Academic journal article International Journal of Business

The Pressure to Perform: Option Compensation and Forced CEO Turnover

Academic journal article International Journal of Business

The Pressure to Perform: Option Compensation and Forced CEO Turnover

Article excerpt

ABSTRACT

We study the relationship between the proportion of option compensation in the total compensation of a CEO and the likelihood of forced turnover. Our results confirm prior findings that CEOs who receive higher option compensation are more likely to lose their jobs for poor performance. However, this positive relation between option compensation and forced turnover does not hold for influential CEOs and firms with poor governance structures. Our results are robust to various measures of firm performance, alternative definition of forced turnover, more than one lags of option compensation, inclusion of total compensation, CEO equity ownership and firm risk.

JEL Classifications: G30, J33

Keywords: stock options; compensation; termination; governance

I. INTRODUCTION

The comfortable corner office in some of the largest firms of the world underwent tremendous transformation during the 1990s. The world of CEOs experienced two important trends simultaneously: skyrocketing increase in performance linked compensation and higher likelihood of performance related turnover. Business Week reports that two thirds of all major companies of the world replaced their CEOs at least once between 1995 and 2000. Similarly, the average pay of a CEO of S&P 500 firm increased from $2.7 million in 1992 to S14 million in 2000 (Daines, Nair, and Kornhauser, 2005). However, the increase in pay mainly came from performance linked compensation. Murphy (2000) reports that the proportion of options in total CEO compensation of S&P 500 Industrials increased from 27 percent to 51 percent from 1992 to 2000.

Whereas the trends in CEO compensation and forced CEO turnover were noted and discussed in both academics and popular press during the 1990s, few attempts were made to find out if these trends were related to each other. In this study we investigate if and how performance related CEO turnover is related to performance linked compensation for the period 1993-1999. Our results indicate that controlling for the economic determinants of forced turnover, lagged proportion of option compensation of a CEO is positively related to the likelihood of forced turnover. This implies that an increase in the proportion of option compensation increases the likelihood of forced turnover. However, further investigation shows that CEO influence and corporate governance also affect this positive relation between option compensation and forced turnover. We find that the positive relation between option compensation and forced turnover is not statistically significant for influential CEOs (i.e. for CEOs who stay in their jobs longer than the median tenure of their industry or have been hired from within the company). Similarly, the positive relation between option compensation and forced turnover is significant for firms that have strong governance structures. Our results show that there is no statistically significant relationship between option compensation and forced CEO turnover in firms that have poor governance structures.

Our empirical findings are robust to various measures of firm performance and an alternative definition of forced turnover. We also control for total compensation and find that our results do not change. The results are also robust to the inclusion of CEO equity holdings or firm risk. Moreover, this relation does not change when we use two lags of option compensation to mitigate concerns about simultaneity.

Our empirical results may be explained by the boards' attempt to justify huge (potential) payments to their CEOs. During the 1990s boards searched for "savior" CEOs (Khurrana, 2003) who were expected to lead their companies to El Dorado. In this hope these executives were paid like Hollywood celebrities, often in the form of executive stock options to avoid media attention. However, option compensation due to its very design offers the executives virtually unlimited upside if the company performs well but punishes them only marginally if the company performs poorly. …

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