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E-MailVyacheslav Fos is Assistant Professor of Finance at Boston College. This post is based on an article by Professor Fos and Wei Jiang, Professor of Finance at Columbia Business School.
In our paper, Out-of-the-Money CEOs: Private Control Premium and Option Exercises, forthcoming in the Review of Financial Studies, we examine the effects of proxy contests on CEOs’ option exercise policies. When faced with a challenge to insider control, we find that CEOs value company shares significantly more than the market due to the potentially decisive role their attendant voting rights could play in ex ante close proxy contests. By demonstrating that the strategic exercise of vested options is a potentially effective defensive tactic, we provide further support for the role of aggressive shareholder activism in market-based corporate governance.
A proxy contest reveals that at least some shareholders consider the incumbent CEOs or directors to be “out of the money,” i.e., their value to the firm is lower than what they cost the firm. Facing a control challenge, such CEOs may exercise vested options (including in-the-money options) in a way that differs from what benchmark models predict. Changes in insider ownership via option exercises are an important supplement to other tactics incumbents deploy to enhance voting power. Proxy contests usually emerge after more moderate and negotiations-based forms of activism have failed to accomplish a resolution, indicating that the voting power of insiders and their opponents is similar ex ante.
We find strong evidence that insiders do use their option exercise policy as a control tactic. After controlling for the standard variables that prior literature has shown to affect early exercise of insider options, we find that the presence of proxy contests reduces the frequency of exercise-and-sell transactions by 80%, and increases the frequency of exercise-and-hold transactions by about 60%. These phenomena represent two sides of the same coin: Because he or she values the shares more than the market, an insider is less willing to sell shares at the market price, keeping other motives such as liquidity needs and diversification constant. On the other hand, the insider is more likely to exercise the option with the intention to hold the shares because the voting rights are equivalent to a lumpy dividend. If the difference between her private valuation and the market’s is high enough, an insider may even exercise options that are out-of-the-money relative to the market price.
Our results closely align with features unique to proxy contests. For example, we show that deceleration (acceleration) of exercise and sell (exercise and hold) is more pronounced before the first record date of a proxy season. Moreover, the unusually high rates of exercise and hold by CEOs stop mostly at the record date, while the unusually low rates of exercise and sell continue beyond that point but in decreasing magnitude until resolution. Thus, CEOs attempt to gain additional votes just in time, and to maintain the option to acquire more voting rights as long as the proxy contest is still looming. Furthermore, the effect is more pronounced when the CEO’s private benefits from keeping her position are higher or when the voting rights are more crucial (e.g., when the CEO belongs to a slate of directors up for reelection).
Our paper extends the literature on the private value of corporate control and the value of voting rights. Earlier studies primarily attempt to identify the value of control to a marginal trader in the market, who tends to be small and thus may not provide a good proxy for the value of control to insiders. In comparison, this study focuses on the private value accruing to agents in control that is incremental to the “fair market value,” where the latter could already include the value of voting rights to outside shareholders. Calibrated to option valuation models, the abnormal patterns suggest that insiders facing control challenges value the marginal shares above the market price by 5% to 10%.
More generally, our study sheds light on how far insiders are willing to go to maintain control, and on the role that insider ownership could potentially play as a defensive tactic against control challenges. Importantly, we show that CEOs are more likely to distort their exercise behavior when their firms already deploy strong defenses (e.g., staggered boards) and insiders already resort to alternative tactics (e.g., postponing shareholder meetings).
The full paper is available for download here.
