Managerial gaming of stock and option grants

• Published date: 01 August 2017
• DOI: http://doi.org/10.1111/fmii.12081
• Date: 01 August 2017

DOI: 10.1111/fmii.12081

ORIGINAL ARTICLE

Managerial gaming of stock and option grants

Yisong S. Tian

YorkUniversity

Correspondence

YisongS. Tian, Schulich School of Business,

YorkUniversity.

Email:ytian@schulich.yorku.ca

Abstract

In this paper, we examine managerial gaming of different types of

equity grants, both at the initial award of the equity grants(front-end

gaming) and the unwinding of the equity holdings in the future (back-

end gaming). We find that the potential gains from stock price manip-

ulation vary substantially across different types of equity grants.

While traditional stock option grants are less vulnerable to front-

end gaming, theyare more vulnerable to back-end gaming than other

types of equity grants (e.g., restricted stock grants). To prevent or

discourage managerial gaming, firms should preset all terms of the

equity grant in advance and link its future payoff to average stock

prices (e.g., by grantingAsian stock options).

KEYWORDS

back-end gaming, equity incentives, executive compensation, front-

end gaming, restricted stock grants, stock option grants, stock price

manipulation

JEL CLASSIFICATION

G13, G30, J33, M52

1INTRODUCTION

Isthere a dark side to linking executive compensation to stock price performance? Indeed, managerial equity incentives

are found to be associated with certain opportunistic managerial behavior such as committing accounting or securi-

ties fraud (e.g., Bergstresser & Philippon, 2006; Burns & Kedia, 2006; DuCharme, Malatesta, & Sefcik, 2004; Denis,

Hanouna, & Sarin, 2006; Johnson, Ryan, & Tian, 2009). In particular, some executives appear to “game” their equity

compensation by manipulating the stock price in order to gain extra payoffs from their equity holdings (e.g.Bebchuk

& Fried, 2010; Fried, 2008). By controlling the release of inside information, providing misleading information to the

public or using other means (e.g., Cicero, 2009), executivesmay gain better terms for new equity grants (e.g., via spring

loading or backdating) or time the sales of equity holdings in order to boost payoffs.

The “gaming” hypothesis is also supported by surveys of Chief Financial Officers (CFOs).In a recent survey of 169

CFOs of U.S. public companies for example, Dichev,Graham, Harvey, and Rajgopal (2013) report that approximately

c

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Financial Markets,Inst. &Inst. 2017;26:127–152. wileyonlinelibrary.com/journal/fmii 127

128 TIAN

20% of the firms manage earnings to misrepresent economic performance that typically accounts for 10% of the

reported EPS. They also find that the most likely reason for earnings manipulation, with 93.5% of the CFOs admitting,

is the desire to influence stock price. A more troubling finding is that these CFOs believe that earnings manipulation

is difficult to unravel from the outside and may continue for 2 to 3 years without being detected. Such managerial

(mis)behavior providesfurther support for the likely association between equity compensation and managerial manip-

ulation. An examination of the potential consequences of this linkage is thus warranted.

Inthis paper, we analyze the impact of managerial stock price manipulation on the value and payoff of different types

of equity grants, both at the initial award of the equity grant (front-end gaming) and the unwinding of the equity hold-

ings in the future (back-end gaming). We do not speculate on how executivesmay manipulate the stock price. Instead,

we simply assume that they have the ability to do so without being detected by outsiders (at least in the short run)

and examine the magnitude of the potential gains from such manipulation. We also recognize that the vulnerability

to gaming is closely related to the commonly used pay-performance sensitivity (PPS) measure for managerial equity

incentives. As a consequence, care must be taken to ensure that any solution to the gaming problem does not take

away the positive incentives that are meant to align the interests of corporate executiveswith those of the outside

shareholders.

The impact of front-end gaming and back-end gaming must be examined separately. Front-endgaming involves a

downward manipulation of the stock price in order to gain better terms of the equity grant (e.g., a lower exercise

price). In this case, the percentage PPS, defined as the percentage gains in the value of the equity grant for a 1%

change in stock price, is an appropriate measure of the impact of stock price manipulation on the grant-date value

of equity grants. We call this measure front-end gaming sensitivity (FEGS) which is typically negative since a down-

ward stock price manipulation is involved. In contrast, back-end gaming requires an upward stock price manipulation

at the unwinding of the equity grant in the future. To evaluatethe vulnerability to back-end gaming, we need an ex

ante measure, constructed at the time of the equity award, that takes into account all the possible gains from stock

price manipulation at the unwinding of the equity grant in the future and the likelihoodof realizing such gains. We call

this measure back-end gaming sensitivity (BEGS) which is typically positive since an upward stock price manipulation is

involved. It has the interpretation as the percentage gain in expected payoff of the equity grantfor a 1% increase in

stock price.

Armed with these gaming sensitivity measures, we analyze four types of equity grants – restricted stock, traditional

stock options, Asian stock options and indexed stock options1– and their vulnerabilityto gaming. Although all equity

grants are susceptible to managerial gaming, the level of vulnerability can vary substantially from one type of equity

grant to another. While traditional stock options are less vulnerable to front-end gaming, they are more vulnerable

to back-end gaming. In comparison, Asian stock options are more vulnerable to front-end gaming but are much less

vulnerable to back-end gaming. These differences suggest that the choice of equity grants can be an important factor

in gaming prevention.

For front-end gaming, both the wayequity grants are awarded (i.e., the granting policy) and the type of equity grants

firms offer to their executives(i.e., the instrument) are important. Granting policies matter because they spell out how

terms of the equity grants(e.g., exercise price) are set by the granting firm. These policies determine whether or not the

executiveshave the opportunity to influence the terms of the equity grant in their favor.In particular, front-end gaming

is highly unlikely if firms adopt a more stringent granting policy that presets all terms of the equity grant in advance.

Unfortunately,such a policy is rarely adopted in practice. In fact, most firms grant stock options at the money, allowing

the exercise price to be set bythe closing stock price on the grant date. This granting policy provides the opportunity

for executives to game their option grants bybackdating (i.e., altering the grant date in order to get a lower exercise

price) or spring loading (i.e., delaying the release of good news in order to keep the current stock price lower). As a

result, the types of equity grants used still matter since vulnerability to front-end gaming varies across different types

of equity grants.

In back-end gaming, the granting policy is no longer relevant as all terms of the equity grant (including the num-

ber of shares and exercise price) are either fixed or no longer subject to managerial manipulation. Gains in option

payoff can only come from higher stock prices. As a result, the payoff structure of the equity grant plays a more