Determinants and Performance of Equity Deferral Choices by Outside Directors

The following post comes to us from Christopher Ittner, Professor of Accounting at the University of Pennsylvania; and Francesca Franco and Oktay Urcan, both of the Accounting Area at the London Business School.

In our paper, Determinants and Trading Performance of Equity Deferral Choices by Corporate Outside Directors, which was recently made publicly available on SSRN, we investigate the determinants and trading performance of outside directors’ “equity deferrals,” which represent the choice to convert part or all of the current cash compensation into deferred company stock. Director equity deferrals are interesting for two reasons. First, by deferring, the directors give up a sure amount of cash today for firm stock with an uncertain future value, while at the same time substantially increasing the proportion of their compensation that is tied to future firm performance. Second, the equity deferrals can become a form of insider trading, because directors can use these options as a tax-advantaged alternative to open-market purchases of the firm’s stock.

We examine director equity deferrals using a hand-collected sample of U.S. firms that allowed outside board members to defer their cash compensation into equity between 1999 and 2003. We first focus on the factors affecting director equity deferral choices. Consistent with a certainty equivalent story, we find that directors are more likely to defer cash into equity when they receive higher cash compensation levels and when the plans offer premiums for deferrals made into equity. Deferral likelihood also increases with the size of the taxes that are deferred.

Consistent with information and signaling arguments, we find positive associations between director equity deferrals and the deferral elections made by the firm’s executives (i.e., CEOs and/or CFOs) and the firm’s future stock market performance. We also find that directors are more likely to defer in years when they chair the compensation and audit committees. Finally, the likelihood of the equity deferrals decreases with proxies for directors’ wealth that is currently tied to firm performance. These results are robust to alternative model specifications and the inclusion of firm fixed-effects.

We next examine the trading performance of director equity deferrals. We indirectly measure the level of inside information independent directors exploit through their equity deferrals by computing the abnormal returns that the directors earn from these transactions. We find that directors earn significant abnormal returns when they acquire stock through deferrals, and that these returns decrease when the director compensation plans have features that make the deferrals relatively cheaper (i.e., the presence of premiums) and/or some other characteristics that would make the deferrals relatively less discretionary (i.e., the existence of ownership guidelines for directors and the use of deferral options as a replacement for director retirement plans). Finally, we find no evidence that sample directors backdated their deferrals and/or used these transactions to trade during blackout periods.

The full paper is available for download here.

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