Thursday, March 12, 2015

How Equity-based Compensation Misaligns the Interests of Shareholders and Management

Updated December 2016

In today's corporate world, most of us are aware that executive compensation has grown astronomically over the past two decades with most of the growth coming in the form of either stock options or bonus schemes that involve equities.  While the alleged reason that companies took this route was to "better align management interests with those of their shareholders", in fact, what it has done is significantly enrich a very select group of people.  Not only has the increased use of stock-based compensation become pervasive, the issuance of stock has been manipulated to increase the netback to executives.

Unlike most studies which look at how companies time the granting of options, a recent study by the European Corporate Governance Institute looks at how corporations/CEOs strategically time the release of discretionary corporate news to coincide with the months in which the equity portion of their overall compensation package vests.  The study looks at how prevalent this practice has become in two ways:

1.) a CEO who intends to sell stock in a given month that delays certain news releases until the month of vesting is reached.

2.) a CEO who intends to sell stock in a given month that accelerates certain news releases until the month of vesting is reached.

Obviously, corporations need to release information to the investing public to assist investors in making decisions about both buying and selling a stock, decisions that can have a significant positive or negative impact on a share price.  News releases can also be used to attract investor attention which can result in temporary share price appreciation.  By releasing news, ideally, the playing field for all investors is "levelled".

For those of you that aren't aware, stock-based compensation is generally not immediately available to recipients.  For example, in the case of stock options, a certain number of options will be granted and on each one-year anniversary date, a percentage of those options will vest, allowing the option holder to buy the stock at the option price and then sell the shares (presumably at a profit), pocketing the difference between the option strike price and the current trading price of the share.  In some cases, options vest over a three-year or five-year period, meaning that on the first, second, third, fourth or fifth anniversary date, one-third or one-fifth of the total volume of shares granted will vest.    Critical to the analysis, the authors found that CEOs are 23 percent more likely to sell an equity shortly after it vests.  This means that the schedule of vesting leads to equity sales which are closely linked to short-term price concerns.   

The authors used a database that ranged through the years from 2006 to 2011.  They used a database that allowed them to divide news releases taken from over 20,000 public news sources into two types:

1.) discretionary news:  this news is released at the discretion of the CEO and includes things like client and product announcements, special dividends, impairments and write-offs, IPOs, share buybacks etcetera.  Changing the timing of discretionary news is legal

2.) non-discretionary news:  this news is released on a fixed schedule and includes things like quarterly and annual earnings, board meetings, annual general meetings etcetera.

News items are included only if they are sourced from within the corporation and are ignored if they are sourced by the media covering stock market activity.  In months where corporations release news, a typical company has an average of 4 news releases, three of which are discretionary.  Over an entire year, when months with no news releases are included, a typical company releases 1.8 news items per month, 1.5 of which are discretionary.  A median discretionary media article contains 23 percent positive words, 32 percent negative words and 16 percent neutral words.  In vesting months, discretionary news releases have significantly more positive words and fewer neutral words.  Firms also release less discretionary news one month before and one month after the vesting month which suggests that CEOs are either delaying or accelerating the release of discretionary news.

The authors also examined the content of the news releases, looking to see whether the tone of discretionary news changes during vesting months.

Now, let's get to the author's findings.

The analysis shows:

1.)  that an average CEO equity sale represents 6.2 percent of the average daily trading volume and represents 0.165 percent of shares outstanding.  

2.) that the disclosure of one discretionary news item in a vesting month generates a 16-day abnormal return of 28 basis points (0.28 percent).

3.) that on the first day after a discretionary news release, abnormal trading rises by 0.32 percent of outstanding shares.

4.) that the median interval between a discretionary disclosure in a vesting month and the first equity sale by a CEO is five days and the median interval until the CEO sells the entire vesting amount is 7 days.  More than 50 percent of CEOs sell stock in the vesting month and in 17 percent of cases, the CEO sells all of the equity in the vesting month.  CEOs are 23 percent more likely to see shares in a month in which stock vests than in a month in which no stock vests.  All of this suggests that CEOs are concerned about short-term stock price fluctuations.

Here is a bar graph which shows the number of days between discretionary and non-discretionary news releases and CEO equity sales:

This quite clearly shows that discretionary news has a significant impact on the timing of CEO equity sales whereas non-discretionary news has almost no impact.

In conclusion, this research shows that CEOs strategically time the disclosure of discretionary news so that it coincides with the vesting date of their stock-based compensation and that these news releases have a strong tendency to have a positive tone.  These positive news releases lead to temporary increases in equity prices which CEOs exploit, with a median CEO selling all of the vesting equity within 7 days of a discretionary news release in a vesting month.  The study also gives us a sense that the equity market playing field is far from level and that corporations have done whatever possible to misalign the interests of management and shareholders.

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