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How stock options lead CEOs to put their own interests first

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One of the fundamental questions about executive pay is how well the stock awards or options grants that boards of directors dole out actually do their intended job. Do they put senior managers' interests in line with shareholder interests? Or prompt CEOs to boost short-term results in lieu of making long-term investments?

New research would side with the latter. In a paper currently under review in the Journal of Financial Economics, three professors examined the investments CEOs made for their companies in the year before their option grants "vested." Options offer executives the right to buy stock in the future — the vesting date — at an earlier date's price (which is useful, of course, only if the share price goes up).

The researchers found that in the year prior to vesting dates for big option grants, CEOs spent significantly less on long-term investments: research and development in particular, as well as advertising and other capital expenditures. In other words, the pending dates were prompting CEOs to pump up short-term results while sacrificing long-term spending — moves that could, in theory, boost the share price and ultimately put their own interests above the company's.

"Managers actually behave myopically," says Katharina Lewellen, a professor at the Tuck School of Business at Dartmouth College who wrote the paper with collaborators from Wharton and the University of Minnesota's business school. "They’re more short-term oriented than shareholders would like."

The study looked at approximately 2,000 companies between 2006 and 2010, using data from the executive compensation research firm Equilar. They found that in the year ahead of the vesting date, R&D spending declined by an average of $1 million per year.

The researchers also found that when options were about to vest, executives were more likely to meet or just slightly beat the earnings forecasts of analysts. Coming so close to analysts' estimates, rather than producing big swings above or below the target, "suggests it really has to do with vesting," Lewellen says. "The vesting actually affects manipulation."

Options are a compensation tool designed to retain executives and reward performance. And while they are increasingly being replaced by shares of restricted stock in executive pay, they still made up 31 percent of the average long-term incentive package in 2012, according to a 2013 analysis by James F. Reda & Associates, a compensation consulting firm.

Because options are not as "certain" as restricted stock grants (options can be worthless if the stock price on the vesting date is lower than the price at which they were granted), they've been falling out of favor in executive pay packages. They're also less popular after changes to accounting rules that began requiring stock option awards to be expensed. And they suffered image problems after a number of scandals involved companies using options inappropriately to create even more lucrative windfalls for executives.

But for academics, they remain something of a gold mine. Unlike with the sale of other equity, CEOs know when their options are scheduled to vest and expire, making it easier for researchers to link the actions leaders take at the firm with their potential for pocketbook profits. "The reason why vesting is an interesting experiment is that the vesting period was determined a while ago," Lewellen says. "We can make a good case that there's a cause and effect relationship."

The great irony, of course, is that while the ultimate goal of all this short-term thinking is to goose the stock price, it apparently doesn't. Lewellen and her collaborators found that share prices did not increase, on average, following the earnings reports associated with executives' vesting schedules. The reason, she says: Investors have wised up to spending cuts made in advance of earnings reports, and have priced such manipulation into the market.

"It's like a vicious cycle," she says. "Investors expect them to do it, so [CEOs] do it. At the same time, they are not fooling anyone."

Jena McGregor is a columnist for On Leadership.

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