Stock Options Application of agency theory to corporate governance

Transcription

Direct and indirect governance mechanisms
The general discussion on governance has demonstrated that
In the presence of subjective knowledge, management decision are not predictable, and
at times even not understandable in hindsight.
Management appointment and termination are procedures clouded in ambiguity.
Activism in governance institutions is not meaningful beyond some point.
Management must be the central institution of decision-making and strategy
formulation. Overly active governance institutions undermine this principle.
Thus, rather than controlling management actions, one should rather incentivize
management to use its private information to the benefit of all.
We move from the governance to the incentive model.
Vorlesung International Corporate Governance
Professur für BWL, insb. Internationale Wirtschaft
Stock Options
Application of agency theory to corporate governance
Vis-a-vis the contract in the absence of ”hidden costs”, the optimal contract between
principal and agent overcompensates the agent in good times, and undercompensates
him in bad times.
Good times:
Bad times:
Philosophy:
Stock option plans, management shares
The takeover market
Management teams compete for the assets of the firm
The market for management teams lowers the specific
assets of financial investors!
Executive pay includes stock options and share packages to incentivize managers
Pavlick, Scott and Tiessen
Compensation and firm performance
First step:
Pay-performance sensitivity
How well is the income of managers and shareholders aligned?
That there is some alignment is relatively uncontroversial today
Second step:
Does performance-related compensation improve on firm performance itself?
Measurement issue: what is performance?
Accounting profits?
Long-run stock returns?
Study specific events (takeovers): do managers act in shareholders interest?
Results:
On specific events: supportive of motivation effect.
On general performance: mixed to no effect.
But: general performance may be affected by too many factors / endogeneity.
Yermack: Why do corporations award stock options?
Hypothesis:
Award stock options when agency costs are high.
The greater the agency problem, the more options should be awarded.
Detailed hypotheses:
The more equity a manager owns, the less stock options should he get.
The closer the manager is to retirement, the more stock options he should get
The higher Tobin’s q, the more the managers info matters, the more options he should get
The noisier accounting returns when compared to stock returns, the more options
The more debt a firm has, the less options the manager should get
Managers of regulated industries receive less stock options
Liquidity constrained firms should prefer paying management with options
Stock options motivated for tax reasons only
Window dressing of financial reports through stock options (stock options are not
deductible).
Yermack: Why do corporations award stock options? (ctd.)
Dependent Variable:
A measurement of stock option variability w.r.t. stock price variability:
1st component:
Derivative of option value w.r.t. stock price
2nd component:
Shares in option award / Total shares outstanding
Multiply the two: Price sensitivity times volume intensity
Divide result by total salary including bonus
Incentive component as proportion of total salary
Yermack: Results
Only three effects are mildly significant
- Managers in regulated industries receive less stock options
- Noisy accounting data increase the incidence of option awards
- Liquidity constrained firms use options more frequently
The core variables do not determine stock option allocations
Three interpretations are possible
- Stock options are not used effectively (i.e. in accordance w/ agency theory)
- Economic theories on option awards are flawed
- Data and testing methodology are flawed
Yermack: Results (ctd.)
Second paper by Yermack finds that earnings announcements report big gains if
stock option awards were made before earnings announcements.
More gains for the CEO accrue if the CEO is on the firm’s compensation
committee
Study by Brenner, Sundaram, and Yermack (2000) on strike price resetting:
Resettings correlate with variables indicating conflicts of interest in the board
Most likely interpretation of findings:
- Theory of actual option awards is incomplete.
- Options may be part of the problem rather than a solution.
Management Share Ownership
General theoretical effects:
Motivation (at lower levels of ownership)
Entrenchment (at higher levels of ownership)
Findings
Initially, both effects were empirically supported
Lately, performance effects of management ownership shares have been
difficult to verify (endogeneity!)
Are value effects of management shares not there, or just difficult to identify?
NO SMOKING GUN!
Stock Options in Germany after KontrAG 1998
Regression explaining 5-year average salary jumps of top managers from 1993 – 1997
vs. 2001 – 2005.
Variable
Profit per employee[1]
Revenue growth
! (total employees)
Log
Growth management board
Mean
€ 5.437
107%
9,63
1%
SDEV
€ 1.478
103%
1,31
24%
Base Salary
min 1 st.dev.
T€ 701
T€ 747
T€ 830
T€ 1071
Base Salary
plus 1 st. dev.
T€ 1328
T€ 1247
T€ 1122
T€ 870
Pavlick, Scott and Tiessen
Survey the literature on executive compensation until 1993
Agency theory is not the only theory: also tournaments, human capital.
Tournaments help identify the best managers in a firm: promotion system.
Do tournament systems need stock option awards for top managers?
Performance may be a function of human capital:
Larger firms need better managers and need to pay them more.
The only thing we certainly observe is that large firms pay more.
More theories
Intrinsic motivation: (Bruno Frey from Zurich researches on the issue)
Equity:
Compare yourself to appropriate reference group
Even income distribution becomes value in and of itself
Rent-seeking:
Bebchuk, Fried and Walker (2002)
Enron, Worldcom, and executive compensation
The Economics of Accounting Firms
- 1977 US Supreme Court Decision lifts ban on advertising in the professions
- Intensified competition justified with reference to ‘reputation’
- Can reputation work in the auditing profession?
The rate of audit failure is less than 1 percent
The customers never see the auditor do their work
Firm’s decisions on hiring the auditor are made by managers who are
the subject of the audit
- Conversely, with doctors and lawyers, it works reasonably well.
- The liberalization of the auditing market was based on a theoretically
flawed argument!
The economic response of the auditing profession
Cut costs by
- lowering auditing standards
- pay less (lower quality of applicants)
Seek additional revenues in consulting (auditing is ‘foot in the door’)
(consulting is a response to, not a cause of the problem)
Additional revenues are diffused by higher liability claims from law suits
500,000,000
400,000,000
300,000,000
Total
200,000,000
100,000,000
96
93
19
90
19
87
Year
19
84
19
81
19
78
19
75
19
19
19
19
72
0
67
A m o u n t o f S ettlem en ts
Total Amount of Settlements
The political response of the auditing profession
Lobby Congress for softer liability rules
(Joint and Several vs. Proportional Liability)
1995 Private Securities Litigation Reform Act
Congress overturns Presidential Veto (only time in Clinton Administration)
Accountants’ Contributions to Political Campaigns
The Business Model Since 1995
Competition, lower audit fees, fast growing consulting business
In 1999, the Securities and Exchange Commission saw the adverse
consequences, wrongly identified consulting services as the culprit,
and tried to stop consulting
Audit industry beat back the effort with political help from the Congress
(disclosure of fees only) Another Political Victory!
Extensive failures of corporate audits are the results of this 25-year chain
of events
Executive compensation then fueled the fire!
Assumptions behind market-based compensation
Markets are efficient (not subject to manipulation by managers)
In spite of the support it enjoys in accounting academia, the
assumption is false
Financial reports are hard, based on unique accounting standards
and incorruptible auditing
Again, a false assumption
Governance mechanism to grant equity-based compensation is
beyond manipulation
Yet another false assumption
How did executive compensation soar?
Director’s compensation committees often controlled by executives
Annual survey techniques of executive compensation consulting firms
Flexible accounting standards (not bad with vigilant analysts and investors)
Auditor under pressure, controlled by managers
Highly leveraged options, one-sided
Skewed accounting for stock options
Result: top to bottom ratio changed from 40 to 500
Incentives to Manipulate
With increased compensation, and increased dependence of compensation on
accounting and market measures, incentives to manipulate accounting and stock
prices rose
The link between Accounting figures and Stock Prices is created by financial
analysts, who assumed continuity in reporting standards.
If the governance, accounting and auditing were rock solid links, it would not
matter. But they are not beyond manipulation
Attempts to better align manager and shareholder interests in the end also
resulted in more manipulation by managers.
With this, stock options become a problem rather than a solution to the
manager shareholder conflict.
The Daimler-Chrysler Merger
Different countries experience different compensation practices: culture!
10-member management board of Daimler-Benz earns less than No. 2 at Chrysler!
Lutz earned $13 mn. before retiring.
Eaton cashes in on previous years’ bonuses, stocks and options: $ 69mn.
All five Chrysler top execs earn $ 168 mn. in merger deal.
Schrempp earns some $1.1-1.5 mn. per year plus Daimler stock options
Ekkehard Wenger goes to court over Daimler stock options: not index linked!
19.4.2000: DC says that “strike prices linked to index-based, performance related
goals or to fixed share price targets would create a significant comparative
disadvantage, particularly compared with competitors in the US.” Shareholders
approve at AGM.
Underlying shares represent 9.7% of share capital!!! Maturity until 2005.
Options are awarded to 1600 top employees at Daimler Chrysler.
The Daimler-Chrysler Merger
International differences in annual chief executive compensation (in US$):
USA France
UK Germany
900,000 523,000 490,000 424,000
UK is already more “Americanized”, Netherlands, France, Spain follow suit.
“Germans argue that executive pay should be closer to that of the average
worker. High pay could endanger social peace. By widening the gap between
rich and poor, German democracy could be jeopardized. The enrichment of
an individual on the backs of workers is considered exploitation.”
Feuerstein, head of Daimler work council: “Daimler-Benz has achieved
considerable cost reductions and thereby improved its competitiveness. All
this was not done to stuff more money into shareholders’ pockets. We
will do everything in our power to prevent that an American company will be
made out of Daimler-Benz.”
Synopsis
Yermack finds that stock options are not awarded according to agency theory
Bebchuk, Fried and Walker explain US managerial contracts with reference to
rent-seeking, not agency (efficiency).
There is a number of dysfunctional elements in executive compensation:
Announcement timing
Strike Price Re-settings
Accounting Fraud (Supported by weak auditing firms)
International evidence suggests that in most countries, most managers are
highly motivated to do a good job despite a noticeable absence of performance
based remuneration to the extent observed in the USA.
Develop other theories further to understand compensation practice better!

Stock Options Application of agency theory to corporate governance

Transcription

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