El modelo MLA

4.2.1 Market cycles and stock option compensation

Whereas industry observers have speculated the relationship between stock option compensation and market cycles, there is surprisingly very little academic literature at present regarding the relationship between stock option compensation and market cycles aside from brief mention or acknowledgement of the market. However, there is a lot of IPO (Initial Public Offering) literature on market cycles.

In the earlier literature regarding long-term performance of IPOs, it is argued that hot markets are mainly constituted of lower quality firms because they appear to have worse stock returns than IPOs from cold markets (Loughran and Ritter, 1995). Other literature also suggests these lower quality issues arise from managers taking advantage of bullishness from investors to demand an IPO (e.g. Lerner (1994); Field (1997)) However, more recent articles such as Helwege & Liang (2004) have shown the quality and characteristics of firms do not seem to differ much. Derrien (2005) also points out that this poor long term performance is perhaps connected to overpricing driven by other indicators in the market about investor optimism. Although some of these hypotheses have found little support in the context of IPOs, they still may shed some light as possible explanations for stock option usage. In like manner some of these hypotheses could apply to stock option compensation; some companies may issue excessive amounts of stock options simply to take advantage of the bull market. There is also the implication that option grants in a “cold” bear market cycle may some how be of higher quality.

Although there are no major articles focusing on the relationship between stock option compensation and stock market cycles, Hall & Knox (2002) developed a model that provides an interesting explanation to stock option grant levels in a possible bull or bear

market on the basis of managing incentive levels. However, contrary to the thought that option grants might decrease with a cooler market, the paper argues that option grants may instead increase in reaction to lost incentives. The article focuses on the “fragility” of incentives provided by options (with analysis based on options during a bull-market period). As the incentives provided by stock options are based on the option delta, the incentives can vary depending on the stock price, particularly when options go out-of- the-money, as the non-linear payoff of options lead to much larger changes than options moving into the money in the opposite direction. The authors note that approximately 30% of options were out-of-the-money at the peak of the bull market in the 90s, which may have impacted on the fit of their model.

4.2.2 Accounting and stock option compensation

From a finance perspective it is generally accepted that a change in accounting should not theoretically impact value, as it does not impact the underlying cashflows that contribute to a firm’s value. Unless the change in accounting practice provides important information in calculating value, there should be no change, based on the assumption that the market is efficient. As under SFAS 123 companies were required to disclose details regarding their stock option compensation in footnotes, no new information would be released through any change in the accounting standard, only greater transparency by “shifting” the information. So in theory, a change in accounting standards should see companies continue business as normal (i.e. not change their equity based compensation), unless there are other considerations involved. However, the evidence behind this hypothesis is mixed.

Rees & Stott (2001) found that footnote disclosed information did provide value relevant information. Using stock option data from footnote disclosure, the authors found a significant positive relationship between company returns and stock option usage, particularly for firms with more growth opportunities. The implications of their findings being that investors had incorporated information from footnotes into their valuation of a firm; and that increased stock option usage was seen as beneficial to the firm.

However, Hassan, Espahbodi, Rezaee, & Tehranian (2002) found evidence to suggest that footnote disclosure was insufficient as a substitute for “recognition”. Focusing on the impacts of company returns surrounding events in the early 1990s when the initial SFAS

123 exposure drafts requiring recognition of stock option expense and the later announcement regarding reversal of the decision to expense; the authors found that there were significant abnormal returns for firms, especially for high-tech, high-growth and start up firms. Whereas, if footnote disclosure was a substitute for recognition, then there should have been any reason for abnormal returns.

In more recent times, Carter, Lynch & Tuna (2007) examined the change in the revisions to SFAS 123, more specifically the impact of SFAS 148 in December 2002 (an amendment of SFAS 123) which gave companies new alternatives to voluntarily recognize stock options. The authors found that companies which had decided to recognize stock options, have since decreased their option grants, swapping them for restricted stock grants.

Aboody, Barth & Kasznik (2004) also focused their research surrounding the introduction of SFAS 148, however, instead of focusing on the impact of the transition on company returns, they sought to identify the characteristics of firm’s that chose to voluntarily expense their options. They found that firms were more likely to have expensed if they had high participation in capital markets, and found there was no significant relationship between size of option expense to be recognized and the decision to make the transition, once other factors had been accounted for. They also found that companies which did choose to expense had significant positive returns upon announcement, especially if transparency was stated as a motivation behind the decision. The hypotheses behind these increases are that companies which disclose have a higher quality of earnings, and due to the timing of the decisions, it would reduce political costs involved with uncertainty surrounding the integrity of many companies.

4.2.3 Corporate Scandals and executive stock option compensation

Although the argument for linking corporate scandals to executive stock option compensation is somewhat weak, it has some indirect support from Michael Jensen, one of authors behind the seminal 1990 paper supporting greater use (based on 1980s levels) of equity based compensation. Jensen (2005) points out that although stock options do not provide the initial incentive for accounting fraud, it can provide the incentive to continue to manipulate earnings if a “line has already been crossed”. The rationale being, that once earnings have been manipulated once, expectations of future earnings are likely

to be raised, thus giving the incentive to continue to deceive the market through fraudulent acts in order to meet those expectations. However this only analogizes stock option compensation to a fuel to a fire, so if all efforts are made to prevent the fire, then stock option compensation is not an issue.