Investor reactions to equity-based compensation
for management during the financial crisis and
global recession between 2007 and 2012
January 16, 2015
Abstract
This thesis investigates the reactions of investors to announcements of equity-based incentive contracts eligible to the management of a company during the financial crisis and global recession of 2007-2012. Since multiple scholars and researchers argue that the financial crisis of 2007-2008 was caused by excessive risk-taking of managers induced by equity-based executive pay before this crisis, I argue that investors will not approve of such compensation packages in the period where the losses of this crisis have been borne by investors. Results show significantly positive average cumulative abnormal returns after these announcements, which contradicts my expectation. Furthermore, the dilutiveness of the stock issuance for these
contracts and company type do not affect investor reactions.
Jel Classifications : C12, C14, G01, G02, G11, G14
Keywords: equity-based incentive contract; management; risk-taking; financial crisis;
investor behavior
Words : 12499
Karlien van der Vaart
Student number : 2041286
Master thesis Finance 2014-2015
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Investor reactions to equity-based compensation for
management during the financial crisis and global
recession between 2007 and 2012
1. IntroductionIn the period 2007-2008, one of the worst economic crises since the Great Recession of 1930 took place which caused stock markets throughout the world to drop excessively. A lot of factors that could explain how this financial crisis could have been caused have been proposed. One of these proposals concerns the equity-based executive compensation of banks and financial companies prior to the financial crisis. In his article, Bebchuk (2012) mentions how these payments could have led to the financial credit crisis of 2007-2008. He states;
‘Unfortunately, rather than provide incentives to avoid excessive risk-taking, the design of pay arrangements in financial firms encouraged such risk-taking.’
Excessive risk-taking induced by these equity-based compensation packages before the financial crisis destroyed firm value and according to the view of some researchers (Lin et al. ,2013; Bebchuk and Spamann, 2009; Board Of Governors of the Federal Reserve System ,2011 and Blinder, 2009) even caused the financial crisis1. Since investors might
associate these equity-based compensations for executives with ‘perverse’ incentives at managers to take on too high risks that will destroy shareholder value, it is interesting to research the reactions of investors to the use of equity-based compensation for managers in a period in which these reactions have not been investigated before; the financial crisis (2007-2008) and a period of financial distress thereafter; the global recession (2008-2012). By analyzing 1000 firms in the United States, which are a member of the Russell 3000 during the financial crisis and global recession, I investigate whether announcements of (higher) equity-based compensation eligible to the management of a company led to significant changes in trading behavior of investors. This will be measured by the change in
1 This thesis does not answer the question whether the financial crisis was caused by these equity-based executive
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stock price after these announcements. The research question of this thesis will therefore be;
What are shareholders’ reactions to new or higher equity-based compensation for management during the financial crisis and global recession of 2007-2012? 2
Although there is a large extent of literature available which describes the
relationship between equity-based compensation for managers and firm performance, little has been written about the reactions of investors to these equity-based incentive contracts in the financial crisis and global recession. Their trading behavior could be influenced by the fact that investors might associate the equity-based executive compensation packages with the losses these incentive contracts have caused in the financial crisis (Lin et al., 2013; Bebchuk and Spamann, 2009; Board of Governors of the Federal Reserve System, 2011; Blinder, 2009). Investor reactions to equity-based incentive contracts in the period of the financial crisis and global recession might therefore be heavily weighted by the negative perception shareholders might have towards these equity-based incentive contracts. Additionally, referring to the recency hypothesis (Hoyer et al., 2013), it might be expected that the negative perceptions towards these equity-based compensations will be stronger in a period immediately after the losses of the financial crisis have been borne (2007-2009) compared to a few years after the financial crisis (2010-2012) since the losses are easier to bring to mind. The aim of this thesis is therefore to investigate whether shareholders are significantly influenced by the view of certain scholars and researchers who state that the financial crisis was caused by equity-based executive pay prior to the financial crisis.
First, literature which describes the relationship between executive stock ownership
and firm performance as well as a bias in investor decision making, the recency effect, will
be discussed. Second, data and methodology used in this reseach are described. Third,
results concerning the change in stock price after announcements of equity-based incentive contracts eligible to the management of a company in the period of the financial crisis and
global recession will be analyzed. Furthermore, I will explain the results of bivariate analyses
measuring whether average cumulative abnormal returns in the period after these announcements are affected by the dilutiveness of the stock issuance for these contracts
2 In this thesis, I wil mention the period of the financial crisis and global recession which took place between 2007 and 2012
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and company type (financial versus non-financial companies). Finally, I will answer the main research question and I wil mention some suggestions for further research.
2. Literature review
2.1. Executive compensation and firm performance
According to Fama and Jensen (1983), individuals want to maximize their utility when they engage in firm relationships. Because of this phenomenon, the agency theory, certain governance mechanisms that make sure that the interests of the principals (owners) and agents (managers) of the company are aligned have been created. One of these seven mechanisms introduced by Agrawal and Knoeber (1996) are the shareholdings of managers3.
Top executives are more likely to act in the shareholders’ interests when they are
compensated with common stock of the company (Chung and Pruitt, 1996). As Frydman and Jenter (2010) state; "The purpose of option compensation is to tie remuneration directly to share prices and thus give executives an incentive to increase shareholder value". Jensen and Murphy (1990) additionally state that the most efficient way to incentivize managers to behave is to compensate them with a meaningful percentage of the firms’ total outstanding shares rather than a certain amount of money. When senior managers own a substantial percentage of the company’s common stock, they will obtain a ‘feedback effect’ on their actions because their compensation varies with changes in market value of the company. Since a company’s market value increases when managers exert effort and decreases when they do not, it is in their best self-interest to maximize effort. Thus, due to these equity-based compensations for managers the differential between the interests of shareholders and the management will diminish, and therefore agency costs will decline. These equity-based incentive contracts for management will thus be beneficial to shareholders since the contracts maximize their net expected economic value after transaction (e.g. contracting) costs (Core et al., 2003).
Several studies have examined the effect of these equity-based compensations for managers on firm performance. These studies find mixed results regarding this relationship. For example, research results of Chung and Pruitt (1996) indicate a positive relationship between a firms’ executive stock ownership, executive pay and Tobin’s Q. Mehran (1995)
3 The other six mechanisms to align interests between management and shareholders mentioned by Agrawal and Knoeber
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finds that companies where CEO compensation is relatively sensitive to firm performance tend to produce higher returns for shareholders than companies in which this relationship is weak. Firms where CEOs get an equity-based compensation tend to perform significantly better than firms where the CEOs get a compensation independent of firm performance. This relationship is even stronger for higher levels of equity compensation. Furthermore, the percentage of total compensation that is equity-based rather than the level of executive pay results in higher incentives to behave at managers, which is in line with the statement of Jensen and Murphy (1990) mentioned earlier. This can be argued since executives’ equity-based compensation is found to have a significant positive relationship with Tobin’s Q and return on assets, which are proxies for firm performance. A similar result was found in the study of Core and Larcker (2002). They state that stock returns are higher in firms that implemented target management ownership plans, which means that managers are required to own a minimum amount of common stock of the company. These results indicate that there exists a positive relationship between pay-to-performance sensitivity in executive compensation and firm performance which shows support for the intended effect of incentive contracts. Interests will be aligned, which declines agency costs and therefore the value of (shareholders’) common stock will be maximized.
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mention that stock markets reacted positively to long-term incentive plans for executives irrespective of whether these plans were implemented. Furthermore, reactions of investors to implementations of these long-term incentive plans were more positive in firms that stated that the purpose of these incentive plans was to reduce agency costs compared to firms that did not state this purpose. Additionally, a more recent study by Ikäheimo et al. (2004) finds that announcements of employee stock option plans targeted to the
management of Finish firms listed on the Helsinki Stock Exchange resulted in significant positive reactions of investors. The same result is found in the study of Matsuura (2003) where he studies market reactions to stock option plans eligible to the management of firms in Japan.
Although these studies find positive relationships between managerial equity-based compensation and firm performance as well as stock prices, other studies indicate that these results cannot be generalized to every company and equity-based incentive contract. For example, Himmelberg et al. (1999) test whether managerial ownership can be seen as an exogenous variable in the regression model which measures the relationship between managerial stock ownership and firm performance. Results indicate that managerial ownership cannot be fully explained by observed firm characteristics4. Unobserved firm
heterogeneity, measured by superior monitoring technologies of owners, intangible assets and the degree of market power also seem to affect the level of managerial ownership5.
After controlling for observed firm characteristics, superior monitoring technologies of owners, intangible assets and the degree of market power, no evidence can be found for the hypothesis stating that changes in ownership of managers will influence firm performance. Thus, due to the fact that managerial ownership is an endogenous variable in the regression model measuring the impact of managerial ownership on firm performance, results can falsely indicate a (significant) relationship between managerial ownership and firm
4 Himmelberg et al. (1999) mention that observed firm characteristics are the stock price volatility, industry dummies, firm
size, capital intensity, cash flow, R & D intensity, advertising intensity and gross investment rates.
5 A) If superior monitoring technologies are available, lower levels of managerial stock ownership to align interests are
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performance. In fact, Himmelberg et al. (1999) state that it is difficult to find valid instruments measuring managerial ownership since there is a high possibility that these variables might also determine a firms’ Tobin’s Q. Therefore, it proves to be difficult to measure whether there exists a causal relationship between managerial ownership and firm performance. Second, Ozkan (2011) finds a significantly positive relationship between cash compensation of CEOs and firm performance. The relationship between total (equity- and cash-based) CEO compensation and stock returns is however not significant. Robustness tests measuring the relationship between managerial equity-based compensation and a) industry adjusted stock returns, b) return on assets, and c) industry adjusted return on assets do not indicate divergent results. According to Ozkan (2011), reports of corporate
governance which accentuate the link between (equity-based) executive compensation and firm performance do therefore not always seem to be efficient in practice. Frydman and Jenter (2010) state that this relationship between equity-based compensation and firm performance will only be positive when the incentive contract optimally balances incentives provided to risk-averse managers against the exposure of compensation that is highly
volatile. Although a higher amount of equity-based compensation induces managers to act in the interests of shareholders, managerial incentives may also induce managers to take on higher risks, especially in the case of stock options, which have highly volatile payoffs. Apart from that, although equity-based incentive contracts for managers align interests of
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2.2. Causation of the financial crisis of 2007-2008
Multiple scholars and researchers blame corporate governance systems of banks and financial institutions for one of the worst economic crises in history. The Board of Governors of the Federal Reserve System (2011) for example states; “Risk-taking incentives provided by incentive compensation arrangements in the financial services industry were a contributing factor to the financial crisis that began in 2007”. In a press release, they additionally stated that flaws in these compensation arrangements for non CEO-executives would have induced these executives to take on too high risks that would harm firms (Fahlenbrach and Stulz, 2011).6 Bebchuk (2012) mentions two major flaws in features of executive pay before the
financial crisis which induced executives to take on these high risks. First, executive bonus and equity-based pay in banks and financial companies showed a high reliance on results in the short run. The use of stock options strenghtened the gambling on short-term profits by executives since executives would only participate in these short-term gains, while they did not lose money after investing in a bad project (Lin et al., 2013). These losses would be borne by the investors of these banks and financial institutions. After the realization of those short-term results, executives were free to pocket their bonusses and rebalance their
portfolios based on short-term stock prices. Banks and financial institutions therefore permitted executives to get rid of equity incentives based on those stock prices. Thus, executives were encouraged to obtain short-term profits even though these investment choices could destroy long-term shareholder value. Additionally, Beltratti and Stulz (2009) state that banks with shareholder-friendly boards showed worse performance in the
financial crisis than banks that were not characterized by such boards. Fahlenbrach and Stulz (2011) furthermore argue that the performance of CEOs whose interests before the financial crisis were better aligned with those of shareholders was worse during the financial crisis than the performance of CEOs whose interests were not aligned with those of shareholders. The credit crisis can therefore not be blamed on a lack of incentive alignment between shareholders and management. The stock options granted to executives, intended to align interests between both parties rather encouraged managers to take on more risk than would be optimal for shareholders. Managers took these risks because the investment opportunities seemed profitable for shareholders at first glance, but ex post it turned out
6 A high-risk investment may either cause an increase or a decrease in the value of a firm’s assets while the expected value
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they were not. This phenomenon can be explained by the second relevant feature Bebchuk (2012) mentions. This feature concerns the agency costs of external claimants of banks and financial institutions, other than equity holders. Since pay arrangements for executives prior to the financial crisis did not consider the potential losses of other external claimants such as bondholders and the government, executives were not incentivized to minimize their
potential losses. Bebchuk and Spamann (2009) furthermore state that bank executives’ compensations were subject to highly levered bets on the value of a banks’ capital since these companies also issued an enormous amount of debt. Due to these high debt issuances, stock options granted to executives encouraged the executives to underweight downside risks of their investments. This can be explained by the moral hazard problem apparent in banks and financial companies7. Entities that provide equity to a firm will favor more
risk-taking by executives since they will receive the full upside potential (stock price minus invested capital) while downside risks for the company (when the stock price is lower than the amount of invested capital) will be borne by the government in the case of bankruptcy due to the limited liablity of shareholders. Therefore, although the net expected value of the risky strategy may be negative for the firm, shareholders favor this risky strategy as long as the shareholders’ upside potential is higher than their downside risk.8 Because shareholders
would not lose more money than their invested capital, they tended to underweight the losses which would be borne by the government in the period prior to the financial crisis. Therefore, because managers acted in the interests of shareholders they tended to
underweight downside risks of investments. Furthermore, the use of stock options as a form of executive compensation exacerbated this moral hazard problem since the managers would only participate in the gains. Thus, the equity-based incentive compensation packages for executives prior to the financial crisis did not lead to the intended effect of higher firm performance but rather to ‘perverse’ incentives at managers to take on too high risks that harmed the long-term sustainable growth of companies, and therefore the wealth of shareholders (Lin et al., 2013).
Earle (2009) argues that confidence, which is the belief based on experience or
7 This is a general problem in banks and financial companies, it is therefore not specifically apparent in the financial crisis.
8 As an explanation I refer to the example of Bebchuk and Spamann (2009). A bank has $100 in assets ( $10 equity and $90
debt). A risky strategy has a 50 % chance to increase firm value with $20,and a 50 % chance to decrease the value with
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evidence influences the expectations of investors for the future. These expectations will influence the amount of money investors will invest in the company. This confidence in equity-based compensations for managers in the financial crisis and global recession may be harmed since it is argued that the financial credit crisis of 2007-2008 was caused by
executives taking on too high risks in the period before the financial crisis (Lin et al., 2013; Bebchuk and Spamann, 2009; Board of Governors of the Federal Reserve System, 2011; Blinder, 2009). It can therefore be argued that the perception of investors towards these equity-based incentive contracts will be negative during the financial crisis and global recession. Their perception towards these equity-based incentive contracts will be one that resulted in a large loss; the financial crisis. It is therefore expected that during the financial crisis and global recession, investors will focus their attention more towards the losses these equity-based executive compensations have caused, the financial crisis, than to the potential gain of increased firm performance due to the alignment of interests of management and shareholders (Chung and Pruitt, 1996; Mehran, 1995 and Core and Larcker, 2002).
In short, the intended effect of equity-based incentive contracts eligible to the management of a company is to align the interests of managers and shareholders. Because shareholders are aware of the fact that managers will exert more effort when they are compensated with equity, it is expected that shareholders will react positively to such equity-based incentive contracts. These reactions might however be different during the financial crisis and global recession. According to Lin et al. (2013), Bebchuk and Spamann (2009), Board of Governors of the Federal Reserve System (2011) and Blinder (2009), the financial crisis was (partly) caused by equity-based compensation packages of executives before the financial crisis that lead to ‘perverse’ incentives at managers. The losses caused by these equity-based compensation packages could induce shareholders to evaluate the equity-based compensations for executives negatively during this financial crisis and the global recession. The null and alternative hypothesis to be tested in this thesis will therefore be;
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Additionally, to measure to what extent the dilutiveness of a stock issuance for these based incentive contracts and company type affect investor reactions towards equity-based compensation contracts for management during the financial crisis and global
recession, I introduce two subhypotheses.
First, Martin and Thomas (2005) state that the stock issuances for equity-based incentive contracts eligible to the management should not be highly dilutive. This is because highly dilutive stock issuances cause a decline in the value of common stock available to investors. Shareholders will therefore not approve of highly dilutive stock issuances. The first subhypothesis will therefore be;
H1a: Announcements of higher managerial equity-based compensation during the financial crisis and global recession of 2007-2012 lead to significantly more negative changes in share prices for highly dilutive stock issuances of equity-based incentive contracts compared to equity-based incentive contracts which are less dilutive.9
Second, because it is argued that the financial crisis was (party) caused by equity-based executive compensation packages of banks and financial institutions prior to the financial crisis (Lin et al., 2013; Bebchuk and Spamann,2009; Board of Governors of the Federal Reserve System, 2011; Blinder, 2009), investors of these financial companies have experienced the losses of these managerial equity-based compensation packages while investors in non-financial companies have not. Therefore, investors of financial companies may react more negatively towards announcements of equity-based incentive contracts eligible to management compared to investors of non-financial companies. The second subhypothesis will therefore be;
H1b: Announcements of higher managerial equity-based compensation during the financial crisis and global recession of 2007-2012 lead to significantly more negative changes in share prices for financial companies compared to non-financial companies.
Furthermore, a behavioral bias in the decision making of investors, the recency hypothesis, states that an event that occures later in a sequence will have more influence in future decision making compared to events that occured earlier in this sequence (Hoyer et
9 In general, the relationship between dilutive stock issuances and investor reactions is negative. There is no reason to
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al., 2013). Hartono (2004) finds that changes in the order and timing of dividend and earnings surprises resulted in different effects on stock returns. Later surprises of these dividends and earnings were associated with larger impacts on stock returns than earlier surprises. Referring this to the announcements of equity-based incentive contracts for management in the financial crisis and global recession, it can be argued that the hypothesized negative relationship between announcements of equity-based incentive contracts eligible to management and firm performance will be stronger in a period immediately after the losses of these executive compensation packages have been borne compared to announcements made a few years later. Because the losses caused by these equity-based executive compensation packages in the financial crisis are more recent than the gains of higher firm performance due to aligned interests before the financial crisis (Chung and Pruitt, 1996; Mehran, 1995; Core and Larcker, 2002), investors are expected to focus their attention more towards the losses of these equity-based incentive contracts than to their potential gains. The second hypothesis that will be tested in this thesis will therefore be;
H2: Announcements of higher managerial equity-based compensation during a period immediately after the losses of the financial crisis have been borne (2007-2009) lead to significantly more negative changes in share prices compared to announcements of higher managerial equity-based compensation made a few years later (2010-2012).
3. Data
3.1. Sample selection
In this study, the event study methodology is used to measure investor reactions to the announcements of (higher) managerial stock ownership as a form of executive
compensation during the financial crisis and global recession. To be able to measure these reactions, I focus on firms that announced equity-based incentive contracts that were eligible to the management10 of a firm in the period between September 2007 and
December 2012. Therefore, I randomly selected 1000 companies from the Russell 3000
10 No general definition of ‘management’ exists for the sample of firms used in this study. For some firms in the sample, a
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Index and studied all their proxy statements11 for the years 2007-2012 which were available
on the site of the Security Exchange Commission (SEC). For this period, a total of 250 announcements of equity-based incentive contracts eligible to the management of 201 companies could be acknowledged12. Unfortunately, stock prices for four firms could not be
gathered. These firms, which in total made seven announcements of equity-based incentives for management were therefore removed from the sample. To be able to assign an event date to the announcement of these equity-based incentive contracts I analyzed other event studies which measured investor reactions to announcements of additions to corporate boards (Farrell and Hersch, 2005), announcements of CEO perquisites (Yermack, 2006), announcements of CEOs inside debt (Wei and Yermack, 2011), announcements of stock option compensation for outside directors (Fich and Shivdasani, 2005) and announcements of long-term performance plans (Kumar and Sopariwala, 1992).13 Since these studies use the
filing date of the proxy statements as the event date, I also consider this date to be the event date14. Yermack (2006) and Wei and Yermack (2011) additionally mention that some firms
file a preliminary proxy statement a few weeks before the definitive proxy statement. For 243 announcements, I therefore checked whether firms filed a preliminary proxy statement prior to the definitive proxy statement. In 44 cases, firms did file such a preliminary proxy statement. For five events, equity-based incentive contracts eligible to management were also announced in press releases. These press releases however occurred on the same day as the filing date of the definitive proxy statement. Furthermore, I analyzed whether
companies announced the incentive plan of managerial equity-based compensation on their websites before the proxy filing dates. In no case, companies placed an announcement of an equity-based incentive contract eligible to the management on their website prior to the filing date of the (preliminary) proxy statement. Finally, I checked whether other news that could influence investor reactions was released on the filing date of the (preliminary) proxy
11 A proxy statement is a ‘’ document containing information that a company is required by the SEC to provide to
shareholders so they can make informed decisions about matters that will be brought up at an annual stockholder meeting’’
(www.investopedia.com)
12 Since multiple firms in the sample made more than one announcement of equity-based incentive contracts eligible to
management, I considered a 120-day estimation period to rule out that previously announced incentive contracts (announced more than 120 prior to the ‘current’ incentive contract) bias the results (see methodology section).
13 Kumar and Sopariwala (1992) considered the proxy stamp date or the proxy mailing date (the one that was first) as the
event date. Because firms now mail their statements to the Security Exchange Commission, these two dates are the same and are nowadays called the filing date of the proxy statement (Choi and Dow, 2008).
14 For one event, the announcement date of the proxy statement occured during the weekend (February 7, 2009).
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statement by searching through the LexisNexis News Database. For seven of these 243 announcements, press releases about the firm that were likely to influence stock prices at the announcement date were found. These press releases stated that these companies appointed new management positions, executive officers violated SEC rules, companies had insolvent balance sheets or that a company had completed acquisitions on the
announcement date. These seven events were also eliminated from the sample since the reactions of investors are likely to be influenced by these ‘other’ events. The reaction of investors to announcements of equity-based incentive contracts eligible to the management will therefore not be measured when these events are included in the sample. All in all, 236 announcements of equity-based incentive contracts eligible to the management of 193 US firms in the period of the financial crisis and global recession are included in the sample.
3.2. Data description
The distribution of announcements of equity-based incentive contracts eligible to the management of a company in the period of the financial crisis and global recession
(September 2007-December 2012) are depicted in Table 1. The average amount of
announcements in the years 2008-2012 equals 47. Most striking is however that only three announcements of equity-based incentive contracts have been made in 2007. I reckon that this difference can be (partly) explained by the fact that announcements in the period from January till August 2007 have not been included in the sample since the financial crisis began in September.However, one could argue that approximately twelve announcements (47/12 months *4 months) of equity-based incentive contracts should be acknowledged in the period September- December 2007. Since a total of three announcements is significantly lower than twelve, it might be the case that other variables are influencing the amount of announcements of equity-based incentive contracts made in the period between September and December 2007. Whether this assumption is correct is beyond the scope of this
research. It might however be interesting to research this in the future.
Table 1. Distribution of announcements of equity-based incentive contracts eligible to the management of a company in the financial crisis and global recession.
2007 2008 2009 2010 2011 2012
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The events of this study always consider an increase of managerial equity-based compensation, either by a proposal for a new equity-based incentive plan or through increasing the available number of shares for issuance under an existing equity-based incentive plan, which is called an amendment to an existing incentive plan. In 82 events, a new incentive plan was proposed, while amendments to existing incentive plans were proposed in 154 events.
4. Methodology
4.1. Event study
The first step in measuring the reactions of investors to equity-based incentive contracts eligible to the management of a company in the financial crisis and global recession is to calculate abnormal returns in this period. For this study, I use the market model methodology described by Brown and Warner (1980, 1985) to calculate abnormal returns around the filing dates of the (preliminary) proxy statements (Farrell and Hersch, 2005; Yermack, 2006; Fich and Shivdasani, 2005 and Kumar and Sopariwala, 1992).15Eq. (1)
describes how these abnormal returns are calculated.
AR i,t = R i,t - 𝛼̂ i -𝛽̂i *R m,t (1) The returns of all companies (Ri,t) are compared with the returns of the market index (Rm,t) , the S&P 500. Although event studies are commonly used to measure changes in stock returns after corporate events, no standard estimation and event window exists. However, estimation periods are not shorter than 120 trading days (Campbell et al., 2003). Because some firms in the sample file their proxy statements every six months, or in cases in which preliminary proxy statements are filed, five months after the last announcement, an
estimation period of 120 trading days is used. By using a longer estimation period, previously made announcements of equity-based incentive contracts eligible to the management of a firm will be influencing the estimation period, which will bias the results. Therefore, returns for the 120-day estimation period preceding two days before the announcement date (Subramani and Walden, 2001; Campbell et al., 2003) are calculated. The returns in this
15Binder (1998) mentions five methods for performing event studies; mean-adjusted returns, market-adjusted returns,
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estimation period are then compared with the trading behavior of investors in the event window (-1;1) (Farrell and Hersch, 2005; Fich and Shivdasani, 2005), immediately after the announcement date of equity-based incentive contracts eligible to management. Fig. 1 depicts the timeline used in this study.16
Figure 1. Timeline of the event study measuring investor reactions to announcements of equity-based incentive
contracts eligible to the management of a company in the financial crisis and global recession (MacKinlay, 1997)
Estimation window Event window |---|---|---|---|
-122 -2 -1 0 1
Taking into consideration that stock prices can revise during one day, cumulative abnormal returns in the period after an announcement of an equity-based incentive contract eligible to management, the event window, are more important to calculate. (MacKinlay, 1997; Campbell et al., 2003). Furthermore, if the event is expected to influence stock prices at days after the event date, average cumulative abnormal returns are more useful than average abnormal returns. Eq. (2) shows how these cumulative abnormal returns are calulated.
CAR i, t = ∑𝑡2𝑡=𝑡1 𝐴𝑅 𝑖, 𝑡17 (2)
4.2. Additional analyses
Besides the performed event study which measures the reactions of investors to announcements of equity-based incentive contracts eligible to the management of a company for the whole sample (236 events), this section considers four additional analyses regarding average (cumulative) abnormal returns in the event window. I will briefly discuss the purpose of each analysis.
4.2.1. Number of announcements
To measure whether the reactions of investors of companies that have made one
16 Since previous event studies use varying lengths of event windows, I also calculated average (cumulative) abnormal
returns in the event window (-5;5) as a robustness test to indicate whether results differ when a different event window is used. This event window is also used in the study of Kumar and Sopariwala (1992). The estimation window in this study is (-126;6)
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announcement of an equity-based incentive contract differ from investor reactions of companies that have made multiple announcements in this period, the additional analysis ‘Number of announcements’ is performed.
4.2.2. Source of proxy statement
To measure whether investor reactions to definitive proxy statements differ from the reactions of investors to preliminary proxy statements, the additional analysis ‘Source of proxy statement’ is performed.
4.2.3. Purpose of incentive contract
To validate whether the announced equity-based incentive contracts are supposed to increase firm performance as stated by Agrawal and Knoeber (1996), I investigated the purposes of these incentive contracts, which were stated in the proxy statements. In general, firms argue that the purpose of equity-based incentive contracts eligible to the management is;
Purpose 1: Aligning executive compensation with the firms’ business strategy and/or aligning the interests of management with the interests of shareholders.
Purpose 2 : Aligning executive compensation with the firms’ business strategy and/or aligning the interests of management with the interests of shareholders and
attracting, motivating and retaining executive officers.
To measure whether investor reactions to announcements of equity-based incentive contracts with purpose 1 differ from reactions of investors to announcements of equity-based incentive contracts with purpose 2, the additional analysis ‘Purpose of incentive contract’ is performed.
4.2.4. Announcement type
To measure whether investor reactions to announcements of new equity-based incentives differ from investor reactions to amendments to existing equity-based incentive plans, the additional analysis ‘Announcement type’ is performed.
4.2.5. Differences of (C)AARs
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Difference AAR = AARevent window, group a – AAR event window, group b (3) Difference CAAR= CAAR event window,group a – CAAR event window, group b (4) These differences will be tested on significance using the Student’s t-test.
4.3. Bivariate analyses (Determinants of average CARs)
The next step in measuring investor behavior after announcements of equity-based incentive contracts eligible to management is to measure whether average cumulative abnormal returns in the event window are affected by the dilutiveness of the stock issuance for these equity-based incentive contracts and company type (financial versus non-financial companies). Therefore, I create bivariate analyses where average cumulative abnormal returns are dependent on these variables. Additionally, a total of nine control variables that are also likely to influence average CARs are included in the model. The explanatory
variables and their expected relationship with average CARs will now be discussed.
Variable 1 : Dilutiveness of stock issuance
Martin and Thomas (2005) notice that shareholders do not approve of highly dilutive stock issuances since the value of investors’ common stock declines. Therefore, I expect the relationship between announcements of equity-based incentive contracts eligible to the management of a firm in the financial crisis/ global recession and average CARs to be more negative for highly dilutive stock issuances compared to contracts with low dilutive
issuances. 18
Variable 2: Type of company
According to Lin et al. (2013), Bebchuk and Spamann (2009), Board of Governors of the Federal Reserve System (2011) and Blinder (2009), the financial crisis of 2007-2008 was caused by equity-based executive compensation in banks and financial institutions prior to the financial crisis. Investors of financial companies have experienced the losses of these equity-based compensation packages, while investors in non-financial companies have not. Therefore, I expect investors of financial companies to react more negatively towards
18 The relationship between the dilutiveness of a stock issuance and investor reactions is a general (negative) relationship.
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announcements of equity-based incentive contracts eligible to management in the financial crisis and global recession compared to investors of non-financial companies.19
Control variables
To validate that the relationships between the two variables just discussed and average CARs are robust, I also include control variables in the bivariate analyses. The first control variable entails firm size, measured by the natural log of total sales (Farrell and Hersch, 2005; Fich and Shivdasani, 2005; Yermack, 2006; Kumar and Sopariwala, 1992). Furthermore, although many event studies that measure investor reactions to executive pay, board structures, stock splits, voting rights for shareholders and various other topics use the proxy statement filing date as the event date, Brickley (1986) states that other proposals announced in these proxy statements could also influence investor reactions. I therefore analyzed all 236 proxy statements and checked whether announcements of other proposals could be influencing the average cumulative abnormal returns. I found six other proposals of plans that could influence average CARs. First, in 34 events, announcements of new
(requirements for) directors or changes in board structure were announced (Rosenstein and Wyatt, 1990).20 Secondly, employee stock purchase plan announcements were spotted in 22
proxy statements (Chang, 1990). Third, 15 proxy statements contained announcements of a change in the number of authorized shares or a change in the price of shares or options (Lamoureux and Spoon, 1987). For 213 events, appointments of independent auditing firms were announced in the proxy statement (Aggarwal et al., 2007). The fifth proposal, apparent in 9 events is the announcement of director incentive plans (Gerety et al., 2001). The last proposal for which I include a control variable captures cash-based incentive compensation for management which was announced in 14 proxy statements (Ozkan, 2011). Finally, to check whether reactions of investors differ for firms that announced an equity-based incentive contract eligible to management earlier in the period 2007-2012, the eighth control variable ‘earlier announcement’ is implemented in the bivariate analysis. Eq. (5) depicts the bivariate analysis.
19 This relationship is not a general one, I specifically expect this relationship during the financial crisis and global recession.
20 Changes in requirements for directors imply changes in age limits for directors and/or a change in the percentage of
20
Average CAR = c + β1 Dilutiveness of stock issuance + β2 Type of company + β3 Firm size + β4 Δ Directors/ Board structure + β5 Employee Stock Purchase Plan + β6 Δ Number of
authorized shares/ (option) price + β7 Appointing of independent auditing firm + β8 Director Incentive Plan + β9 Cash Incentive Plan for management + β10 Earlier announcement + ε (5) Table 2 shows how the explanatory variables of the bivariate analysis are calculated.
Table 2. Explanation of variables used in the bivariate analyses
Explanatory variable Measurement of value
Dilutiveness of stock issuance
Type of company
Control variables 1. Firm size
2. Δ Directors/ Board structure 3. Employee Stock Purchase Plan 4. Δ Number of authorized shares
/ (option)price
5. Appointing of independent auditor 6. Director Incentive Plan
7. Cash Incentive Plan for management
8. Earlier announcement
Shares or options available for issuance in the contract
Common stock outstanding after implementation of the contract1
Dummy variable :
1) Financial company 0) Non-financial company
Natural log of total sales
Dummy variables;
1) Proposed in proxy statement 0) Not proposed in proxy statement
1) Proposed in proxy statement 0) Not proposed in proxy statement 1) Proposed in proxy statement 0) Not proposed in proxy statement
1) Proposed in proxy statement 0) Not proposed in proxy statement 1) Proposed in proxy statement 0) Not proposed in proxy statement 1) Proposed in proxy statement 0) Not proposed in proxy statement
1) Proposed in proxy statement 0) Not proposed in proxy statement
1 Common stock outstanding after implementation of the incentive contract equals common stock outstanding prior to the
plan + Amount of shares and/or options available for issuance in the incentive contract (+/- Change of stock under a proposal for a change in the number of authorized shares). This value equals the percentage of common stock that is issued in favor of these equity-based incentive contracts for management, and therefore the percentage of investors’common stock that is ‘diluted’.
4.4. Discussion of descriptive statistics of the explanatory variables
21
highly dilutive stock issuances for equity-based incentive contracts. Firm size varies from a minimum value of 4.76 to a maximum value of 11.51. The majority of the observed values however varies from 8.28 to 9.49 which indicates that firm sizes in the sample are relatively similar. The number of events for which a dummy value equals zero and one are depicted in Table b2. The table shows that 197 announcements of equity-based incentive contracts in the sample are announced by non-financial companies, while 39 announcements are made by financial companies. Except for the appointment of an independent auditing firm, other proposals that were announced in the same proxy statement as the equity-based incentive contract for management were observed in approximately 4-15% of the events.
Appointments of independent auditing firms were announced in 90% of the proxy
statements. This indicates that average CARs are in general also dependent on appointments of independent auditing firms. In some cases, average CARs depend on other proposals as well.
4.5. Correlation matrix
The correlation matrix in Table c in the appendix displays the correlations between all explanatory variables of the bivariate analysis. The highest correlation exists between the variables ‘Dilutiveness of stock issance’ and ‘Firm size’. The correlation between these variables equals -0.171 which indicates that ‘Dilutiveness of stock issuance’ and ‘Firm size’ tend to vary together in approximately 17.1 % of the observations. Since this correlation is not high enough to be worried about multicollinearity in the bivariate analysis which could bias the results, all variables can be included in the bivariate analysis.
5. Results
5.1. Univariate analysis of abnormal returns
22
Table 3. Results of event study analysis in event window (-1;1).
Average Z-score P-value
AR (0) 0.002 -1.80 0.04a
AR (1) 0.000 -0.05 0.48
CAR (-1;0) 0.003 -2.26 0.02a
CAR (0;1) 0.002 -1.48 0.07b
CAR (-1;1) 0.003 -2.50 0.01a
aSignificant at a 5% confidence interval
bSignificant at a 10% confidence interval
Table 3 shows that average (cumulative) abnormal returns are positive for all windows. Except from average abnormal returns at one day after the announcement of equity-based incentive contracts eligible to management, AR (1), all (C)AARs are significant. As a robustness check, I also calculated the average CAR in the event window (-5;5). Results are similar to the results depicted in table 3 (Average CAR; 0.003, Z-score; -1.84, P-value; 0.03). For the days following the announcement of equity-based contracts eligible to management in the period of the financial crisis and global recession, I therefore find evidence which indicates that the stock prices of companies announcing an equity-based incentive contract eligible to the management are higher rather than lower after this announcement. This contradicts my expectation formulated in the first alternative hypothesis (H1).
5.2. Results of additional analyses
23
more positively towards announcements of amendments to existing equity-based incentives compared to announcements of new incentives. For the analysis ‘Purpose of incentive contract’ I find no evidence of significant differences in (C)AARs in the event window (-1;1). However, the robustness test which calculates the differences of (C)AARs in the event window (-5;5) shows that (C)AARs are significantly higher for announcements of equity-based incentive contracts with purpose 1 compared to announcements of equity-equity-based contracts with purpose 2. Therefore, investors tend to react more positively to
announcements of equity-based incentive contracts with the purpose of aligning interests between shareholders and management compared to the situation in which companies state that the contract also serves another purpose, namely attracting, retaining and motivating executives.
5.3. Recency effect
Average cumulative abnormal returns in the window (-1;0) for announcements of equity-based incentive contracts eligible to management made in the periods 2007- 2009 and 2010-2012 are depicted in Fig. 2. The non-significant results for the windows (0;1), (-1;1) and (-5;5) can be found in Table e in the appendix.
Figure 2. Average cumulative abnormal returns for the periods 2007-2009 and 2010-2012 in the event window (-1;0)
From Fig. 2, I infer that (C)AARs are higher (more positive) in the period 2007-2009 compared to the period 2010-2012. The difference (0.007) is significant at a 1% confidence interval. Announcements of equity-based incentive contracts eligible to management made immediately after the losses of the financial crisis have been borne (in the period 2007-2009) therefore resulted in statistically significantly higher positive average CARs compared to announcements made a few years later, in the period 2010-2012. This result contradicts the second alternative hypothesis (H2) which argued that investors would react more negatively
24
towards announcements of equity-based contracts eligible to management in the period 2007-2009 compared to the period 2010-2012.
5.4. Bivariate analyses (Determinants of average CARs) 5.4.1 Results of bivariate analysis without control variables
In the previous section I mentioned that statistically significant positive (C)AARs can be acknowledged in the period following the announcement of equity-based incentive contracts eligible to management during the financial crisis and global recession. In this section I measure whether the dilutiveness of the stock issuance for these equity-based incentive contracts and company type affect these significant CARs.
Table 4 depicts the results of the performed bivariate analyses. For the event windows (-1;0) ,(0;1), and (-1;1) the coefficients of the explanatory variables are displayed. The associated P-values are presented between brackets.
Table 4. Results of bivariate analysis excluding control variables.
Dependent variable Average CAR (-1;0) Average CAR (0;1) Average CAR (-1;1)
Intercept
Dilutiveness of stock issuance
Type of company R2 0.0030 (0.15) 0.013 (0.57) -0.0036 (0.29) 0.0072 0.0018 (0.34) 0.0014 (0.95) 0.0027 (0.40) 0.0031 0.0033 (0.14) 0.0058 (0.82) -0.0013 (0.73) 0.0009
Table 4 shows no significant results. Results of the performed robustness test in the event window (-5;5) are displayed in Table f in the appendix. These results do not differ from the results depicted in Table 4. Therefore, I cannot conclude that average CARs are
25
5.4.2. Results of bivariate analysis including control variables
The results of the bivariate analyses where control variables are included in the regression model are displayed in Table 5. Once again, the coefficients of the explanatory variables are presented in the table, the associated P-value is displayed between brackets. Table 5. Results of bivariate analysesincluding control variablesa
Dependent variable Average CAR (-1;0) Average CAR (0;1) Average CAR (-1;1)
Intercept 0.0013 (0.32) 0.014 (0.31) 0.0096 (0.47)
Dilutiveness of stock issuance 0.0044
(0.84) -0.0051 (0.83) -0.026 (0.92) Type of company -0.0044 (0.13) 0.0018 (0.56) -0.0023 (0.56) Firm size -0.0011 (0.43) -0.0009 (0.53) -0.0004 (0.77)
Δ Directors/ Board structure -0.0025
(0.52)
-0.0006 (0.84)
-0.0027 (0.50)
Employee Stock Purchase Plan -0.0006
(0.89)
-0.0034 (0.42)
-0.0045 (0.35)
Δ Number of authorized shares/ (option) price
0.0027 (0.69)
X1 -0.0018
(0.75)
Appointing of independent auditor 0.0015
(0.74)
-0.029 (0.58)
0.0004 (0.93)
Director Incentive Plan 0.0010
(0.92)
-0.0045 (0.61)
-0.0071 (0.32)
Cash Incentive Plan for management -0.0011
(0.82) -0.0003 (0.95) -0.0040 (0.50) Earlier announcement -0.0050 (0.10) -0.0038 (0.19) -0.0047 (0.21) R2 0.0262 0.0190 0.020
a For the bivariate analyses on Average CAR (-1;0) and Average CAR (0;1), White heteroskedasticity- consistent standard
errors have been used due to the violation of the assumption Var(µt) = σ2 (homoscedasticity in variance)
1 Since this control variable shows a significant influence on average CARs at a 10% confidence interval, this variable is
26
Table 5 shows that the results of the bivariate analyses including control variables do not differ much from the results found earlier. No significant relationships can be
acknowledged between the explanatory variables ‘Dilutiveness of stock issuance’ and ‘Type of company’ and the dependent variable, average cumulative abnormal returns. These results are robust since the same result is found in the bivariate analysis which measures the impact of the dilutiveness of the stock issuance and company type on investor reactions in the event window (-5;5). Results of this robustness test are displayed in Table g in the appendix.
6. Conclusion
In this thesis I examine investor reactions to announcements of equity-based incentive contracts eligible to the management of a company in the period of the financial crisis and global recession which took place between September 2007 and 2012. This thesis contributes to existing literature since reactions of investors to equity-based pay in the financial crisis and global recession have not been investigated before. Although these incentive contracts are most likely to be approved by shareholders due to alignment of interests which will increase shareholder value, certain scholars and researchers argue that the financial crisis was (partly) caused by these equity-based compensation packages for executives. Therefore, I expect that investors will react negatively towards announcements of equity-based compensation eligible to the management of a company in the period where the losses of this financial crisis have been borne by investors.
I find that investors react significantly positive to announcements of equity-based incentive contracts eligible to management in the period of the financial crisis and global recession. Additionally, statistically significantly more positive increases in stock returns were found in the period 2007-2009, immediately after the losses of the financial crisis have been borne, compared to the period 2010-2012, a few years after these announcements were made. These results contradict my expectations stated in the alternative hypotheses, since I expected a negative relationship between announcements of equity-based incentive contracts and investor behavior. The significant positive stock returns after the
27
6.1. Limitations and critical reflection of the research
The aim of this thesis was to measure whether investors are significantly influenced by the view of multiple scholars and researchers who state that the financial crisis was caused by equity-based executive compensation prior to the financial crisis. This study does however not answer the question whether these compensations actually did cause the financial crisis. If shareholders have evidence stating that equity-based executive pay was not a primary cause of the financial crisis, their reactions may be different from the reactions hypothesized in this thesis. Second, as discussed in the data section, this study considered announcements of equity-based incentive contracts eligible to the management of a
company, where at least executives were eligible to the contract. However, multiple firms in the sample also considered chief financial officers, directors, consultants and advisors to be part of the management. Therefore, shareholders will also react to the payment of these other parties of the management. Since no scholars and researchers have argued that the payment of these other parties have caused the financial crisis, shareholders might react differently to equity-based pay for chief financial officers, directors, consultants and advisors compared to equity-based executive pay. Therefore, to measure whether investors are significantly influenced by the view of those scholars and researchers who state that the financial crisis was caused by equity-based executive pay, it may be wise to solely consider announcements of equity-based compensation eligible to executives. A final critical note I would like to point out concerns the control variables used in the bivariate analyses. I considered the study of Wei and Yermack (2011) to be helpful in finding control variables. They reckon that shareholders are likely to react to other proposals announced in the proxy statement as well.21 Therefore, I followed their strategy in finding control variables which
entailed analyzing the proxy statements for other proposals that could be influencing investor reactions. However, it turns out that employee stock purchase plans and director incentive plans are related to the use of equity-based compensation for management. It could therefore be argued that these variables are not appropriate as control variables in the bivariate analyses. Other variables that could be used as control variables are CEO’s age, education and affiliation (Fich and Shivdasani, 2005; Yermack, 2006). These variables were not included in the bivariate analyses since the data required was not always available in the
28
proxy statements. This information should be gathered from annual reports and company websites.
6.2. Lessons and recommendations
Since this study noticed that investor reactions to equity-based pay of management were positive it can be concluded that shareholders approve the equity-based management pay in the financial crisis and global recession. These results therefore show no evidence for the expectation that investors may have a negative perception towards equity-based management pay in the financial crisis and global recession. Investors were therefore not worried about executives taking on too high risks induced by equity-based executive pay. These results indicate that companies can continue granting their management an equity-based compensation in the future since investors react positively towards these contracts.
As emphasized multiple times in this thesis, stock options encourage high risk-taking of executives to the highest extent since managers will only participate in the gains of investments while losses will be borne by investors (Frydman and Jenter, 2010 ; Bebchuk, 2012 and Bebchuk and Spamann, 2009). Therefore, I do recommend companies to think very carefully about whether they want to compensate management with these stock options since executives will undertake investments that may destroy firm value irrespective of whether they act in the interests of shareholders.
6.3. Suggestions for further research
The additional analysis ‘Announcement type’ found that investors react less positively to announcements of new equity-based incentive contracts for managers in the financial crisis and global recession compared to announcements of amendments to existing equity-based incentive plans. Currently, there are no studies that could explain this result. Therefore, I suggest researching this in the future since this could be of high importance for companies. When companies know why these results differ, they could choose to exclusively announce amendments to existing equity-based incentive contracts or provide more
29
contracts was to decline agency costs compared to companies that did not state this purpose, they did not measure whether investor reactions would differ if companies also stated the purpose of attracting, retaining and motivating executives. It could be that
investors react less positively to these equity-based incentive contracts since they do not see how attracting, retaining and motivating executives will be beneficial for them. Whether this reasoning could explain the observed results should however be researched in the future. Finally, I would like to propose researching to what extent a ‘Say on Pay’ procedure can explain the significant positive reactions to equity-based incentive contracts for
management in the financial crisis and global recession. This procedure provides shareholders a voice in the payment of management and contributes to making
management pay more transparent, accountable and performance-linked (Hodgson, 2009). Cai and Walking (2011) state that the ‘Say on Pay’ procedure is a mechanism that may aid in aligning interests between management and shareholders by giving shareholders a voice in executive pay which will lead to more efficient compensations for management, causing an increase in firm value. Therefore, the potential of too high risk-taking of executives induced by these equity-based compensation (which is the main problem stated in this thesis) could be declined. 22 One could also argue that shareholders’ confidence in equity-based
compensation, that may be harmed as explained in this thesis, may be restored since
shareholders’ opinions about the accountability and performance-linkage of these executive compensation will be taken into consideration in the case of a ‘Say on Pay’ procedure23.
Since investors’ confidence on equity-based executive compensation may be restored if they can give an advisory vote on executive pay, shareholders may weight the losses of the financial crisis less in the case in which a company has adopted a ‘Say on Pay’ procedure compared to the case in which a company has not adopted such a procedure. This may therefore be an explanation for the observed positive average cumulative abnormal returns after the announcements of equity-based incentive contracts.
22 For example, shareholders could mention that a firm should lower the amount of stock options granted to executives
since this encouraged (too) high-risk taking to the largest extent compared to compensation in the form of common stock (Frydman and Jenter, 2010 and Bebchuk and Spamann (2009). Since too high risk-taking is declined, shareholder value will increase which is favored by shareholders.
23 Grundfest (1993) mentions that management is expected to act in the best interests of shareholders when a ‘Say on Pay’
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