Andrew Ward: CEOs Make Money from Bad Company News

Stock options are often used to align the interests of stakeholders and CEOs, as both benefit when share price rises. New research shows, however, that companies release more negative news during the period immediately before stock options are granted to their CEOs, which financially benefits the CEOs. CEOs, who control the release and tenor of the information, see higher future gains when options are granted while the share price is lower.

“What we find is that in this period, companies release more negative news than at any other time of the year, which reduces the share price to the CEO’s advantage,” said Andrew Ward, professor of management and the Charlot and Dennis E. Singleton ’66 chair at Lehigh. Ward co-authored the paper, “Unintended Consequences: Information Releases and CEO Stock Option Grants,” published online in the Academy of Management Journal, with Timothy Quigley and Scott Graffin of the University of Georgia and Tim Hubbard of the University of Notre Dame.

The researchers examined 1,753 grant dates representing 659 CEOs across 627 large U.S. firms from 2009 to 2013. For the year before each grant, they examined press releases issued by the firm to examine the positive or negative tone of each release, over a total of 49,436 releases.

“Our results suggest that CEOs may be manipulating markets to alter their firms’ stock price for their own benefit and that the timing and tenor of press releases is one mechanism that executives can use to do so,” the researchers said. The study is the first to look at current manipulation occurring with CEO stock options using the CEO’s ability to control information flowing from the firm, Ward said.

Regulations Intended to Constrain Managerial Opportunism

With ultimate decision authority at their organizations and access to information because of their positions, CEOs have substantial control over the flow of information to external stakeholders, specifically, deciding if and how information will be released by the firm, and also often have “asymmetrical” levels of information—when they know more than boards or shareholders.

Despite increased regulation after the options back-dating scandal of the mid-2000s, where CEOs were caught manipulating the strike price (purchase price) of options by post-dating option grant dates to when stock prices were most advantageous—most notably benefiting Steve Jobs and Michael Dell—the researchers found some CEOs still benefit from strike-price manipulation via information releases.

“Our results suggest that, despite sweeping regulations designed to rein in managerial malfeasance, CEOs continue to leverage their informational advantage to bypass regulatory efforts,” they said.

The researchers found that CEOs use their information advantage to mute the desired effects of stock options to equalize interests among CEOs, boards and shareholders: Specifically, that the period leading up to a CEO option grant date is unique in being the one instance when CEOs are incentivized by options to reduce the stock price of their company, putting the CEO’s interests in direct conflict with those of shareholders. The researchers argue that CEOs use their information advantage to reduce their firms’ stock price through impression management tactics, using strategic releases of information to shape the perceptions of audiences both within and outside organizations.

The researchers expected that regulations within the Sarbanes-Oxley Act of 2002, limiting that information control and requiring organizations to disclose material events by the end of the fourth day after the event, would stop manipulation of the price at which options were granted, Ward said. “We thought we’d check to see if there were any manipulation still going on, and, surprise, there was. This is certainly much more subtle than the back-dating scandal, and now, just as then, only a minority of companies are engaging in it, but we find strong evidence that manipulation is still occurring.”

They also found that relatively underpaid CEOs are more likely to employ this tactic, and that CEOs in high-discretion settings are more able to pursue those actions.

How News Manipulation Affects Price

CEOs are typically awarded the option to purchase sizable blocks of the firm’s shares at some future date, often years into the future, at a strike price, or purchase price, equal to the current price of the stock. If the share price increases above the strike price, options are “in the money,” creating wealth gains for the CEO equal to the new price minus the strike price times the number of options awarded. Thus, the lower the stock price is at the time of the grant, the higher the potential future payout is for the CEO, as not only is the strike price lower, but the number of share options granted increases.

While impression management theories typically predict that CEOs will describe their firms in the most positive (or least negative) light possible, this logic doesn’t hold during the small window leading to an option grant, due to the incentives created by those options. During this time, CEOs may shape the release of information by casting the firm in a more negative light, which reduces the firm’s stock price, decreases the strike price of a CEO’s options, and provides a private financial benefit as it becomes easier for the CEO to achieve a larger “in the money” option in the future.

“We show that the tool commonly used to address the agency problem - stock options - may be manipulated by CEOs using a mechanism—information asymmetry—that the options are designed to, at least indirectly, alleviate,” the researchers said.

In short, while options might align interests of shareholders and the CEO by creating common gains from increasing the stock price after the grant is given, prior to the grant, options incentivize behaviors that are counter to shareholder interests. Given the amount of stock options awarded to typical CEOs, even a small shift in a firm’s stock price can lead to sizable changes in wealth.

The findings suggest there is a dip in stock price leading up to the option grant dates for CEOs, even after the implementation of Sarbanes-Oxley, by as much as 2.24 percent. The researchers also found that firms tend to release more negative information in the period leading up to option grants, and a link between negative press releases issued prior to an option grant date and a firm’s stock price.

“In terms of how widely used the tactic is, we found that approximately 55 percent of CEOs (studied) saw a negative abnormal return in the 45-day trading period before an option grant and so benefited from the stock price decline,” they said. “Further, 11 percent of CEOs had at least two grants where the stock saw an abnormal decline of more than 2 percent in the 30 trading days prior to the grant and a more than 2 percent rebound in the 30 days after.”

Policy and Practice Impacts

Ward said the study has considerable impact to change policies and practices, both through regulatory changes the U.S. Securities and Exchange Commission might make to thwart the practice, and through changes boards might make to stop the tactic. Boards might want to implement smaller, more frequent grants, such as monthly, rather than larger annual grants, or move away from options in favor of stock grants, he said.

“Shareholders will be interested in this information, as we may see shareholder lawsuits arise from this, as some short-term shareholders who traded shares in the pre-option period will certainly have been harmed by the practice,” Ward added.