J. Carr Bettis

Managerial Ownership, Incentive Contracting, and the Use of Zero-Cost Collars and Equity Swaps by Corporate Insiders

Zero-cost collars and equity swaps provide insiders with the opportunity to hedge the risk associated with their personal holdings in the companys equity. Consequently, their use has important implications for incentive-based contracting and for understanding insider trading behavior. Our analysis indicates that these transactions generally involve high-ranking insiders and effectively reduce their ownership by about 25%, on average. Given the potential of these financial instruments to substantially alter the incentive alignment between managers and shareholders, we suggest that increasing the transparency of these transactions may provide valuable information to investors.

Stock and Option Grants with Performance-Based Vesting Provisions

We assemble a sample of 983 equity-based awards that include either an accelerated- or a contingent-vesting provision tied to firm performance and explore the frequency, contractual nature, usage, and implications of such awards. We find that performance-vesting (p-v) provisions specify meaningful performance hurdles and provide significant incentives for executives. The propensity to use p-v provisions is positively related to the arrival of a new CEO and the proportion of outsiders on the board of directors and negatively related to prior stock performance. Performance-vesting firms have significantly better subsequent operating performance than control firms. Abnormal accounting performance does not arise from earnings management or discernible differences in financial or investment policy. The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

Insider Trading in Derivative Securities: An Empirical Examination of the Use of Zero-Cost Collars and Equity Swaps by Corporate Insiders

We provide an examination of the use of zero-cost collars and equity swaps by corporate insiders to hedge the risk associated with their personal holdings in the companys equity. These financial instruments have important implications for insider trading and incentive-based contracts. Our analysis indicates that these transactions generally involve high ranking insiders (CEOs, board members and senior executives) and cover over a third of their equity holdings. We also find that insiders appear to initiate hedging transactions immediately following large price runups, prior to increases in stock price volatility, and prior to poor earnings announcements. In addition, abnormal returns following insider hedging activities are more negative than those associated with ordinary insider sales. Overall, the evidence indicates that executives can use these hedging instruments to significantly alter their effective ownership positions in the firm.

Performance-Vesting Provisions in Executive Compensation

The usage of performance-vesting (p-v) equity awards to top executives in large U.S. companies has grown from 20 to 70 percent from 1998 to 2012. We measure the effects of p-v provisions on value, delta, and vega of equity-based compensation. We find large differences in the value of p-v awards reported in company disclosures versus economic value. We also find that equity-based grants continue to convey significant compensation convexity (vega) after ASC 718 (2005) and that, counter to recent claims in the literature, our analysis empirically reaffirms the presence of a causal relation between compensation convexity (vega) and firm risk.

Compensation Goals and Firm Performance

How is firm performance related to executive compensation goals? Using a large dataset of performance goals employed in incentive contracts we study this question. A disproportionately large number of firms exceed their goals by a small margin as compared to the number that fall short of the goal by a small margin. This asymmetry is particularly acute when compensation is contingent on a single goal or if there is a discontinuous jump in compensation earned for meeting the goal. Firms that just exceed their EPS goals have higher abnormal accruals as compared to firms that just miss their EPS goals. Firms that just exceed profit goals have lower R&D and SG&A expenditures, and experience lower long-run stock returns as compared to firms that just miss their profit goals. Overall our results highlight some unintended costs of linking executive compensation to specific performance goals. JEL Classification: G30, J33 ∗PhD student in Finance, W.P. Carey School of Business, Arizona State University. Corresponding author. e-mail: bfbennett@asu.edu. †Research Professor of Finance, W.P. Carey School of Business, Arizona State University ‡Associate Professor, Olin Business School, Washington University §Hubert C. and Dorothy R. Moog Professor of Finance, Olin Business School, Washington University in St. Louis.Using a large data set of performance goals employed in executive incentive contracts, we find that a disproportionately large number of firms exceed their goals by a small margin as compared to the number that fall short of the goal by a similar margin. This asymmetry is particularly acute for earnings goals, when compensation is contingent on a single goal, when the pay-performance relationship around the goal is concave-shaped, and for grants with non-equity-based payouts. Firms that exceed their compensation target by a small margin are more likely to beat the target the next period and CEOs of firms that miss their targets are more likely to experience a forced turnover. Firms that just exceed their Earnings Per Share (EPS) goals have higher abnormal accruals and lower Research and Development (R&D) expenditures, and firms that just exceed their profit goals have lower Selling, General and Administrative (SG&A) expenditures. Overall, our results highlight some of the costs of linking managerial compensation to specific compensation targets.