Equity-based Compensation and Firm Performance

Transcription

1 Cand.merc FIB/Finance Master Thesis Author: Vivi Meidahl Højen Instructor: Jan Bartholdy Equity-based Compensation and Firm Performance The effects from equity-based compensation program adoption on firm security price and operational performance in listed Danish companies, in the period Aarhus School of Business Aarhus University 2007

2 Abstract In recent years, the use of equity-based compensation programs as part of remuneration packages in listed Danish companies, have increased from the first compensation programs granted in the mid 1990 ies, until today. The amount of new grants peaked in 2001 thereafter decreasing a little. However, in 2006 the amount of new compensation grants increased again, following newly listed companies issuing such grants, and companies re-granting after a period without equity-based compensation programs. Executive compensation has been widely recognised, as being an important internal mechanism to align the interests of the executives and the shareholders, thereby, reducing the agency conflicts. However, there is an increased amount of criticism to the use of equity-based compensation contracts. The critics argue that the cost of these programs exceeds the gains. Using a sample of listed Danish companies in the period , this thesis examines the relationship between equity-based compensation and firm performance. The types of equity-based compensation used in this thesis are stock options, warrants and employee shares. Empirical investigations of the short- and long-term security price performance have been performed, as well as an investigation on operational performance, measured using three proxies for firm performance; return on assets (ROA), return on equity (ROE) and Tobin s Q. In the investigation, of the relationship between compensation contracts and increased performance, in the form of security price performance, the empirical results show no significant effects from the equity-based compensation contracts in the short-term perspective. Using event study methodology, including an event window of five days (-2, 2) the investigation finds no days with significant abnormal returns, having used the marked model to calculate abnormal returns. The results are the same using either a standard parametric t-test or non-parametric rank test, to test the significance of the abnormal returns. The long-term event study using an event window of (-12, 12) months, finds no significant event month abnormal returns however, there are significant abnormal returns in the fourth and twelfth month following the event. The security price performance findings are contrary to several previous findings, however

3 the effect of equity-based compensation on security prices, can be argued to decrease over time as the granting of such programs becomes more and more common. The empirical investigation of ROA, ROE and Tobin s Q as performance proxies, show that there are no significant effects from compensation program adoption on firm operational performance, comparing pre-adoption performance with post-adoption performance for the sample of listed Danish companies. Similarly, there is no significant difference in operational performance, between the sample of equity-based compensation adopting companies, and a comparable sample of matched companies not having adopted such programs. These findings suggest, that the way the equitybased compensation contracts have been used in Danish companies to date has not yet, contributed to the desired reduction of agency conflicts in the companies under investigation.

4 Table of Contents Table of Contents 1. INTRODUCTION PROBLEM STATEMENT METHOD SELECTION THESIS STRUCTURE DELIMITATIONS COMPENSATION PROGRAMMES COMPENSATION PROGRAM DESIGN Definitions PURPOSE OF COMPENSATION PROGRAMS THEORETICAL PERSPECTIVES Principal-Agent Conflicts Reduction of Agency Conflicts Critiques to the Reduction of Agency Conflicts Corporate Governance Systems Nørby Report Disclosure Requirements EMPIRICAL INVESTIGATIONS FINDINGS SHORT-TERM PERFORMANCE FINDINGS LONG-TERM PERFORMANCE VALUE CREATION, PERFORMANCE MEASURES AND HYPOTHESES SHORT- AND LONG-TERM SECURITY PRICE PERFORMANCE Efficient Market Hypothesis Expected Market Reaction Causality in Compensation and Firm Performance OPERATIONAL PERFORMANCE Performance Proxies Expected Effect HYPOTHESES SECURITY PRICE ANALYSIS DATA COLLECTION: SECURITY PRICE PERFORMANCE Preliminary Analysis of the Initial Sample EVENT STUDY METHODOLOGY Event Study Framework Problems in Event Studies Event Definition and Event Study Frame Event Clustering Return Models Return Calculation Thin Trading Parameter Estimation...46

5 Table of Contents Abnormal Returns Calculating Abnormal Returns Test of Abnormal Returns INVESTIGATION DESIGN RESULTS- SECURITY PRICE PERFORMANCE SHORT-TERM RESULTS LONG TERM RESULTS OPERATIONAL PERFORMANCE ANALYSIS DATA COLLECTION: OPERATIONAL PERFORMANCE Control Sample Selection Control Sample Problems Effective Matching WILCOXON TEST METHODOLOGY PRELIMINARY ANALYSIS RESULTS- OPERATIONAL PERFORMANCE SHORTCOMINGS AND FUTURE RESEARCH SUGGESTIONS : SHORTCOMINGS AND QUESTIONS RAISED INTERESTING FUTURE RESEARCH CONCLUSION...79 LIST OF TABLES AND FIGURES:...83 REFERENCES APPENDIXES

6 Introduction 1. Introduction Since the mid 1990 ies, a large part of the listed Danish companies have introduced different types of equity-based compensation programs, as part of their remuneration package. In 2001, the adoption of equity-based compensation programs comprising of either options, warrants or both reached the highest level, 107 companies equivalent to 49% of the Danish listed companies used stock-based pay, see Bechmann and Hjortshøj (2006). Between 2001 and 2005, the share of listed companies using equitybased pay fell to approximately 40%. In a recently updated study by Bechmann (2007) it is highlighted, that the amount of companies using stock options as compensation increased again in This increase is a result of companies having decided to grant equity-based compensation again in 2006, after a period of not using such compensation. Similarly, many of the newly listed companies on the Copenhagen Stock Exchange use equity-based compensation as part of their remuneration programs. The interesting aspect is what the reasons are, behind granting these compensation schemes? Equity-based compensation grants are motivated, by the desire to create a link between the goals of the owners and the goals of the executives. The owners of listed companies (the shareholders) main goal are to maximize the achieved return, compared to returns that might be achieved from alternative investments. Contrary, the executives will often be driven by other goals, which are affected by the company s stakeholders and the executives own interests, with respect to salary, utility value and the overall development of the company. How is it possible to minimize these potential conflicts? An equity-based compensation grant is viewed as a means to align the interest of shareholders and managers, since it results in a share of ownership. The share of ownership thereby provides the right incentives to maximize firm value, by tying the employee pay more closely with changes in shareholder wealth. But do companies that grant executive compensation which is equity based actually perform better? International and Danish companies use of equity-based compensation, as part of a remuneration package is subject to a lot of criticism. Do these compensation programs have the desired effect with respect to increased firm performance? Supporters of Vivi Meidahl Højen 1

7 Introduction stock option grants as an incitement tool, argue that these grants help align the interest between shareholders and executives in the companies, and therefore argue that this goal congruence will result in increased firm performance. Opponents argue that the effects of these programs, are highly overstated and the costs of granting these programs are higher than the benefits achieved, thereby, diluting the interests of the shareholders. If the recipients are rewarded based solely on the development in the company stock price, and not benchmarked against the performance of similar companies, or a general market index, the recipients will be awarded without performance during bull-markets and punished during bear-markets. So are the recipients in instances of general stock price increases actually paid without performance? The debate of pay for performance currently resurfaced in the Danish media, when it became publicly known that several top executives, among them, the executive from Roskilde Bank, received a large amount of money due to the exercise of their stock options. One of the critics in the Danish media was another top executive N.E Nielsen, who amongst other things is the chairman of Amagerbanken. His argument was that since Roskilde Banken had not experienced any larger stock price increase than Amagerbanken during the last two year, the executive was paid due to a general increases on the stock market and not due to an increase in performance 1. While equity-based compensation, have delivered significant wealth transfers to the recipients of the grants, the degree to which it has resulted in a wealth transfer to the shareholders is more unclear. Empirical evidence on the effects of equity-based compensation, with respect to firm performance, is somewhat inconclusive. Some researchers find that there is a positive relationship between granting equity-based compensation to executives and increased firm performance, while other researchers find that such a relationship does not exist. Despite the interest and actuality in this topic, the relationship between granting equity-based compensation and increased firm performance in Denmark, has to the author s knowledge not been subject to an extended amount of empirical research to date. An event study based on Danish stock market data, finds that there is a relationship between the announcements regarding 1 Business.dk, Jonas Schrøder, 19 of January 2007 Vivi Meidahl Højen 2

8 Introduction equity-based compensation grants and increases in company stock prices. However, the effects differ according to the type of incentive granted, see Rose (2002). Due to, the relatively scarce amount of research in this topic, this thesis will try to investigate the effects of equity-based compensation grants on firm performance Problem Statement This thesis will try to answer the following question: Does the adoption of equity-based compensation programs in listed Danish companies, lead to increased firm performance? This thesis will seek to investigate the existence of a relationship between the adoption of equity-based compensation programmes in listed Danish companies and company performance in the period It will be analyzed if the companies create wealth to the shareholders in the form of increased stock prices, or improved operational performance Method Selection This thesis, assumes that stock prices are proxies for company performance and will therefore apply, the event study methodology to investigate a possible average abnormal security price performance. The security price performance will be investigated in the short term as well as long term perspective. The thesis, also assume that accounting numbers are good proxies for company operational performance. A Wilcoxon matched-pairs sign test will be used to determine if operational performance differs between an experimental group of companies, and a control group of companies. Similarly, a Wilcoxon test will be performed to investigate if the operational performance within the two groups changes between the pre-adoption period and the post-adoption period. Vivi Meidahl Højen 3

9 Introduction 1.3. Thesis Structure Figure shows the different elements of the paper as well as the work process, by which this thesis will be structured. The figure also highlights, how the different elements of the thesis are inter-connected Figure 1.3.1: Thesis Construction Problem Statement Theory Analysis Interpretation Empirical Research/ Data Conclusions/ Answers Source: Andersen (2005) This thesis, will based on the problem statement seek to investigate the relationship between equity-based compensation and firm performance. The relevant theory, behind granting equity-based compensation, the principal-agency theory will be explained and discussed. The empirical evidence of the relationship between equity-based compensation and firm performance will be highlighted, and used in forming several hypotheses for further testing. Based on the hypotheses, empirical investigations of the effects from equity-based compensation grants on firm performance, using Danish data will be performed, applying the event study methodology in the short term as well as the long term. Likewise long term operational performance will be analyzed by comparisons of accounting numbers, from before and after the adoption of compensation programs. The performance measures will also be compared to similar companies without compensation programs. Finally the questions arising from the results of the investigations will be discussed. Vivi Meidahl Højen 4

10 Introduction 1.4. Delimitations The focus in the theoretical as well as empirical part of this thesis will be, if the granting of equity-based compensation results in increased wealth to the existing shareholders. Therefore, other also interesting aspects such as how equity-based compensation affects the wealth of the recipient and company benefits in terms of tax advantages will not be analyzed. This delimitation is based on the expected comprehensiveness of the study, if this had also been included in the present analysis. Similarly, it will not be analysed how the individual companies shareholders are affected by the adoption of equity-based pay since the analysis is performed on an aggregate level. The value of possible economic benefits of the grants will not be analyzed. The focus of the analysis will merely be whether or not there is a significant effect. There will, be no distinction between executive and lower level recipients of the share-based compensation programs. It will, therefore not be analysed if there is a difference in company performance between granting to executives and granting to all employee levels within the companies. When the term compensation programs for executives, are used in this paper the term actually also covers compensation for other employee levels. The subject will be touched upon, if relevant for drawing inference from the results of the tests. In this thesis, it is assumed that the role of compensation programs is to provide incentives to increase firm performance, therefore, the issue of compensation programs as tools for attracting and attaining employees will not be discussed or analyzed. It is assumed in this thesis, that the link between attracting and attaining skilled employees and firm performance is not direct. The use of equity-based compensation to attract and attain employees is assumed to be a competitive parameter used by the companies, and not as a means to directly increase firm performance. The paper will, only look at compensation programs including options, warrants and employee shares. Therefore, other compensation types such as performance plans based on accounting performance or bonus schemes will not be included in the Vivi Meidahl Højen 5

11 Introduction investigation. These delimitations have been made in order to look at compensation programs which are highly influenced by the development in the company stock price. The paper, will not investigate which type of compensation program is the most optimal, but will investigate the chosen types of stock-based pay under one heading, equity based compensation. The analysis of the optimal compensation program in terms of the created incentive effects is therefore, beyond the scope of this thesis. Only listed Danish companies will be included in the empirical investigations. Therefore, non-listed companies are not included. From the listed companies, financial institutions such as banks and insurance companies, has been excluded from the analysis. This delimitation has been made, because such companies are subject to different requirements compared to other types of companies. Financial institutions are subject to increased requirements regarding the company solvency as well as the financial accounts. Firm performance is measured solely on economic performance measures, and therefore this paper does not look at non-financial performance measures. Since, nonfinancial performance measures are more difficult to measure these have been delimitated from the investigation. Vivi Meidahl Højen 6

12 Compensation Programmes 2. Compensation Programmes This part of the paper, introduces the important issues in relation to equity-based compensation programmes. These practical and theoretical issues are central, since it is important to put them into perspective before the actual analysis of the compensation programs effects on firm performance. Similarly, the theoretical issues are the foundation behind the expected market reaction and the hypotheses, which will be explained later in the thesis Compensation Program Design The term executive compensation contracts, covers a wide variety of arrangements which corporations uses to determine the overall executive remuneration. These contracts differ with respect to the time period used to measure the performance, as well as how the performance is measured. According to Larcker (1983) most major U.S corporations uses some sort of short-term compensation contract, most often a bonus plan. Bonus plans base the remuneration on yearly performance, most often yearly income. Similarly, many large companies also use long-term compensation contracts. The difference between the short-term and the long-term compensation contracts is that long-term contracts measure performance over a period of more than one year. Often the performance is measured by the change in share price over the relevant time period. The topic regarding the level of executive pay has been a mayor theme in the academic and business circles in the last decades. However, according to Jensen and Murphy (1990) the problem is not how much the executives are paid, but how they are paid. They argue that in many companies the compensation to executives is virtually independent of performance. Optimally the compensation program should be constructed in such a manner that it optimizes the incentives created by the program and thereby also optimizes the performance. Jensen and Murphy (1990) argue that the optimal compensation includes large portions of equity-based pay. Their findings are also supported by the findings by Hall and Liebman (1997). Nevertheless, both papers argue that the current CEO contracts are not necessarily constructed efficiently, in the sense that there is still some work left in designing the optimal compensation Vivi Meidahl Højen 7

13 Compensation Programmes contracts. On average the median value of a share-based grant in Danish companies increased between 2001 and 2005 with 3 million DKK, see Bechmann and Hjortshøj (2006). This shows that the companies granting the programs have increased the value of the grants in the period. Despite, the increase in the value of the grants, most Danish managers still receive most if their incomes from their normal wage; see Rose and Mejer (2003). Several recommendations, regarding the optimal design of compensation programs exist within the theoretical literature. According to Larcker (1983), base salary and/or bonus contracts should be decreased when performance plans are introduced. If such a reduction in base salary is not made, the compensation contracts are merely an excess salary and the motivational aspects which are the fundamental reasoning behind the grants might diminish. The problem of optimal compensation program construction is also commented in Bechmann and Møller (2003). The paper argues that salary and share-based payment should not be viewed as two separate entities. The granting of for example options should result in a decrease in the salary. However, only a few Danish companies actually follow this approach, why it could be argued, that they do not achieve the optimal motivation effect from the compensation grants. Another aspect in the optimal design of compensation programs is, whether or not the equity-based compensation should be granted to executives as well as lower level employees. Leonard (1990) state that top executive compensation, should be more closely related to company performance, than lower level employees. Top executives, are better able to affect company profits, and therefore the executive performance is easier to observe by outsiders. Consequently, the company has to compensate the executive in order to prevent other companies from hiring the executive. This will also result in a higher increase in motivation generated by the compensation programs, for the executive compared to lower level employees. Bechmann and Møller (2003) argue that incitements generated by equity-based programs will only be created for top level employees since lower level employees is incapable of affecting the stock price. This could be argued, to have an impact on the reaction from the shareholders to the granting of these programs. If the shareholders believe that only top level employees will be efficiently motivated by these grants, any reaction on the stock market to grants to lower level employees will not be present. Of the options Vivi Meidahl Højen 8

14 Compensation Programmes granted in Denmark in 2006, 25% was granted for the board of directors, and in 2001, 16% was granted to the directors. Similarly, equity-based compensation programs granted to non-executives is increasingly given to other management levels 2. This indicates that an increasing proportion of the compensation programs granted are granted to the higher level employees in the Danish companies. According to Bechmann and Møller (2003) many Danish companies including companies in the old KFX index, now known as OMX C20 have used options as part of their remuneration package, without seriously considering the pro s and con s of using them. Whether or not there is a link to increased performance is not seriously investigated before the programs are adopted. If the effects does not exist the recipients of the compensation programs are rewarded without performing. The purposes behind the granting of equity-based compensation programs will be further explained in section Definitions There exist, several types of long-term compensation programs however this thesis only focuses on stock options, warrants and employee shares. A stock option, typically a call option, provides the holder with the right but not the obligation, to buy the company stock at some predetermined time and often predetermined price. If the price of the option increases between the time of the award and the time of exercise, the holder of the option receives the gain. The typical stock options granted to company employees differ from the listed options, since they often require an extended holding period before an exercise is possible. Likewise, the employee stock options often have a longer maturity often ten years. The stock option regards already existing shares of company stocks, contrarily, warrants gives the holder the right to buy newly issued company shares at a predetermined price. The difference between warrants and stock options therefore, lie in the effects on the share capital. Warrants are newly issued shares and thereby increase the share capital, whereas, stock options have no effects on share capital. 2 Børsen ( ) David Bentow. Vivi Meidahl Højen 9

15 Compensation Programmes Employee shares allow the holders the right to obtain shares in the company in which they are employed in. The employee shares are often sold to the employees at a favourable price, and even sometimes given to the employees free of cost, often in connection with a company jubilee or such. Options, unlike employee shares do not require an initial outlay of funds from the recipient. Similarly, the downside risk by holding options is lower than for employee shares. It can be argued that options put the recipient in a win-win situation, since there is an unlimited upside chance and a limited downside risk, since the recipient can merely walk away and choose not to exercise the option; see Elayan et al (2001). Common for all three types of compensation is that the value to the employee is tied to, and dependent on the development of the company s stock price, over the holding period of the contact Purpose of Compensation Programs Equity-based compensation programmes are granted based on a wide range of different reasons, these reasons being theoretical as well as practical. The issues will be further explained and discussed in the following sections of this thesis. This part serves only as an introduction to the purposes of using equity-based pay, as part of a remuneration package. Reduction of agency conflicts Risk taking incentive Short and long-term goal maximization Attracting and attaining employees Most of these issues can be viewed as parts of the principal-agency problems. Therefore, it can be argued that the main reason why companies use equity-based pay is to try to reduce these conflicts. The subject of equity-based compensation programs as a means to attract and attain skilled employees is beyond the scope of this paper. However, it is mentioned here to highlight, that reductions of the principal-agency conflicts, are not the only motives behind granting these programs. Vivi Meidahl Højen 10

16 Compensation Programmes 2.3 Theoretical Perspectives. This section will describe the principal-agency conflict and the possible theoretical solutions. Moreover, the section will also include a short discussion of the effects of the corporate governance system. These issues are central in the formation of the hypotheses, which will be used in the investigations of the relationship between equity-based compensation and firm performance Principal-Agent Conflicts Due to the separation of ownership and management a principal-agent relationship exist in listed companies; see Jensen and Meckling (1976). An agency relationship is characterized as a relation based on a contract between two or more people, the principals and the agent. The agent performs tasks and makes decisions on behalf of the principals, see Ross (1973). Listed companies are based on such agency relationships, in which the management makes decisions regarding the day-to-day operations of the company on behalf of the principals. The agency theory is of interest, because asymmetric information and goals as well as conflicts of interest, exist between the principals and the agent. Agency costs arise, due to the lack of symmetric information between the agent and the principals. This moral hazard problem is based on the argument that, the management actions cannot be observed, let alone contracted upon; see Holmstöm (1979). Being that, shareholders know less about the company and the consequences of management decision, there is a need to monitor and control the management of the company, resulting in the occurrence of agency costs. All of these agency costs is assumed to be captured by the financial markets, and reflected in the stock prices, and therefore in the valuation of the company. The shareholders (principals) main objective is company profit maximization, which will increase the value of the company in terms of increased stock prices or improved operational performance, and thereby increase the value of their investment. The management (agent) on the other hand will not always make decisions based on the best interest of the shareholders. This is due to the fact that the agent is influenced by Vivi Meidahl Højen 11

17 Compensation Programmes the interests of the stakeholders of the company and other more personal interests; see Jensen & Meckling (1976). These conflicts, results in an increase in the agency cost when the management does not try to maximize the value of the firm. A theoretical foundation behind the principal-agency conflicts is that the management of the company is risk-averse as well as effort-averse. Meaning, that the management is declined to take on any excessive risk and will also only put in the minimal necessary work effort to keep the shareholders satisfied. The lack of risk-taking behaviour from the management is to some degree, a result of the differences in time horizon between the shareholders and the management. In equilibrium, the value of the firm should be equal to the discounted value of all future free cash flows. Hence, in theory the shareholders relevant time horizon runs into the indefinite future; see Hall (2002). Contrarily, the managers are often argued to be biased by short-termism, because there employment with the company is limited in time. According to Nickell (1995), a result of short-termism is that the management will have a tendency to favour projects that yield high short-term accounting returns, at the expense of more long-term value enhancing projects. The principal-agency problems facilitate the argument that, equity-based incentive programs could help to solve these problems. Equity-based compensation results in an employee co-ownership of the company, thereby motivating and aligning the interests, of the employees to those of the shareholders. Nevertheless, the shareholders do not always possess all knowledge about the company, and the decisions made by the company. Therefore, it is to some degree still possible for the management to manipulate the information, which affects the stock prices. Moreover, it is also possible for the management to manipulate the operational performance measures Reduction of Agency Conflicts According to Holmström and Milgrom (1991), the use of company equity-based compensation programs serves a dual function. It serves as a tool to allocate the risk between the principals and the agent, while also serving as a means to reward productive efforts. The risk is shared between the principals and the agent, since the equity-based compensation results in a co-ownership of the company, and therefore Vivi Meidahl Højen 12

18 Compensation Programmes the principals no longer bear the risk of inefficient management alone. Some of this risk is transferred to the agent. The other function of the compensation programs is that they increase the motivation for the agent, to work harder and more productive. Increased productivity and efficiency, is associated with improvements in company operational performance, see Hillegeist and Penalva (2003). The use of stock-based pay as a part of the remuneration programs within the companies, generally serves as a link between the pay received by the agent and the performance of the company. Granting compensation which is linked to the performance of the company s stock price provides the recipient, with incentives to act in ways that will maximize the shareholder value. Therefore, it can be argued that, the granting of equity-based compensation will increase the risk-taking behaviour and the motivation for the recipients, and this will increase the efficiency and productivity. Increased efficiency is assumed to improve company fundamentals, and thereby operational performance Critiques to the Reduction of Agency Conflicts The incentives generated by stock based remuneration is expected to increase the motivation by the recipient to think of long term profit maximization, and not think of short term operational improvements. According to Hall (2003) the opposite reaction with regards to improving company profitability might occur if the programs are not designed carefully. In fact the compensation programs can end up fostering value destroying behaviour as compared to value creating behaviour from the recipients. A problem with the motivation generated by equity-based compensation is that it might result in managers trying to improve short term earnings at the expense of long-term cash flows, to boost the short term share price. Similarly, the desired risk taking incentive generated by equity-based pay might not be present for all types of equity compensation. If the compensation given to the executives are in the form of traditional in-the-money options, this could result in managers being overly cautious since they are unwilling to risk loosing the expected payoff, generated by even small share price increases. Vivi Meidahl Højen 13

19 Compensation Programmes Coughlan and Schmidt (1985) argue that while compensation programs ideally link the interest of the managers with the interest of the shareholders, agency costs still occur because managers have monopoly access to the information which is relevant to the construction and management of these compensation programs. This could motivate the managers, to withhold some relevant information s from the compensation committees, if this information, could link poor company performance, with management behaviour. As argued above, the relationship between the granting of equity-based compensation as reductions in agency conflicts may not be as straightforward as initially expected. Agency conflicts and the related costs, leads to the necessity of having good Corporate Governance systems. The Corporate Governance system serves as an internal as well as external managerial control mechanism Corporate Governance Systems Corporate Governance is a control mechanism, which encompasses policies that serves the needs of the shareholders and other stakeholders, by monitoring that the actions of the managers is in accordance with the approved strategy of the company. Good corporate governance relies on the participation of the external market place, as well as the internal board culture. It can be argued that the perceived quality of the corporate governance system can have an effect on company stock prices. According to Core et al (1999), the corporate governance system has an effect on the company s performance, since, companies with weaker governance structures have greater agency problems and are also found to perform worse, than companies with good governance structures. Historically the Danish governance structure has been oriented towards the protection of stakeholder rights and not only shareholder rights. According to Rose and Mejer (2003), Danish companies have been experiencing an increasing pressure to focus more on optimizing shareholder value. As a consequence, Danish managers have started to receive equity-based compensation as part of their remuneration package. The Danish corporate governance system is characterized as being relationship-based as well as market-based, and institutional investors plays an important role in the Vivi Meidahl Højen 14

20 Compensation Programmes control of the companies. The institutional investors often have close ties to the management; see Rose and Mejer (2003). Nickell (1995) argue that institutional investors might suffer from short-termism, meaning that they favour short-term objectives at the expense of long-term objectives. This is mainly the case with institutional investors, such as funds managers that are assessed frequently on the short-term performance of their portfolios. This is interesting, in the sense that the type of investors can be argued to have an affect on the market reaction to long-term compensation programs, because they will have a tendency to undervalue companies that has a long-term perspective. The increased focus on corporate governance issues has lead to several recommendations regarding the use of compensation programs, as part of a remuneration package. The Danish Nørby Report is one of such recommendation. Similarly, the Copenhagen Stock Exchange has made some recommendations regarding how listed Danish companies should disclose the information related to these programs Nørby Report The Nørby Report, put forward seven recommendations for good Corporate Governance, these include recommendations about the remuneration given to the executives. One of the recommendations in the report by the Nørby committee regards the principals behind, granting equity-based compensation programs. The committee recommends, that the management should not be granted stock options as part of their remuneration package. Such compensations should only be given to the board of directors. Moreover, it is recommended that if the board of directors receives stock options, these options should be granted out-of-the money. According to Bechmann and Jørgensen (2003), the most widely used option type in Danish companies in 2001 was an American call option with a fixed exercise price. Historically most of the options granted have been granted in-the-money. This indicates that the Danish companies historically, have not followed the recommendations from the Nørby Report. Vivi Meidahl Højen 15

21 Compensation Programmes Disclosure Requirements As the use of equity-based pay has become increasingly popular in Danish companies, some recommendations regarding the disclosure of information have been introduced. The Copenhagen Stock Exchange (CSE) recommends that the companies listed on the exchange follow the recommendations put forward by the Nørby Committee. One of the recommendations included in the Nørby Report, regards the disclosure of relevant information concerning equity-based compensation programs. These recommendations are also included in the corporate governance set of rules from the Copenhagen Stock Exchange. If the compensation is granted as a stock option or a warrant, the information that must be disclosed should include the type of option; option or warrant, date of issue, number of options, strike price, time to maturity and exercise provision. Likewise, the companies must inform which parts of the organisation receive the grant. The disclosure should take place immediately, in the form of a company announcement, and the announcement should also be included in the annual report, see Bechmann and Jørgensen (2003). The Danish companies do not always live up to the disclosure requirements set out by the Copenhagen Stock Exchange. The information regarding the value of the incentive programs is not sufficiently good. This lack of information result in information asymmetry, and makes it difficult for the shareholders to be able to evaluate and make informed decisions regarding whether the benefits exceed the costs of these programs, see Rose and Mejer (2003). However, according to Rose (2002) the quality of the disclosed information in Danish companies has improved during the last couple of years. The companies disclose more information regarding the details of the compensation programs and the disclosures are often associated with a separate stock exchange announcements. Bechmann (2007), also report that the quality of information provided to the stock market from the Danish companies have improved during the last couple of years. In 2005, 62 % of the companies using equity-based compensation, disclosed information that was satisfactory for the market to make a correct assessment of the value of these programs. The problem with the rules from the Copenhagen Stock Exchange regarding the disclosure of information is that they are more recommendation than rules. The Vivi Meidahl Højen 16

22 Compensation Programmes companies should either comply or explain. This means, that if a company decides not to comply with the recommendations, they should merely explain, why they have chosen not to follow these recommendations. However, to improve the transparency in the information given to the stock market, the Danish government has approved a change in the legislation that now requires that the main principals behind the compensation programs must be approved at the companies annual meetings 3. The discussion of the theoretical and practical issues behind the granting of equitybased compensation programs, indicate that there is several factors, which influences the effectiveness of these programs. The different issues affect how the market values these grants, and therefore, how the performance of the companies is influenced by the programs. 3 Børsen ( ) David Bentow Vivi Meidahl Højen 17

23 Empirical Investigations 3. Empirical Investigations Several studies have tried to determine the existence of a relationship between the adoptions of stock based incentive programs and firm performance. A large part of these studies have been performed on large stock markets, such as the American stock market. Similarly, only very few studies have tried to investigate the relationship in Danish companies. This section will highlight some of the prior research and results found in Danish and international investigations Findings Short-term Performance Studies using event study methodology to determine the short term impact on stock prices, from compensation grants, have resulted in inconclusive results. Defusco et al (1990), Larcker (1983), Brickley et al (1985), Hillegeist and Penalva (2003), and Rose (2002) find that there is a positive short-term stock price reaction, to the announcements regarding equity-based compensation adoptions. Contrarily, Abowd et al (1991), and, Kedia and Mozumdar (2002) find, that there is no effect on the stock prices. DeFusco et al (1990) argues that while stock option-based incentive programs align the interest between the shareholders and the managers, such programs also increase the managers risk taking behaviour. This is assumed to minimize the agency conflicts. The paper finds that the adoption of stock option based incentive programs, results in an increased implicit stock variance as well as stock return variance. This is consistent with the argument that investors will react to an increase in managerial risk-taking and in correspondence with the argument in section 2.2, that equity-based incentive programs are issued to increase managerial risk taking. Based on an event study Defusco et al (1990) finds evidence for an increase in shareholder wealth surrounding the announcement of an executive stock option plan. Similarly, a negative reaction was detected on the bond market, which indicates that the adoption of stock option programs increases the wealth of the existing shareholders at the expense of the bondholders. However, the view of the bondholder is beyond the scope of this thesis, which will only look at possible stock price changes from the viewpoint of the shareholders. Vivi Meidahl Højen 18

24 Empirical Investigations An investigation by Larcker (1983) displayed a significant positive market reaction on the event day from the introduction of long-term incentive programs. However, the long-term compensation contracts investigated in this paper did not include an equity component. Nevertheless, the findings of this paper are of interest, since it shows that the market reacted quickly to the announcements regarding compensation program grants. This thesis, will investigate if Danish stock market will react to grants, that includes an equity component. A study performed by Rose (2002) on the Danish stock market, uses event study methodology to investigate the effects of incentive program announcements. The analysis uses the non-parametric rank test, and investigates the impact of grants comprised of stock options, warrants and employee stocks, using an eleven day event window. The paper finds that the abnormal returns, on the announcement days are positive and significantly different from zero. However, the significant effect depends on the type of compensation granted. There is only a significant effect from granting stock options and warrants, the effect of granting employee stocks is insignificant. The difference in effects from different compensation types is beyond the scope of this paper. However, they are interesting, since it indicates that the market may not react similarly to different types of grants. Rose (2002) argue that since the granting of stock options has increased over time, the shareholders might come to expect that companies that do not apply equity-based remuneration will introduce such programs eventually. Therefore, the effect of such an announcement will decrease over time, since the expectation of such introductions has already been incorporated into the stock prices. This thesis will try to clarify whether such an effect is still present on the Danish stock market, or if the effects are no longer present. Rose s (2002) argument is consistent with the findings of Hillegeist & Penalva (2003). They investigate, the relationship between the unexpected level of option incentives held by executives and employees, and firm performance. Hillegeist & Penanlva (2003) finds that firms with high levels of unexpected option grants, show higher levels of firm performance, regardless of whether the unexpected options are granted to executives or employees. Vivi Meidahl Højen 19

25 Empirical Investigations An investigation by Brickley, Bhagat and Lease (1985), also find a significant association between compensation programs including an equity component, and improved shareholder wealth, in terms of higher stock prices surrounding the event. The investigation also finds, that there is no significant difference in market reactions depending on the type of compensation plan, equity-based or not. This indicates that the market value, different compensation program types, for different types of companies, meaning, that the optimal compensation type depends on the type of company. The paper also argues that the appropriate compensation package varies from company to company. Therefore, the aggregate analysis performed in this paper will not differentiate between the different compensation types. The above mentioned significantly positive relationships are, contrary to the findings by Abowd et al. (1990) who investigates whether or not announcements regarding human resource decisions, compensation and benefit decisions, affects the level or variation of abnormal shareholder return. The paper finds that there is no significant effect on the shareholder value by human resource decisions regarding compensation. Likewise, an investigation performed by Kedia and Mozumdar (2002) based on 200 large Nasdaq companies finds, that there is no significant abnormal returns associated with options outstanding or options granted, when the options are granted to provide better incentives for the employees to increase firm performance. These findings, are contradicting to the arguments that equity-based compensation, will increase executive motivation, and thereby, decrease the agency conflicts. The article by Kedia and Mozumdar (2002) also argue that the granting of stock options is correlated with high growth opportunities. This means that companies issue these types of grants when they are facing high growth opportunities. This is however not surprising, since stocks listed on the Nasdaq exchange often is characterized as being high growth companies. The interesting aspect is that it raises the question of the causality, in the relationship between compensation program grants and firm performance; if, the management receives stock options as a means to increase firm performance, or if they recieve stock options as a result of expected increases in firm performance. Yermack (1997) analyses the timing of 620 stock option awards in the period , and find that the timing of stock option awards coincides with Vivi Meidahl Højen 20

26 Empirical Investigations favourable movements in company stock prices. This is evidence of the opposite causal relationship compared to the relationship investigated in this thesis Findings Long-term Performance The effect on long term company performance from the adoption of equity-based compensation programs, have also been subject to several empirical investigations. Similarly, to the short term performance, the results of the long term analyses are also somewhat inconclusive. Elayan et al (2001) and Leonard (1990) finds that there is no effect on the long term performance measures, whereas, Murphy (1985), Mehran (1995) and, Brown and Caylor (2004) finds a positive association between the compensation programs and long-term performance. Performance is measured using company fundamentals and market measures, such as income figures and stock prices. Elayan et al. (2001) examines the relationship between incentive compensation schemes and firm performance in New Zealand. This paper is interesting in the sense, that the stock market in New Zealand can be characterized, as being somewhat similar to the Danish stock market. The development in the amount of share-based incentive programs granted in New Zealand has increased since the mid to late 1990 ies, similarly, to the development in Denmark. The investigation applied two-sample t-test ROA, ROE and Tobin s Q to test the relationship between compensation and firm performance. They, find no significant association between CEO compensation and these particular performance measures. This is interesting in respect to the operational performance analyzed in this thesis. Leonard (1990) examines the effects of executive compensation policy on the performance of U.S. corporations in the period In a sample of 439 large U.S companies he finds that there are no significant effects on the companies accounting measures from the level of equity in the executive compensation programs. The findings from Elayan et al (2001) and Leonard (1990) is opposite to the findings by Murphy (1985). Murphy (1985) performs an analysis, using data from five hundred executives from 73 large U.S companies over the period from Vivi Meidahl Højen 21