CEO Stock Option Awards : An Empirical Analysis and Synthesis of the Economic Determinants

Much of the existing empirical evidence on the use of stock option compensation conflicts with theoretical predictions. This has led some to conclude that the theories are incomplete or that stock option compensation policies are not optimal, on average. However, most studies use data from the 1980s or earlier. Stock option compensation is dynamic as evidenced by the considerable growth in its popularity as a form of CEO compensation. Further, partly as a result of the increase in stock option compensation, the SEC began requiring firms in 1992 to disclose significantly more detail on executive compensation in their proxy statements. In this study, we use these detailed proxy disclosures to study over 1500 proxy filers (over the years 1992-1997) as we re-visit the controversy. We review the earlier inconsistent findings and we then re-test the theories using a variety of research designs and proxies. Our findings are overwhelmingly supportive of the theoretical predictions. Specifically, both the intensity of incentives provided by CEO stock option awards (also referred to as the pay-performance sensitivity in some earlier studies) and the mix (ratio) of CEO stock option compensation to cash compensation are related to (1) the level of difficulty in monitoring executives? actions; (2) the agency costs of equity and debt; (3) tax costs; and (4) liquidity constraints. Our single exception pertains to financial reporting cost where we do not find, as expected, that firms with high costs of reporting low earnings substitute stock option awards for cash compensation