May 15, 2014

Option for Control

CEOs use their options to fight proxy battles.


Like everyone, CEOs are keen to keep the perks that come with the job. One form of compensation often extended to senior managers is the option to buy shares at a set price, or strike price, at any time before a set expiration date. If the strike price is $50 per share, the CEO only needs to wait until the option is in-the-money — for the market price to exceed the strike price — and can then turn around and sell the shares at the higher market price. Equity shares are often viewed as incentive pay to encourage senior managers to take actions that boost firm value or revenue.

But what do managers do with their options when corporate control is up for grabs? Proxy battles occur when stockholders attempt to solicit proxy votes (in which an agent that represents shareholders of a public corporation attends meetings and casts votes in their stead) to install a new board, threatening managers’ control. The gut response for most managers is to defend their control, as well as the status and benefits that come along with it, says Professor Wei Jiang.

Jiang points to Leonard Riggio, the former CEO of Barnes & Noble, who exercised his option when it was out-of-the-money; he was willing to pay the strike price, at $16.96, which was 13 percent more than market price, for more than 990,000 shares of the bookseller in 2010. Those options expired eight months later, so why did Riggio exercise them and essentially overpay for the shares? Barnes & Noble was facing a proxy battle with activist investor Ronald Burkle, and Riggio was one of the directors up for reelection in Barnes & Noble’s staggered board. With his option exercised, Riggio held a 29.9 percent stake in the company (Burkle was the second-largest shareholder with 19.2 percent) and gained himself an extra 1.7 percent of the votes — a crucial advantage in an expected close contest. (Why not buy on the open market at a lower price? Because additional buying, without pre-commitment, during an information-sensitive period could have subjected Riggio to heightened legal risk associated with insider trading.)

Riggio isn’t alone, according to new research from Jiang, who worked with Vyacheslav Fos, PhD ’09, of the University of Illinois to compare data from several public CEO databases, including data on CEO options packages vested from 1995 to early 2013. They found that CEOs generally distort their option-exercise plans when facing proxy battles. For example, when a proxy contest is looming, the rate at which CEOs sell their shares slows down by 80 percent — by keeping the shares, they also keep their votes.

“The first thing you do is stop selling shares when a proxy battle is on the horizon,” Jiang says. “Once you sell your shares, you’ve also sold your voting rights. CEOs also increase the rate at which they exercise their options and hold the resulting shares — by 50 to 60 percent.” If the CEO is truly desperate to gain votes in a close proxy battle, they’ll even exercise their option to acquire shares out-of-the-money.

Jiang says the evidence that these changes in CEO option-exercise behavior are indeed driven by proxy battles can be found by looking at the record date — the latest date by which shares can be acquired to earn voting rights. “If you acquire shares the day after the record date, sorry, you don’t get to vote in the proxy battle — the previous shareholder does,” Jiang says. “We find that CEOs completely stop exercising and selling shares and quintuple their rate of exercising and holding shares before the record date. After the record date, CEOs start to exercise and sell again and pretty much revert back to their normal exercise and hold rate.”

While previous research has indicated that overconfidence and insider trading may influence whether and how CEOs exercise options, Jiang points out that these findings identify a completely different motive, one that touches on the very core of leading a company: control. “CEOs do all kinds of things to keep their control when it’s under contest,” Jiang says, “especially when they have more benefits to defend.”

Wei Jiang is the Arthur F. Burns Professor of Free and Competitive Enterprise and chair of the Finance subdivision in the Finance and Economics Division at Columbia Business School.

 

Read the Research

Jiang, Wei and Vyacheslav Fos. “Out-of-the-Money CEOs: Inferring Private Control Premium from CEO Option Exercises.” Working paper, Columbia Business School, 2014.