The last two decades have witnessed an enormous increase in stock and option-based executive compensation. The average stock option grant for top executives was a small fraction of CEOs’ total wages in the early 1980s, but has today become an important component of executive compensation (e.g., see Hall and Liebman (1998) and Murphy (1999)). Although traditionally it has been argued that stock-based compensation is necessary to align the interests of managers and shareholders, recent arguments, in light of the corporate scandals involving WorldCom, Enron, and others, have called into question the efficacy of stock-based compensation.
Specifically, it is suggested that, rather than aligning the interests of managers and shareholders, large option grants have instead provided CEOs with incentives to act opportunistically to manipulate the firm’s stock price in order to benefit from appreciation in the value of their stock and option portfolios An issue that is currently at the forefront of public debate regarding corporate governance reforms (e.g., see BusinessWeek 2002, 2003; The Wall street Journal 2003).
This study contributes to this debate by examining whether corporate executives systematically use private information to time the exercises of employee stock options (ESOs), and if so, whether the private information is associated with earnings management by executives. Several recent papers examine different aspects of this issue with mixed results. Nearly all of these papers use annual data on option exercises detailed in the Execucomp database. In contrast, in this study I use a unique database of insider option exercises across a broad sample of 4,254 firms during the period 1996 through 2002.
In contrast to the annually aggregated data provided in Execucomp, my data contains details on the timing of exercise relative to the option’s expiration date and the exercise price of the options, which allows me to more carefully distinguish option exercises that are likely to be associated with private information. By doing so I provide strong evidence that is consistent with the view that some insiders exercise options to profit from information regarding poor future earnings performance. In addition, I find that abnormal returns following option exercises are systematically related to evidence of aggressive earnings management.