The Impact of Shareholder Activism on Financial Reporting and Compensation: The Case of Employee Stock Options Expensing

In our paper forthcoming in The Accounting Review, “The Impact of Shareholder Activism on Financial Reporting and Compensation: The Case of Employee Stock Options Expensing,” my co-author Tatiana Sandino and I examine the economic consequences of more than 150 shareholder proposals to expense employee stock options (ESO) submitted during the proxy seasons of 2003 and 2004. This was the first instance where the SEC allowed a shareholder vote on an accounting matter. Activists had argued that lack of ESO expensing had led to an excessive use of option-based compensation.

Under the current legal regime, shareholder proposals are typically non-binding, raising the question of their real economic consequences. Overall, our findings reveal an increasing influence of shareholder proposals on governance practices.

With respect to accounting choices, we find that firms targeted by ESO expensing proposals were significantly more likely to subsequently adopt ESO expensing relative to a control sample of S&P 500 firms, particularly when the proposals received a high degree of voting support. We also find that non-targeted firms were more likely to adopt ESO expensing when a peer firm was targeted by an ESO expensing shareholder proposal, suggesting the presence of spillover effects of this shareholder initiative.

With respect to compensation practices, we find that targeted firms subsequently experienced a decrease in the level of CEO compensation relative to a control sample of S&P 500 firms, a finding entirely driven by the subset of targeted firms in which the proposal was approved. In particular, the approval of an ESO expensing proposal is associated with a subsequent decrease of approximately $2.29 million in CEO compensation (versus an increase of $0.34 million in non-targeted firms). We also find a decrease in the relative weight of ESO in CEO pay in firms in which the proposal was approved. The evidence of an effect of shareholder votes on executive pay may be of relevance to policymakers debating the introduction of a mandatory advisory annual shareholder vote (known as the “say on pay” vote) on the executive compensation report included in the proxy statement.

The paper also suggests the possibility of a broader effect of this shareholder initiative on the standard setting process which eventually led to mandatory expensing of ESO. In this respect, the ESO expensing initiative exemplifies the emerging role of shareholder proposals as a lobbying mechanism for influencing regulatory reform and may be provide a useful framework in assessing subsequent initiatives sharing this regulatory focus, such as the push for a majority voting election system and the say on pay movement.

The full paper is available for download here.