting windfalls to executives" (Sanders & Hambrick, n.d., p. 3). Too much hubris can create an atmosphere of acquisitions for the sake of acquiring rather than value creation — usually at the expense of shareholders. Seventy percent of mergers fail to achieve their intended profit and cash flow forecasts (Straub, 2007). For these reasons, some theorists suggest that "stock options may not resolve the agency problem in the way they had initially envisioned" (Jensen, Murphy, & Wruck, 2004).
During periods of mass optimism, where asymmetric information is at its highest, the valuations placed on firms increase dramatically, making acquisition costs steep relative to intrinsic value. Companies — particularly those led by executives with a large proportion of their wealth in options — often pay extreme premiums over what a target company is actually worth. The failed merger of AOL and Time Warner is a prime example of the potential impact of subjective perceptions and asymmetric information on an investment.
The Time Warner–AOL deal was struck at the peak of the dot-com bubble, but within months that bubble burst, leaving a wake of billion-dollar losses. No buyer could be found for AOL, a dial-up service that was cresting just as the market moved to high-speed internet. The price was based on the irrational beliefs of AOL's executives. Richard Morgan, the assistant managing editor of The Deal, asserted that the high price was never appropriate: "Back then a lot of people were drinking the Kool-Aid about the new economy. When they announced that they were going to create the deal of the century, they put the value at $166 billion. Today, the market cap of Time Warner, which contains AOL, is only $28 billion. So that's a loss greater than 80 percent" (Moon, 2009).
Asymmetric information also impacts the labor market as emotions continue to weigh on management decision-making. Fear of catastrophe abroad, a potential double-dip recession (Phil, 2012), and the approaching fiscal cliff made management reluctant to recruit and hire employees, keeping unemployment elevated above 8 percent for several consecutive years. Major firms investing heavily in technology rather than human capital further illustrates this dynamic. Technology is easier to acquire in a low-interest-rate environment and easier to maintain, and technology projects often have positive NPV with high margins and low variable costs — thus reducing risk. Asymmetric information within the context of American society was impacting the strategic decision to hire, and this ultimately affected shareholder value and management risk-taking.
Companies positioned themselves in a more conservative manner, reflecting the extreme pessimism of the market. Businesses cut benefits, hired less, lowered wages, and became more cost-conscious. Large financial institutions laid off workers while simultaneously posting increased profits and record earnings. Wells Fargo, for example, had five consecutive quarters of record earnings growth yet initiated cost-cutting measures in response to regulatory pressure. As the psychology of the market shifts, so does the behavior of large and small businesses alike (Rabin, 1998).
"Risk-taking incentivized by implicit government or societal backstops"
"Survey design, sampling, and ethical considerations"
"Quantitative and qualitative results from 30 financial executives"
The main result of this study is that both loss aversion and the bearing of risk in stock-based compensation structures do impact the risk-seeking behavior of managers. The respondents quite naturally extended the meaning of loss beyond the immediate implication of a loss-generating investment to the logical repercussion of job loss — the two concepts were apparently inextricably linked in the minds of the respondents. The economic circumstances — including decision context variables, managers' perceptions, and project financial information — were believed to impact the risk-seeking behavior of managers (Barron and Waddell, 2003; Sawers et al., 2006). The literature supports this view, illustrating how the influence of these parameters can increase markedly for managers who have current wealth at stake. While the public has singled out stock options as an important influence on risk-seeking behavior by managers, the theoretical research does not fully bear this out. The prevailing argument is that the influence of stock-based compensation on risk-seeking behavior "does not necessarily hold under all economic conditions" (Barron and Waddell, 2003). In an optimally designed compensation plan, both stock options and restricted stock are considered to play an important role (Barron and Waddell, 2003).
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