Managers place a low value on equity-based compensation because it exposes them to the risk of the firm. Such undervaluation and the need to achieve diversification may force a manager to sell his own stock of the firm in response to equity-based awards. In this paper we examine whether such stock selling by an executive depends on the aggregate level of management ownership of the firm. We argue that stock selling occurs at a high level of aggregate ownership where an executive has a low probability of being replaced. Our findings support this "management ownership" argument of compensation-based stock trading. One implication is that the board's effort to minimize agency conflicts becomes less effective once aggregate ownership increases to a certain threshold level. (JEL G30, G32)
Firms grant equity-based compensation such as stock options and restricted stocks to align managers' interests with those of the shareholders. Such awards, which are not tradable when they are granted, expose managers to the risk of the firm.1 As a result, an undiversified manager's private value of equity-based compensation is less than the market value. Meulbroek (2001) shows that managers' private value can be as low as 53 percent of the market value for Internet-based firms. Undervaluation of equity-based compensation may force managers to sell shares of the firm that they already own to increase portfolio diversification. Ofek and Yermack (2000) provide evidence of such compensation-based stock selling by corporate executives.
In this paper we take the view that compensation-based stock selling by an executive also lowers the management ownership level in the firm, which increases the probability of his replacement. Thus the executive is faced with the conflicting goals of achieving the benefits of his portfolio diversification and maintaining management ownership at a level where his replacement is difficult.
A number of empirical studies show that replacement of executives is related to management ownership of the firm. High ownership reduces the probability of an acquisition attempt, as Mikkelson and Partch (1989) and Song and Walkling (1990) have shown, which helps avoid replacement of the target firm's executives after the acquisition. [See Walsh (1988), Walsh and Ellwood (1991), and Martin and McConnell (1991).] Also, internal replacement by the board of directors is less likely to occur when management has a high ownership stake in the firm. [See Alen (1981), Allen and Panian (1982), Boeker (1992), and Denis, Denis and Sarin (1997).] To guard against such internally and externally instigated replacement, the executive of a low management ownership firm could be reluctant to sell his shares of the firm's stock. Furthermore, since replacement is generally associated with declining firm performance, as in McEachern (1975), Gilson (1989), Boeker (1992), Gilson and Vetsuypens (1993), and Martin and McConnell (1991), the executive of a poorly performing firm can show a preference to keep management ownership at a high level.
We examine whether stock selling by key corporate executives in response to stock-based compensation occurs after a certain level of aggregate management ownership is reached. We predict that an executive engages in compensation-based stock selling when management ownership is high.3 The empirical findings are consistent with our predictions that at high levels of management ownership, executives tend to sell previously owned shares in response to stock option grants. On the other hand, executives tend to accumulate shares when aggregate ownership is low. The results are less pronounced for options exercise and restricted stock awards.
Do our empirical results depend on the level of individual ownership by an executive? After all, management ownership is the sum of individual ownerships. We analyze this possibility and find that executives …