Rewarding Poor Performance: Why Do Boards of Directors Increase New Options in Response to CEO Underwater Options?

• Date: 01 September 2014
• Published date: 01 September 2014
• Author: Yuanyuan Sun,Taekjin Shin
• DOI: http://doi.org/10.1111/corg.12065

Rewarding Poor Performance: Why Do Boards

of Directors Increase New Options in Response

to CEO Underwater Options?

Yuanyuan Sun* and Taekjin Shin

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: When the stock options granted to CEOs go underwater, boards of directors tend to award

additional stock options to their CEOs. Drawing on agency theory and attribution theory, this study explores social

psychological mechanisms that explain why boards of directors increase new option grants to CEOs in response to

underwater options.

Research Findings/Insights: Using the compensation data of CEOs at 966 US f‌irms, we found that contextual factors such

as market conditions and industry performance affected boards of directors’ decisions to grant new stock options. Consis-

tent with our hypotheses, boards of directors granted a greater number of new options to CEOs in response to CEOs’

underwater options during the recession period than the recovery period, and they granted fewer new options when the

f‌irm’s industry performance was high rather than low.

Theoretical/Academic Implications: This study incorporatesattribution theory in understanding boards of directors’ causal

attribution of f‌irm performance and its impact on executive compensation. It complements earlier studies on causal

attribution by exploring the role of contextualfactors. It also contributes to the research by examining the attribution process

of boards of directors rather than that of top management, as well as the consequences of the causal attribution in terms of

ex-post adjustment in executive option compensation.

Practitioner/Policy Implications: This study provides up-to-date and improved evidence on boards’ decision making about

executive stock options. Practitioners and policy makers can benef‌it from the study’s f‌indings that board members rely on

contextual information about the market and the competition when they make causal attribution of f‌irm performance

changes, which tends to affect their decisions about executive compensation.

Keywords: Corporate Governance, Executive Compensation, Agency Theory, Attribution Theory, Board Policy Issues

INTRODUCTION

Stock options have been widely used as an important

part of executive compensation. In the United States,

they have become increasingly popular since the 1980s.

Stock options provide strong incentives for executives by

linking executives’ interests with shareholder value, and

they also help f‌irms to retain executive talent. However, the

purported effects of incentive alignment and executive

retention become questionable when the stock price declines

below the option exercise price, a situation in which the

options are called “underwater.” Executives are not able to

realize any value from underwater options and thus suffer a

wealth loss. This inevitably leads to the question of what

f‌irms can do when options go underwater.

Previous studies have examined how f‌irms respond to

underwater options, including option repricing (lowering

the exercise price of underwater options), six-and-one

option exchanges (cancelling and reissuing options after

six months), new stock grants, and new option grants

(Balachandran, Carter, & Lynch, 2004; Kalpathy, 2009;

Zamora, 2008). Option repricing has almost disappeared

*Address for correspondence: Yuanyuan Sun, School of Labor and Employment

Relations, University of Illinois atUrbana-Champaign, 15 LER, 504 E. ArmoryAvenue,

Champaign, IL 61820, USA. Tel: 217-4185288; Fax: 217-2449290; E-mail: syuanyu2@

illinois.edu

408

Corporate Governance: An International Review, 2014, 22(5): 408–421

© 2014 John Wiley & Sons Ltd

doi:10.1111/corg.12065