Reverse monitoring: on the hidden role of employee stock-based compensation.

• Author: Hannes, Sharon

This Article develops a new understanding of equity-based compensation schemes, such as employee stock option plans. Current literature views such schemes as a measure aimed at motivating the recipient employees to work harder for the firm. Under that view, this method of remuneration either complements or substitutes for other measures used to monitor the performance of the recipient employees. In contrast, this Article proposes that recipient employees be viewed as potential monitors of other employees and that stock options (or similar types of compensation) motivate them to fulfill this task. This view has many applications and can shed light on persistent puzzles, including why there is sweeping use of stock ownership plans by many "new economy" firms. No junior employee at Microsoft or Intel can improve the value of her heavyweight employer to such a degree that it will make it worthwhile for her to work harder once stock options are offered. Nevertheless, given the sensitivity of the "knowledge industry" to leakage of its intellectual property, all employees can add much to the company's value by standing on guard against such loss. If technology is both a vulnerable and critical asset for the organization, option recipients will be alert in protecting against infringement. Since not much effort needs to be exerted to monitor their peers and supervisors to prevent this significant harm, incentive compensations can easily motivate employees to perform their monitoring task. Many other applications of this new view that cannot be explained by the current literature are discussed in the Article.

TABLE OF CONTENTS INTRODUCTION I. THE PROLIFERATION OF EXECUTIVE AND BROAD-BASED ESOPs IN THE UNITED STATES II. NON-INCENTIVE-BASED JUSTIFICATIONS FOR THE ADOPTION OF ESOPs ON A BROAD BASIS A. Retention B. Financing Constraints C. Sorting D. Accounting Considerations E. Morale, Teamwork, and Norms F. Tax Considerations III. REVERSE MONITORING: A NEW VIEW OF ESOPs AS AN INCENTIVE MECHANISM A. On Two Versions of Agency Theory Explanations B. Additional Empirical Verification IV. INITIAL INQUIRY INTO ADDITIONAL APPLICATIONS OF THE REVERSE MONITORING THEORY CONCLUSION INTRODUCTION

The literature explains that broad-based employee stock option plans, as well as other types of stock-based compensation, are designed primarily to motivate employees to exert greater effort. This Article questions this traditional and widely accepted view and supplements it with another justification for such a type of compensation. Stock options "privatize" the firm's monitoring task into the hands of its employees. Each employee equipped with stock-based compensation is motivated to monitor other employees--including that employee's supervisor--to make sure her peers do not harm the firm and that they do their best to maximize its value. This view of options turns the traditional understanding on its head. Instead of emphasizing the role of options in alleviating the burden of monitoring recipient employees, the proposed view, which I term "reverse monitoring," underlines the role of those employees as monitors of other employees. (1)

This view may shed light on several puzzles that the traditional literature does not answer in a satisfactory manner. (2) For one, it may explain why many "new economy" firms grant across-the-board stock-based compensation. (3) The traditional account explains that efforts of employees in this industry sector are especially valuable but hardly measurable. It is doubtful, however, whether the contribution of the ordinary engineer at Microsoft has enough of an effect on the value of Microsoft stock for this argument to hold. In contrast, the reverse monitoring argument explains that Microsoft stock may, indeed, suffer salient damages if its employees tamper with or transfer its highly valuable source code or other proprietary intellectual property. Stock-based compensation provides a powerful incentive for the recipients to monitor their fellow employees against such behavior. And these employees have the ability to fulfill this monitoring task much more efficiently than any other, outside agent. In some cases, this view justifies granting options to many employees, not only to highly creative ones or those at the top of the pyramid. From this perspective, Intel's longstanding policy of granting options to all employees is understandable and far from naive. (4) Simply put, in many high-tech firms, option grants are one of many measures for preventing intellectual property leakage or sabotage.

One recent study clearly presents the challenge that broad-based employee option plans pose for the traditional literature:

However, many firms also offer firm-wide stock options and profit sharing plans that provide even less incentive than executive plans after all, most workers can expect to reap a very minimal amount of personal gain from their contribution to firm value or profits. Given the free-rider problems associated with group compensation plans, their prevalence is puzzling. (5) This description accurately reiterates and questions the commonly held rationale for option grants. Although every employee with stock options is expected to exert more effort at work due to the options, why would anyone cause herself discomfort based on the remote possibility that her modified behavior will substantially alter the value of the option grant? The picture changes dramatically if we instead view the recipient employee as a monitor herself and not as a target of monitoring by means of the option. No substantial effort is required of employees to monitor their peers, as their working interactions allow them easily to observe their fellow employees. In contrast to the literature's paradigm of options overcoming recipients' natural resistance to exerting greater effort, peer monitoring is almost costless and requires only awareness. It is therefore hardly surprising that most new economy firms arrange the working environment in an open floor plan, as open spaces and option grants are complementary measures. Even if employees handle especially valuable and sensitive information, the employer has no need for sophisticated surveillance techniques, since the employees, armed with options, are always watching their peers on the firm's behalf. It is hard to imagine anyone in a better position to fulfill this mission, and because their explicit duties do not include this task, it is wise to give them an incentive to do so in the form of options. Ironically, options cause employees in these firms to work harder, not because (as is commonly thought) they consider themselves owners, but because their peers are watching and they care.

Moreover, in many new economy firms, almost any employee can cause considerable damage to the firm by way of breach of trust or otherwise tampering with the firm's intellectual property. This harmful potential is usually much more significant than any beneficial potential that one employee bears, as one rotten employee can spoil the achievements of many others. This reality underscores the use of options as a monitoring device. If a malicious or untrustworthy employee wishes to harm the firm, it is unlikely her option grant will cause her to reconsider. The value of the option grants of her peer employees, however, could drop substantially if she were to carry out such a scheme. This causes her peers to be alert to the possibility of such an occurrence. When an employee becomes cause for concern, other employees (including those usually supervised by her) will quickly report her to eliminate the danger she poses. Altogether, the proposed view of option grants tilts both sides of the classic equation. On the one hand, employees need exert almost no effort in monitoring their peers, especially if the working environment is arranged transparently. On the other hand, peer monitoring can prevent much damage to and leakage of valuable information to competitors. Thus, a medium-sized option package that cannot motivate an employee to work harder can easily motivate her to monitor. As we shall see below, recent empirical studies that refute the classic view of option grants as an incentive device correspond perfectly with the argument presented in this Article.

The reverse monitoring theory has additional important applications that deserve further attention and will not be developed at length in this Article. First, the proposed approach explains why stock-based compensation is justified for key officers in concentrated-ownership enterprises. Resembling the argument above, it is doubtful that these grants are the optimal manner to motivate these officers to exert greater effort. After all, in a concentrated-ownership firm, in contrast to a diffused-ownership firm, the entity has a controller who can reward or sanction the executive officers directly, without need for the crude measure of options. The reverse monitoring theory suggests an alternative explanation. Equipped with options, key officers guard against expropriation by the controlling shareholder of the entity, although they must do so in a covert manner so as to prevent the controller's revenge. Concentrated-ownership firms with this type of compensation structure should be able to win the trust of institutional investors more easily. Given such a compensation scheme to her officers, the controller is more likely to pursue the interests of all shareholders, rather than her own agenda. This explanation sheds light on why equity-based compensation is on the rise outside U.S. borders, where firm ownership is commonly concentrated (and self-dealing by the controller is a major issue), as well as in U.S. firms with controlling shareholders

A second important application relates to gatekeepers. Equity-based compensation for gatekeepers is an attractive measure from the reverse monitoring perspective. However, such measures can be tricky. While...