Two essays on the agency costs associated with executive stock option exercises
Cicero, David Clay
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This dissertation is derived from two manuscripts. In the first manuscript (Chapter 3), I consider executive stock option exercise timing in light of the possibility for exercise backdating. I find that 28 (16) percent of executive option exercises were not associated with immediate stock disposition before (after) the August 2002 enactment of more restrictive reporting requirements for insider transactions under the Sarbanes-Oxley Act. I interpret this as evidence executives often exercise options with the intention of holding the acquired shares for a year to qualify for long-term capital gains tax treatment. Exercises are associated with a return trough when no shares are disposed of at exercise, and a return peak when shares are disposed of at exercise. In the pre-Sarbanes-Oxley period, executives appear to have often timed exercises based on private information regardless of the exercise strategy, and backdated exercise dates when they either did not immediately dispose of shares or only disposed of shares back to their company. The evidence of backdating largely ceased after the Sarbanes-Oxley Act, but evidence of information timing persists. I conduct an analysis of option exercise backdating and corporate governance, and find that exercise backdating is associated with weak internal controls. However, consistent with a “skin in the game” theory, executives are less likely to backdate exercises when they hold a larger stake in the company. In the second manuscript (Chapter 4), I examine long-run stock and operating performance around executive option exercises, and consider whether executives manage earnings to enhance the profitability of their exercise strategy. If an executive intends to immediately dispose of the acquired shares, the incentive is to manage earnings upward prior to exercise to sell the shares at a higher price. If the executive intends to hold the shares, the incentive is to manage earnings downward prior to exercise (to minimize exercise-year taxes) and upward following exercise (to sell at a higher price). Long-run stock and operating performances around subsamples of exercises classified by the timing of stock disposition are consistent with each of these strategies. Earnings management is apparent only when the executive immediately sells the acquired shares.