Option Grants to CEOs of Target Firms: Rent Extraction or Incentive Alignment? ABSTRACT Managerial rent extraction is a non-trivial phenomenon during acquisitions: in a sample

Managerial rent extraction is a non-trivial phenomenon during acquisitions: in a sample of 364 deals from 1999-2005, over one target CEO in four experiences compensation increases due to option grants received just before the acquisition while target shareholders suffer losses. Indeed, the top quartile of rent extraction CEOs pocket an average of 19 million dollars from option awards granted several months prior to the acquisition while shareholders of rent extraction targets experience average abnormal returns of -22 percent during the three years ending just after the merger announcement. Rent extraction occurs in weakly governed companies. Targets exhibiting rent extraction are more likely to grant their CEOs lucrative options packages after starting negotiations with eventual acquirers, but less likely to obtain higher takeover premiums. Self-dealing CEOs benefit from stock option vesting periods and other restrictions that disappear when their firms are sold. Acquisition announcements typically result in a large increase of the target firm stock price because of the acquisition premium. Stock options with grant dates just before the acquisition announcement result in huge immediate profit for the target firm executives that receive these options. In addition, these options typically become exercisable when the sale of the company is consummated. This occurs because the vesting periods and other restrictions disappear as the “change in control” clause becomes effective, and a completed acquisition always constitutes a change in control for the target firm. An imminent acquisition provides CEOs with the opportunity to increase their stock option holdings prior to the announcement and obtain huge payoffs when their firms are eventually sold. These conjectures motivate the hypotheses we address in this paper. The rent extraction hypothesis posits that pre-acquisition option grants are designed to enrich target CEOs and not necessarily their firms’ shareholders. The alternative is the incentive-alignment hypothesis which predicts that option grants to target CEOs prior to acquisitions will induce CEOs to work hard in getting a high offer for their firms and therefore more value for their shareholders. Distinguishing between these two hypotheses in the context of firms to be sold is difficult because it is possible that both rent extraction and incentive alignment occur simultaneously. Therefore, our research design identifies situations when rent-extraction likely occurs, which are those when target CEOs, but not target shareholders, benefit from the acquisition. In a sample of 364 acquisitions during 1999-2005, we first identify 219 targets that experience negative abnormal returns during the three-year period ending one day after the acquisition announcement. Thus, the shareholders of these 219 firms lose even after receiving the acquisition premium. In 102 of these cases, target CEOs experience an increase in their compensation due to options 1 Given their direct involvement in acquisition negotiations, CEOs likely know of the impending sale of their firm months before market participants do. Since most of the target’s stock price increase occurs during the four weeks before and up through the deal announcement date (Schwert 1996), and because the firm’s sale causes option awards to immediately become exercisable (Cai and Vijh 2007), CEOs can stockpile options prior to the sale and benefit from acquisition premiums paid for targets which in recent years are in the order of 30%. grants before the acquisition. Therefore, in approximately 47 percent of situations when target shareholder wealth declines, CEO gain from option grants. We view these target firms as prime suspects of rent extraction. However, as we discuss later, it is possible that that in certain situations actions by these firms could be consistent with an incentive alignment behavior. Empirical tests reveal that firms suspected of rent extraction exhibit weak corporate governance. Indeed, for these firms we also find that option-based pay increases to target CEOs are more likely whenever boards (1) are chaired by the CEO, (2) are busy, and (3) have a busy compensation committee. These results are robust to numerous controls for CEO and firm specific characteristics. Our multivariate tests show that target firms in which rent extraction is suspected are more likely to initiate merger talks with potential acquirers, to file unscheduled option grants in the year of the acquisition, and to grant higher and more valuable stock options to their CEOs prior to the deal. These results suggest that, in the context of a firm’s impending sale, option granting might be a covert form of insider trading. Despite these findings, we are unable to rule out the incentive alignment hypothesis because it is possible that option awards to these target CEOs motivate them to negotiate a higher premium for their firms and therefore obtain more value for the targets’ shareholders. Next, we present two pieces of evidence that strongly suggest that suspect targets are indeed engaging in rent extraction. First, we find that these firms are more likely to grant their CEOs option awards after merger negotiations with their eventual acquirers are underway. Second, we find that takeover premiums obtained by targets suspected of rent extraction are not larger than those negotiated by other targets. According to our multivariate tests, the takeover premium is about 14 percent lower for targets in which rent extraction is alleged. Overall, these findings indicate that the actions of our suspect firms are consistent with our rent extraction hypothesis but not with the incentive alignment alternative. 2 Busy boards are those in which the majority of the outside directors have three or more directorships (Fich and Shivdasani, 2006). The results herein indicate that rent extraction has a material effect on the wealth of many CEOs. Based on the last option grant received on average five months prior to the official acquisition announcement, the top quartile of rent extraction target CEOs receive an average payment of 19 million dollars. In contrast, as will we show, shareholders of rent extraction targets experience average abnormal returns of about -22 percent during the three years ending one day after the merger announcement. Our findings have important public policy implications on the efforts by regulators to curb corporate malfeasance. On the one hand, we show that instances of rent extraction drop from 35 percent to 14 percent after the 2002 Sarbanes-Oxley Act (SOX) is promulgated. This result indicates that rent extraction has subsided but is not completely eliminated. On the other hand, the problem may soon reemerge because the Securities and Exchange Commission (SEC) recently released an amendment proposal to rule 14(d)-10 of its 1934 Securities Act. The rule change would provide a safe harbor allowing the compensation committee of a target's board of directors to approve employment compensation, severance or other employee benefit arrangement for its executives during a tender offer negotiation. Such laissez faire attitude would pave the way for target shareholder expropriation during acquisitions by top managers. The paper proceeds as follows. Section I reviews the appropriate literature. Section II describes the data we use in this study. Section III presents our empirical analyses. Section IV concludes. 3 Section 403 of SOX requires public company officers and directors to report their receipt of stock options within two days of the grant. 4 See SEC release 2005-176. Rule 14d-10 of the 1934 Securities Act provides that no bidder may make a tender offer unless “the consideration paid to any security holder pursuant to the tender offer is the highest consideration paid to any other security holder during such tender offer.” Although this rule appears to be simple in concept, courts have struggled when applying it to the variety of arrangements that exist or are entered into with executives of a target company (who are usually stockholders as well) in connection with an acquisition transaction. These arrangements often include severance payments, stay bonuses, noncompete payments, and other cash and equity compensation arrangements designed to retain and provide incentive to top managers. I. Literature Review A. Evidence on Rent Extraction and Incentive Alignment The efficiency of top management compensation contracts in general, and whether stock options benefit top managers more than shareholders in particular, continues to be the subject of considerable academic debate. Underlying this debate are two popular hypotheses: incentive alignment and rent extraction. The incentive alignment hypothesis states that an increase in equity holdings causes top managers to take actions that will enhance shareholder wealth. In contrast, the rent extraction hypothesis states that such increase occurs in anticipation of good news and is used by top managers with private information for their own benefit. Recent studies report evidence in support of the incentive alignment hypothesis. For example, Hall and Murphy (2002) find a positive association between CEO stock-based compensation and firm value. Fich and Shivdasani (2005) find that stock option plans for outside directors enhance firm performance. Hanlon, Rajgopal, and Shevlin (2003) show that future earnings are positively associated with stock option grants. In contrast, other studies support the rent-extraction hypothesis. For instance, Bebchuk, Fried, and Walker (2002) indicate that the pattern of granting at-the-money options to CEOs is pervasive. Yermack (1997) finds that option grants are timed in anticipation of good news and Carpenter and Remmers (2001) show that top managers use their private information to time exercises of options. In the situation in which the sale of the firm is imminent, the incentive alignment perspective means that options granted to top managers prior to a merger deal are aimed at increasing firm value because the target CEO, who is often directly involved in the negotiations with the acquiring firm, will work hard to get the highest possible price for his firm. In contrast, the rent extraction hypothesis implies that such grants are designed to enrich top managers. In a closely related paper, Heitzman (2006) finds that equity awards before an acquisition are used by boards to align CEO’s and shareholders’ incentives. He argues that the grants are more likely explained by incentive alignment issues within an acquisition setting and that there is no evidence that opportunistic actions by the target CEO drive observed equity grants prior to a firm’s sale. Heitzman’s results are in contrast to those we present in this paper. We believe that our empirical design enables us to show that the actions of many target firms are consistent with those predicted by the rent extraction hypothesis. B. Acquisitions and Payoffs to CEOs of Target Firms Recent studies show that target CEOs might be willing to accept lower acquisition premiums when the acquirer promises them a high-ranking managerial post, such as a board seat in the combined firm, after the acquisition is completed (see, Hartzell, Ofek, and Yermack (2004) and Wulf (2004)). This probably explains why certain measures aimed at providing compensation relief to CEOs of firms that are sold, such as golden parachutes, are often favorably received by investors (Lambert and Larcker (1985)). Stock and option holdings may provide a powerful incentive for CEOs to sell their firms. Cai and Vijh (2007) show that CEOs with higher equity and option holdings are more likely to get acquired, accept a lower premium, and offer less resistance. Cai and Vijh argue that, in the case of target CEOs, incentives to sell their firms arises from the adverse effect of illiquidity on personal valuation of securities. Meulbroek (2001) and Hall and Murphy (2002), among others, show that the executives’ value of a firm's stock and option holdings can be much lower than the market value. They argue that the difference arises because executives are often undiversified and unable to sell their stock or hedge their options due to several liquidity restrictions. This difference might explain (1) why CEOs who are able to sell their firms’ stock do so when they get new option grants (Ofek and Yermack, 2000) and (2) the early exercise behavior of executives documented by Hemmer, Mastsunaga, and Shevlin (1996) and by Bettis, Bizjak, and Lemmon (2004). Since the equity and option holdings of CEOs play an important role in their incentives to sell their firms, our multivariate tests control for the potential effect that these variables may have in the incentive alignment or rent extraction behavior of target CEOs. C. Corporate Governance and Payoffs to Shareholders of Target Companies When a firm is targeted, the board has the authority and responsibility to approve an acquisition offer. When deals are approved, the appropriate corporate officers of both firms sign the merger agreement and the target board files a proxy statement detailing the arrangement with the Securities and Exchange Commission (SEC). The board is also responsible for distributing the agreement and calling for a special meeting of the target shareholders where a formal vote ratifying the acquisition takes place. This process provides the target’s board with considerable discretion over the ultimate success of an acquisition. For example, boards can adopt a variety of antitakeover measures, such as poison pills, in order to increase its ability to either defeat a takeover offer (Malatesta and Walkling, 1988), or enhance its bargaining position with the bidder (Comment and Schwert, 1995). To address this issue, our tests control for the Gompers, Ishii, and Metrick (2003) index which adds 24 antitakeover provisions tracked by the Investor Responsibility Research Company (IRRC). Several papers document that corporate governance in general, and the composition and incentives of the board of directors in particular, play an important role in determining the welfare of target shareholders in acquisition deals. For example, Bange and Mazzeo (2004) report that firms with individuals concurrently holding the titles of CEO and chairman of the board are more likely to receive bypass offers that generate higher target shareholder gains. Harford (2003) argues that, at the margin, the loss of directorship income may induce outside directors to resist acquisitions that are in the shareholders' interests. In contrast, Cotter, Shivdasani, and Zenner (1997) find that a majority of outside directors enhance target shareholder gains. In addition, target shareholders obtain larger takeover premiums when institutional share ownership is high (Cotter and Zenner, 1994), and when top management has greater stock ownership (Song and Walkling, 1993). 5 They define a bypass offer as an unsolicited tender offer for a controlling majority interest in a target that is allegedly unanticipated by management and by the board of directors. Given the importance of corporate governance in determining the way in which target shareholders fare, we investigate the corporate governance characteristics of firms where deals in which opportunistic option granting by CEOs and rent extraction are suspected. We also compare whether the governance of firms where rent extraction is alleged is different from the governance of other firms. II. Data and Sample Selection We begin with 3,732 completed acquisitions of pubic U.S. target firms announced during 1999-2005 and tracked by the Securities Data Company (SDC) in its mergers and acquisitions (M&A) database. Next, we require that target firms have data available from the Center for Research in Security Prices (CRSP) and from Compustat. This requirement reduces our sample to 2,405 deals. We restrict observations to those where data for target firms are available from the Investor Responsibility Research Center (IRRC). This restriction reduces the sample to 551 acquisitions. Since our study focuses on option grants prior to merger announcements, we exclude 187 targets that do not grant options to their CEOs during the three fiscal years prior to the announcement date as reported in the Thomson Financial’s Insider Filing database. Our final sample consists of 364 completed acquisitions announced during 1999-2005. Panel A of Table 1 reports the industry distribution of the 364 mergers. Based on the Fama and French (1997) industrial classification, our sample appears well scattered across several industries. Only the Business Services industrial classification exhibits some clustering with just over 15% target firms belonging to that industry. However, to account for the potential effect of the target industry, we include industry and calendar year dummies in appropriate multivariate tests. 6 Our sample begins in 1999, because the coverage of option grants is rather limited in the Thomson Financial database prior to 1996. Panel A also reports the temporal distribution of the 364 mergers. Our sample spans periods of both economic expansion and recession. The annual number of mergers announced is higher at the beginning and at the end of our sample period, which coincides with periods of economic expansion when the stock market valuation is higher. Conversely, merger activity is lower during the 2002-2003 period of economic contraction. In Panel B we report the mode of acquisition, method of payment, attitude, and relatedness of the mergers in our sample. Unlike the stock market driven merger wave during the late 1990s (see for example, Holmstrom and Kaplan (2001)), our sample includes more tender offer and cash deals. Among the 364 acquisitions, 83 are tender offers and 155 are cash acquisitions. The overwhelming majority of the sample consists of friendly mergers. In addition, based on the Fama and French (1997) industrial classification, we find that both the target and acquirer belong to the same industry in 223 deals. Untabulated information indicates that the average (median) target in our sample has a market capitalization of 3.3 billion dollars (0.97) and is purchased for 4.76 billion dollars (1.5). III. Rent Extraction vs. Incentive Alignment A. Determinants of Rent Extraction A.1. Univariate Tests Our research design identifies situations in which rent extraction is likely to occur. If the incentives of CEOs and shareholders are truly aligned, then their wealths are likely to rise and fall at the same time. In contrast, the most egregious cases of rent extraction are likely to occur when CEO wealth increases but shareholders’ wealth does not. We estimate target shareholder returns for the three years ending the day after the merger is announced. We also estimate the change in target CEO option-based compensation during the same period. This estimation window insures that both shareholders and CEOs will benefit from the takeover premium. Panel A of Table 2 7 Our results are similar when we use the two and one year returns prior to the acquisition announcement. disaggregates the returns to target shareholders for different changes in CEO option-based pay. We note that in 102 cases, CEO option-wealth increases even though target shareholders experience losses. We view these instances as cases of potential rent extraction. It is possible that within the 102 cases, the incentives of CEOs and shareholders are truly aligned and that the dissimilar fate of CEOs and shareholders in these instances is due to other factors such as luck. Garvey and Milbourn (2006) find that CEOs are generally rewarded for good luck but not punished for bad luck. However, the situations that we identify appear to be those in which CEOs are actually rewarded for bad luck. Therefore, given the possibility that some or all of the 102 targets are cases of bad luck or failed incentive alignment we will refer to these firms as rent extraction suspects. Panel B documents that the return patterns associated with rent extraction suspects and other target firms are different. For example, among the 364 target firms, companies where rent extraction is alleged do very poorly until the last option grant date prior to the acquisition. During this period, rent extraction suspects earn buy-and-hold abnormal return (BHAR) of about –59 percent. In contrast, other firms exhibit a healthy BHAR of about 29 percent during the same period. Fortunes appear to reverse for rent extraction suspects after the last option grant date until 10 business days prior to the deal announcement (AD-10). During that period, the mean BHAR to rent extraction suspects improves to 1.14 percent, which is significantly different from the previous performance of the same firms at the 1% level. These findings hold when we replace BHARs by cumulative abnormal returns (CARs). Moreover, according to row (3) in Panel B, from AD-10 until AD+1 (the day after the deal is announced) rent extraction suspects outperform other targets. During this 11-day period, rent extraction suspects earn a BHAR of 34.95 percent while other targets earn a BHAR of 21.81 percent. This change in performance, which occurs 8 We calculate BHARs following Barber and Lyon (1997). 9 We calculate returns ending 10 business days prior to the announcement to prevent the takeover premium from entering into the calculation and biasing the result. However, results are qualitatively similar when returns end in day AD+1. 10 We calculate CARs following Dodd and Warner (1983). after the last sets of pre-acquisition options are granted, suggests that timing of options for rent extraction suspects is not incidental. Moreover, as we will show later, this performance improvement appears to enhance the wealth of target CEOs who receive option grants prior to selling their firms. However, the improvement does little to help shareholders recover from the targets’ previous underperformance. Panel C, Table 2 provides key characteristics for our target firms sorted by alleged rent extraction. In general, the two groups do not exhibit significant differences in market capitalization, assets, or leverage. In contrast, corporate governance characteristics described in Panel D of Table 2 display opposite values when the sample is classified according to rent extraction. For example, rent extraction suspects appear more likely to feature (1) CEOs who are also chairman of the board, (2) busy boards, (3) busy compensation committees, and (4) handpicked boards. Given these characteristics, it appears that alleged rent extraction occurs when corporate governance is weak. Overall, the results in Table 2 suggest that rent extraction suspects appear to time their option grants prior to acquisitions and are more likely to be weakly governed. Nevertheless, it is possible that these findings are consistent with incentive alignment if the CEOs of these firms negotiate higher takeover premiums when their firms are sold. Moreover, given the univariate nature of the tests in Table 2 and due to the potential confounding effect of key variables, we now turn to our multivariate analyses. A.2. Multivariate Analyses Actions that CEOs take to expropriate shareholders and the facilitation of such behavior by corporate boards are likely to have its own determinants. Therefore, in order to study the 11 As in Fich and Shivdasani (2006), we define a busy board (compensation committee) as one in which at least half of its outside directors (committee members) hold three or more external directorships. In addition, hand picked boards are those in which the majority of the outside directors join the board after the current CEO is appointed. This variable, which measures the potential influence the CEO over the selection of outside directors, is partially based on Shivdasani and Yermack (1999) and Coles, Daniel, and Naveen (2007). characteristics of firms more likely to perpetrate rent extraction, we run a set of three bivariate logit models in which the dependent variable is “1” for the 102 targets where rent extraction is presumed and is “0” otherwise. Table 3 reports the results for this test. Characteristics often associated with weak corporate governance structures exhibit statistically significant coefficients. Estimates indicate that alleged rent extraction is more likely to occur when CEOs also hold the board’s chairmanship and when boards and compensation committees are busy. In addition, the natural log of assets, our proxy for firm size, exhibits a negative and statistically significant coefficient in all three regressions. This result suggests that rent extraction might be easier to carry out in smaller targets. We note that our regressions include a (0,1) indicator for golden parachutes for target CEOs. Hartzell, Ofek, and Yermack (2004) find that lump sum payments received by target CEOs are lower if the executives are provided with golden parachutes. Therefore, it is possible that firms with golden parachutes are less likely to be associated with rent extraction as well. In our regressions, the golden parachute indicator exhibits a negative, albeit statistically insignificant, coefficient. Governance structures appear to have a material effect on the likelihood of rent extraction. In terms of the marginal effects associated with our coefficient estimates, a busy board increases the probability of rent extraction by 17.14 percentage points. Likewise, a busy compensation committee raises it by 16.55 percentage points. Fich and Shivdasani (2006) report that non-busy boards increase the probability that underperforming CEOs are fired for poor performance by about 6.94 percentage points while busy boards raise the same probability by only 0.59 percentage points. They argue that busy boards are overtaxed and unable to effectively monitor their CEOs. In addition, Core, Holthausen, and Larcker (1999) find that busy boards are more likely to overpay their underperforming CEOs. In line with these studies, our results indicate that target CEOs might be better able to use option grants to expropriate target shareholders prior to an acquisition under busy boards. Our regressions also confirm that powerful CEOs might be more disposed to extract rents from their firms’ shareholders. Grinstein and Hribar (2004) show that acquiring CEOs that also hold the title of chairman of the board are more likely to draw a bonus for acquisitions that do not enhance shareholder wealth. Our finding indicates that CEOs that also chair their board are 12.06 percentage points more likely to extract rent from target shareholders when their firms are sold. B. Option Grants to CEOs of Target Firms Prior to Acquisitions Another piece of evidence on the purported rent extraction behavior of certain target firms comes from the pattern of options granted to CEOs prior to the deal. Table 4 presents option granting activity by our targets. In Panel A of Table 4 we present the Black-Scholes (1973) value of the options during the last four years of the targets’ life which we adjust for dividend payouts (Merton, 1973) when necessary. Panel B of Table 4 presents the number of options granted to the CEOs of targets during the same period. In general, all targets increase the value and quantity of options granted to their CEOs from three years prior to the acquisition (AY-3) to the year of the acquisition (AY0). However, rent extraction suspects outpace other firms both in terms of value and in the number of options granted. From AY-3 to AY0, results in Panel A indicate that the average value of options granted by rent extraction firms increases tenfold from 658,000 to 6,727,000 dollars. In contrast, options to other targets increase by less than 20 percent during the same period, from 3,350,000 to 3,926,000 dollars. Similar increases occur when we study the number of option granted in Panel B. Rent extraction suspects go from awarding their CEOs an average of 38 thousand options in AY-3 to 387 thousand in AY0, while non-rent extraction firms remain quite stable during the same period going from 205 thousand options to 203. The rapid increase in both the number and value of options granted from AY-3 to AY0 suggests a calculated move by rent extraction suspects in increasing their CEOs’ level of option holdings. However, earlier results indicate that alleged rent extraction is more likely to occur in smaller firms. Therefore, it is possible that the patterns of options granted we document are due to the fact that, in recent years, smaller firms have tended to use options more intensively (Oyer and Schaefer (2005)). To address this issue, we assemble a matching sample of non-target firms for our entire sample of 364 targets. Matching firms are identified by controlling for industry, preevent performance, and firm size as suggested in Barber and Lyon (1996). We use total assets in the year prior to the acquisition to proxy for firm size, industry-adjusted return on assets (ROA) to proxy for firm performance, and 2-digit SIC codes to control for industry classification. Panels C and D of Table 4 report the Black-Scholes value and the number of options granted to CEOs from AY-3 to AY0, respectively. In each of the panels, we respectively report dollar values and quantities of options granted to CEOs of target and matching firms sorted by the target firms’ alleged rent extraction classification. Results using matching firms are in line with our earlier findings. Rent extraction targets surpass their matching firms both in terms of the value and number of options granted in the year of the deal (AY0). During AY0, the value of the option granted by rent extraction target CEOs exceeds that of matching firms by about 3.7 million dollars. These results also suggest a deliberate attempt by targets where rent extraction is presumed to boost the option holdings of their CEOs in anticipation of the acquisition.