Swaminathan L. Kalpathy

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.

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.

Stock Option Repricing and its Alternatives: an Empirical Examination

In this paper I examine the likelihood of CEO stock option repricing and its alternatives: namely, option grant, stock grant, and “do nothing.” Multinomial logit results suggest that firms reprice options to increase sensitivity of pay to stock price and to temper down sensitivity of pay to volatility. Moreover, repricing firms are younger and more concentrated in industries where human capital is important. Finally, I find no evidence that internal governance or executive conflicts of interest are relevant in explaining repricing. My results indicate that repricing is motivated by incentive alignment and retention, and not by agency cost considerations.

Performance-Contingent Executive Compensation and Managerial Behavior

Recent regulation and legislation, along with the growing influence of compensation consultants and proxy advisors, have led to an increase in performance-contingent awards. A majority of these awards contain performance conditions tied explicitly to accounting measures. Both the structure of the awards and the opaqueness of award disclosures can provide incentives for earnings management. Our examination reveals no evidence of earnings management through discretionary accruals. In contrast, we find evidence of real activities management. Earnings management varies with accounting metric type, award disclosure opaqueness, and proximity of earnings to performance thresholds. Results are robust to accounting for endogeneity in performance-contingent awards. Our evidence suggests that recent trends in the structure and transparency of pay affect both the incentives for managing earnings and the form of earnings management.

Modeling Equity Compensation with Accounting Contingencies

Of late, both U.S. and International firms have increased the granting of performance-contingent equity awards to their executive officers. Beyond simple stock options, these awards frequently include accounting-based performance targets. Failure to meet or exceed these targets causes award forfeiture. While now a common component in executive pay, little is known about how to value these instruments. In this paper, we model the expected payoff from an equity award with accounting-based payout conditions. The model incorporates numerous characteristics of awards seen in practice, including the coupling of stock price and accounting targets, multiple accounting targets, sliding payout schedules, and the adoption of both “and” and “or” conditions that trigger payout. We also translate the expected payoff into an approximate present value. Given the growing prevalence of performance-contingent features in executive pay, this exercise is important to academics, board members and shareholders, along with other market participants and regulators.

Performance Contingencies in CEO Equity Awards and Debt Contracting

We find that firms that grant performance-contingent (p-c) equity awards with accounting-based vesting conditions to their CEOs have lower cost of debt and less restrictive loan terms. The benefits of p-c accounting awards on debt financing are greater when the moral hazard problem faced by debtholders is potentially more significant—for example, for firms with poorer credit ratings and lower asset tangibility. We find some evidence that certain types of p-c equity awards with stock price–based conditions increase the cost of debt financing. The adoption of p-c accounting-based awards increases firm value, as indicated by stock and bond event studies. Overall, our findings suggest that the incentive-compatibility of accounting-based p-c awards mitigates the potential agency conflict between shareholders and debtholders.

The Role of Peer Firm Selection in Explicit Relative Performance Awards

One of the most significant trends in executive pay in the U.S. over the last several years is the use of explicit relative performance evaluation (RPE) awards. The peer group used to measure relative firm performance is vital in determining the payout from these awards. Since the board of directors along with firm executives determine the selection of peers, we study whether there is any bias in peer selection and measure the economic magnitude of any potential bias. While we find some evidence that peers are selected to increase award payout, we find very little evidence that any potential bias in peer selection has an economic effect on award payouts. Our evidence largely suggests that firms select peers that filter out common shocks to performance, which is consistent with the economic motivation behind the use of RPE awards. Additional analysis indicates that the overlap between peers used for RPE and peers used for compensation benchmarking constrains a firm from biasing pay upwards using compensation benchmarking. Contrary to prior evidence, we do not find any compensation benchmarking bias for firms that use RPE awards. Our research has important implications for the value and incentive properties of RPE awards and suggests that firms use these awards to improve incentive contracts.