TIMING OPPORTUNISM IN GRANTING STOCK OPTIONS: A STUDY OF SINGAPORE LISTED COMPANIES

Transcription

1 TIMING OPPORTUNISM IN GRANTING STOCK OPTIONS: A STUDY OF SINGAPORE LISTED COMPANIES Y. T. Mak National University of Singapore And S.Y. Beh United Overseas Bank March 2007 ABSTRACT A number of academic studies in the U.S. have documented the practice of timing opportunism in the granting of stock options. Recently, one form of timing opportunism, the backdating of stock option grants, has received scrutiny by the U.S. SEC with more than 60 U.S. firms subject to investigation by the SEC for this practice. In this study, we examine if Singapore-listed companies practise timing opportunism in granting stock options. Based on a sample of 128 publicly listed firms making a total of 280 option grants, we find evidence of companies practising timing opportunism in granting stock options. Specifically, companies which have a variable schedule, a single Chairman-cum-CEO, higher managerial ownership and higher percentage of independent directors in the scheme committee are less likely to restrict the extent of timing opportunism. In contrast, government-linked companies are more likely to restrict the extent of timing opportunism. Contrary to expectations, companies with a small board size and a higher percentage of independent directors in the committee administering the stock option scheme are more likely to adopt a variable schedule. 1

2 INTRODUCTION While stock options are widely used as part of the executive compensation packages in the U.S., they are not as widespread amongst Asian firms. For example, the Indian IT sector 1 and Thailand-listed companies 2 had just started to consider using stock options to retain and motivate employees. Likewise in China 3, companies are now looking into stock options as a way to strengthen employees loyalty. Even though the objective of stock options is to reward management for their performance, recent news reports 4 in the U.S. suggest that some companies time the grants of stock options such that recipients of these options profit from their exercise for reasons unrelated to improved performance. Examples of companies alleged to be doing this are Cisco Systems Inc and Tyson Foods Inc 5. In addition, Bebchuk and Fried (2004) have noted that some companies are suspected of manipulating their accounting books or the timing of their financial disclosures in order to extract higher compensation. Such controversies have also been highlighted in a report by The New York Times 6 ; stating that for companies whereby managers obtained 92% or more of their compensation in stock options, about onefifth of them faked their accounting books within five years. Another report by The Globe and Mail 7 also pointed out that of the 43 companies that defaulted in their sample, 22 offered their CEOs larger-than-expected stock option grants or bonuses at least once. Due to these concerns, from June 2005, the Financial Accounting Standards Board (FASB) has laid down rules requiring public listed companies to expense their stock options Previously, they were only needed to report the hypothetical expense of the stock options as a footnote in their annual reports. Nevertheless, loopholes exist because the FASB did not 1 Source: So long, and thanks for all the cash Business Today, Date: 14 th August Source: Thailand: Listed companies eye stock options to retain staff Thai News Service, Date: 10 th August Source: Share options help retain employees Industry Updates, Date: 21 st July Source: Critics eye timing of stock options Tribune Business News, Date: 10 th January Source: Cisco, Tyson sued over options Reuters, Date: 16 th February Source: Stock Options: Do They Make Bosses Cheat? The New York Times, Date: 5 th August Source: High CEO pay linked to higher credit risk: study The Globe and Mail, Date: 8 th August

3 specify the methods of calculating the costs. According to a study by Forbes 8, many companies fiddle with the volatility assumptions of the stock so as to minimize the impact of stock option expense on earnings. It also found that 210 companies from the Russell 1000 had changed their assumptions for stock options in 2004 so that deductions for earnings seemed less onerous. In 2004, the International Accounting Standard Board (IASB) also issued International Financial Reporting Standard (IFRS) 2 requiring the expensing of stock options grants from financial years beginning January Many empirical studies (e.g., Yermack, 1997; Aboody and Kasznik, 2000; Chauvin and Shenoy, 2001; Collins et al., 2005a) have examined in timing opportunism in the granting of stock options. In general, depending on the type of schedule adopted (variable or fixed) by the companies, they find that companies can either time the grant date or the announcement disclosure date. However, few studies have examined the relationship between corporate governance characteristics of companies with the extent of timing opportunism. This study investigates if Singapore-listed companies practise timing opportunism in granting stock options. It also examines the association between ownership and corporate governance characteristics of the companies with the extent of timing opportunism and types of schedule being adopted by the companies. A distinct feature of Singapore s landscape is that ownership of listed companies tend to be concentrated either in the hands of families or the government. The government generally owns controlling stakes in these governmentlinked companies (GLCs) through its investment arm Temasek Holdings. Unlike state-owned enterprises in many other countries, these GLCs are generally regarded as being amongst the most well-governed companies, frequently winning transparency and corporate governance awards. In contrast, family-controlled companies are often seen to have lower standards of 8 Source: A Volatile Brew; Easing the impact of strict new stock option rules Forbes, Date: 15 th August

4 corporate governance. In this study, we examine whether timing opportunism differs between family-controlled and government-controlled companies. PRIOR RESEARCH Prior studies (e.g., Chauvin and Shenoy, 2001; Core et al., 2003; Ke, 2003) argue that the solution to the "principal-agent dilemma" is to give the agents an equity stake in the companies. By far, the most popular way of doing this has been through stock options. Yermack (1995) finds that companies grant stock options more regularly when the cost of direct monitoring is high. In addition, proponents of stock options have argued that stock options enable managers to focus on the stock price of the companies, thereby establishing a link between performance and pay. However, some have argued that stock options are a double-edged sword because it is acting not only as an instrument for solving the agency problem but also as part of the agency problem itself (Bebchuk and Fried, 2004). As Yermack (1997) explains, although incentive compensation may motivate managers to make better decisions, managers may have influence over the terms of their own compensation. As such, they may use this influence to obtain more payout in advance of anticipated stock price increases. Manipulation of Stock Option Grants In the U.S., most boards assign the responsibility of setting executive compensation, including stock option grants, to a compensation committee (Yermack, 1997). However, recent studies show that they often do not function at arm s length when setting the CEO s compensation. According to Yermack (1997) and Bebchuk and Fried (2004), this committee takes into account recommendations from CEOs regarding their own compensation. CEOs are also able to influence their own compensation because they may be involved with the 4

5 selection of the directors or they may serve on each other s boards or compensation committees. According to Bebchuk and Fried (2004), there are two incentive problems with existing compensation structures. First, the equity and non-equity components of executive compensation are not as tightly linked to the level of performance as it used to be. As such, there are weaker incentives for managers to increase company s value. Second, besides influencing compensation packages through the compensation committee, current practices have also created perverse incentives for managers to choose strategies that are less transparent to the market. Prior studies (e.g., Stein, 1989; Bebchuk and Fried, 2004; Bergstresser and Philippon, 2004) point out that the use of equity-based compensation may induce CEOs to manage earnings to improve short-run stock price so that they can cash out their holdings at a higher price in the future. Companies have also adopted measures to minimise outrage costs (Bebchuk and Fried, 2004), by either assigning a smaller portion of the stock options value to the pro-forma expense (Balsam et al., 2003) or by fiddling with the stock options values disclosures in proxy statements (Murphy, 1996). The reasons for choosing strategies which are less transparent to the market arise from the fact that perceptions by important outsiders matter when compensation packages are being determined. Bebchuk and Fried (2004) use the term camouflage to describe the concealment of the true amount of pay or performance-insensitivity of compensation and argue that it plays an important role in current compensation arrangements. This is because the more reasonable a package appears, the more compensation managers can enjoy without facing significant outrage. More seriously, camouflaging can lead to the adoption of inefficient compensation structures that harm a company s performance (Bebchuk and Fried, 2004). 5

6 Conventional stock options have been the victims of such camouflaging because granting stock options can make the exact amount of compensation less visible. If they were to be given out in real cash, it may create outrage from the public or stockholders. In addition, Benz et al. (2001) point out that stock options allow managers to increase their total income with a relatively low risk of losses. Bebchuk and Fried (2004) also note that managers have been using their influence to obtain option packages that provide them with increasing amounts of compensation while failing to offer strong incentives to create company value effectively. A subtle way to do this is to influence the exercise price. In essence, the potential abuse arises because the exercise price is determined by the stock price of the company. As reported in Economist 9, stock prices can rise for reasons that have little to do with the effort from the managers. Fixed and Variable Schedules in Granting Stock Options Yermack (1997) and Aboody and Kasznik (2000) describe two types of schedules which a company may adopt when granting stock options: fixed or variable. Under a fixed schedule of granting stock options, the company grant the options at around the same time every year, whereas under a variable schedule, the company may grant the options at anytime. For these two types of schedule, there are two basic ways in which managers can realize higher gains from their stock options through the exercise price. For a variable schedule grant, the company can opportunistically time the grant date so that the stock price is lower on that date. As the company does not have a stipulated schedule to grant the stock options, they can be changed to suit the date of financial disclosures. Specifically, the grant date can be set after the announcement of bad news or before the announcement of good news, resulting in a lower exercise price. In addition, managers can also set the grant date after stock price declines which are due to unfavorable factors not within their control. 9 Source: "Leaders: Running out of options; Pay for performance." The Economist, Date: 11 th Dec Vol. 373, Issue 8405, page 10. 6

7 Variable schedules attract less monitoring from the public because they are unpredictable. As discussed later, variable schedules provide the company with more flexibility to enhance the value of their option grants. However, the above-mentioned methods do not apply for stock options granted under a fixed schedule. This is because changing the grant date outside a stipulated scheduled date may arouse suspicions. For fixed schedule grants, the method to extract higher gains is to time when the market becomes informed of any forthcoming good or bad news. They do not have to resort to the release of deceptive information. Since managers always know the grant date in advance, all they need to do is to control the timing in which the market will receive the information. Specifically, they can rush forward bad news before the grant date or delay good news till after the grant date. Empirical Evidence on Timing Opportunism Yermack (1997) investigates the influence of managers over the terms of the stock options by analyzing the timing of CEOs stock option grants. Using a sample of CEOs grants between 1992 and 1994, he finds some evidence that grants are timed to coincide with favorable stock price movements. Specifically, after the grant date, companies tend to outperform the market by around 2% and the effect lasts about 50 trading days. By setting the grant date as day 0, the author finds that the cumulative abnormal returns (CARs) for the period (-20, 15) has a value of +1.18%. The author cites these results as evidence of CEOs receiving stock options in advance of good news. However, there are no significant results prior to the grant date. Yermack then divides his sample into two sub-samples - fixed and variable schedule - and calculates the CARs. He finds that the sub-sample with variable schedule has higher average CARs of +3.27% compared to +1.59% from the fixed schedule. This result provides evidence that timing opportunism is less restricted if companies adopt a 7

8 variable schedule. However, Yermack (1997) cannot find evidence that CEOs rush forward bad news and delay good news. To investigate the ability of CEOs in influencing their boards to grant stock options at favorable times, Yermack identifies 13 option grants in which the CEO sits in the compensation committee. He finds that the average 50-day CAR after the grant date has a value of +11.2%, which is much larger than the sample average of +2.16%. Extending the analysis, he defines three cases which the CEO should have relatively lower influence on the compensation committee. These three cases are namely, the compensation committee has a non-executive chairman of the board as a member, the committee has an outside director who owns at least 5% of company s stock and all the committee members are appointed before the current CEO took office. For all these three cases, the average CARs after the grant date are either negative or insignificant. Hence, these provide evidence that CEO influence plays a part in the extent of timing opportunism. Aboody and Kasznik (2000) conduct a similar study to Yermack (1997) but they limit their sample to stock options granted on a fixed schedule. In addition, they believe that Yermack (1997) s results are applicable only for stock options with variable schedule, hence explaining why there is no evidence of manipulation of news. Specifically, Aboody and Kasznik (2000) examine if CEOs make opportunistic voluntary disclosures that influence investors expectation and affect the exercise price of stock options. With a sample from 1992 to 1996, the authors measure changes in investors' expectations using analyst earnings forecasts, stock prices and management earnings forecasts. For analyst s earnings forecasts, the results show that they are abnormally low prior to stock options grants, which is consistent with the authors conjecture of CEOs managing analysts' expectations downwards prior to scheduled option grants. Replicating the method for a sample of grants with variable schedule, the authors cannot find any significant results. For stock prices around the grant 8

9 dates of fixed schedule, the authors find significantly positive abnormal returns (ARs) with a value of +1.67% after grant dates but no significant ones prior to that. For the grants with variable schedule, there are statistically significant results prior to and after the grant dates. Specifically, average CARs over the 30 days prior to and after the grant are -1.78% and +3.20% respectively. Focusing on management earnings forecasts, the authors find that CEOs who receive option grants before the earnings announcement are significantly more likely to issue bad news forecasts. However, they do not find such patterns for grants made on variable schedules. The authors conclude that opportunistic timing of voluntary disclosures is used more for option grants on fixed schedules, while opportunistic timing of grant date is used more for grants with variable schedules. Using a sample with fixed schedules from 1981 to 1992, Chauvin and Shenoy (2001) find a statistically significant decrease in stock prices (-0.57%) during the ten days prior to the grant date. Most of the decrease occurs during the three trading days preceding the grant date and the authors attribute this result as evidence showing information being manipulated by insiders. The authors conjecture that manipulation of the timing of information may be the reason for the ARs. As such, they decided to test if the negative ARs are caused by bad news that is not within the discretionary control of the company or by more informal or private channels. Their results show that companies with discretionary announcements and those that did not have any announcements during the period prior the grant date are the ones causing the large negative returns. Therefore, these provide further support that timing of news or financial disclosures is used more for stock options granted using fixed schedule. Unlike earlier studies which mainly focus on how companies engage in timing opportunism of stock options, Collins et al. (2005a) examine how corporate governance characteristics affect the extent of timing opportunism as well as the type of schedule being adopted. Firstly, they document that the ARs prior to grant dates are smaller (more negative) 9

10 for variable schedule as compared to fixed schedule. On the other hand, ARs after grant date are higher (more positive) for variable schedule relative to fixed schedule. The authors also find that the stock price at the grant date is more likely to be the minimum price around the grant date for variable schedule. The authors cite these as evidence showing that the CEOs exploit the flexibility of variable schedule to lower the exercise price of stock options so as to earn larger profits when they exercise them. The authors also find that the proportion of inside and affiliated directors in compensation committee and board is significantly higher for companies with variable grants. In addition, the CEO is more likely to be the chairman of the board for companies that adopt a variable schedule. The results support the authors conjecture that the likelihood of companies adopting a variable schedule increases with the CEO influence over compensation committees and boards. To supplement the above findings, the authors perform a logit regression and find that the likelihood of companies adopting variable schedule is significantly and positively associated with the percentage of insider and affiliated directors on the compensation committee, the percentage of inside directors on the board and the percentage of CEO s compensation that is option-based. The authors then examine if compensation committees and boards are effective in limiting CEOs timing manipulation and they find that most of the significant results are concentrated in the period after the grant date. For variable schedule, they find that the ability of CEO to time their own option grants is significantly and positively associated with the percentage of inside directors on the board and the percentage of director s compensation that is option-based. No such relationships are found for fixed schedule. Sarbanes-Oxley Act and Stock Option Grants The Sarbanes Oxley Act 2002 (SOX) now requires stock option grants to be reported within two business days after the grants. Collins et al. (2005b) examine if this accelerated 10

11 reporting deadline affects the extent of timing opportunism. For the pre-sox period, they find that the ARs for day -40 to day -1 before the grant date are significantly negative. In contrast, the ARs are insignificantly different from zero in the post-sox period. For the period after the grant date, they find significantly positive ARs in both the pre- and post-sox periods. However, ARs in the post-sox period are significantly smaller. These results indicate that the SOX requirement is able to reduce, but does not eliminate, timing opportunism. The authors then separate the sample into grants with variable and fixed schedules. For the variable schedule grants, ARs prior to the grant date are significantly negative in the pre-sox period but there are no significant results in the post-sox period. As for the ARs after the grant dates, they are significantly positive in the pre-sox and post-sox periods. However, the ARs in the post-sox period are significantly smaller. According to the authors, this provides evidence that the accelerated reporting requirement discourages managers from timing the option grants after the disclosure of bad news but does not completely remove the timing of option grants before the disclosure of good news. For the fixed schedule, ARs prior to the grant dates are insignificant in the pre-and post-sox periods. Although the ARs after the grants are significantly positive in the pre- SOX period, they are insignificant in the post-sox period. These show that the accelerated reporting requirement acts as a deterrence against the timing of information around fixed grants. KEY FEATURES OF THE INSTITUTIONAL ENVIRONMENT IN SINGAPORE Use of Stock Options as Compensation According to Ding and Sun (2001), Singapore Airlines is the first company in Singapore to adopt an ESO scheme in Despite being popular with MNCs, stock options 11

12 were not widely used by Singapore-listed companies until the late 1980s. The use of stock options in Singapore has been rising steadily over the years. Ching and Mak (1999) found that 50.6% of the Singapore listed companies in their sample have adopted stock option plans by Rules Governing Stock Options Both the Companies Act and the listing requirements of the Singapore Exchange (SGX) have rules governing the adoption of stock option schemes and the granting of stock options. The Companies Act requires the number and class of shares for which options are granted, date of expiration of the options, and the basis upon which the options may be exercised, to be disclosed in the directors' report. In addition, the maximum expiration term of options is limited to 10 years. Under the Companies Act, a director is required to notify the company and the SGX within 2 days after he becomes a registered holder of, or acquires an interest in, options. However, it is questionable whether these sections adequately guard against the timing opportunism for several reasons. First, as the Act imposes reporting obligations on directors not companies the notification to the SGX is not announced to the public. Second, these provisions do not apply to executives who receive options but who are not directors. Third, it is unclear when the reporting obligation is triggered. Stock options are sometimes offered at an earlier date but accepted only sometime later by the recipients. Directors may only notify the SGX when they accept the options, but the exercise price for the options may be determined at the date of offer. There is no assurance that the date of offer is a bona fide date. Further, in the case of listed companies, such employee stock options always have minimum vesting periods of at least one year. According to the Companies Act, an interest in shares includes the right to acquire a share, or an interest in a share, under an option, whether the right is exercisable presently or in the future and whether on the fulfilment of a condition or 12

13 not. This seems to suggest that a notification to the SGX should be made at the time of grant, rather than at the time of vesting. However, some lawyers have told us that it is not clear that these provisions in the Companies Act require reporting of options when they are granted, rather than when they vest. The SGX s listing requirements cover matters such as the terms and the limits upon which the number of options may be granted. The SGX rules require that shareholders approval be obtained before the adoption of any share option scheme. In addition, there must be a committee of directors to administer the scheme. If the recipient is a member of the committee, he must not be involved in the deliberations of stock options which will be granted to him. The aggregate number of shares available under the scheme must not exceed 15% of the issued share capital. Participation in the scheme by controlling shareholders and their associates must be approved by independent shareholders of the company, and is subject to certain additional limits and conditions. The SGX rules permit stock options to be granted at a discount of up to 20% off the market price, provided the discount is approved by shareholders. The minimum vesting period for discounted stock options is two years from the grant date, while for other options it is one year from the grant date. Companies granting stock options also need to make certain disclosures in the annual report, including the names of the members administering the share option scheme; the names of directors, controlling shareholders and other recipients who receive at least 5% of the total number of options available; the number and terms of options; total outstanding options; and the total number of options granted and exercised since the commencement of the scheme. Within this framework of rules, it remains possible for companies to practise timing opportunism of the type examined in our study, including the backdating of options. How is this possible? First, companies do not have to choose a fixed date for granting options each 13

14 year. Second, there is no SGX requirement for the immediate announcement of such grants. Third, even though there are provisions in the Companies Act requiring notification of these grants, our earlier discussion indicates that they are unlikely to be effective in preventing timing opportunism. The rules that apply at the moment do not prevent companies from granting options at a time when the share price is relatively low during the particular year, either by granting options before the release of good news or after the release of bad news, or by backdating options. HYPOTHESES The main focus of our study is to investigate if Singapore-listed companies are engaging in timing opportunism in granting stock options. Our study also examines the relationship between ownership, board of directors and compensation committee on the extent of timing opportunism and the type of schedule being adopted. Stock Options Grants and Stock Price Movements Prior studies (e.g., Yermack, 1997; Aboody and Kasznik, 2000; Collins et al., 2005a) indicate that managers engage in timing opportunism in granting stock options. Specifically, most authors find that there are negative ARs prior to stock options grants, possibly as a result of managers either shifting the grant date after bad news or rushing forward bad news announcements. In addition, there tends to be positive ARs after the grant date and the authors attribute this to be evidence of managers either shifting the grant date before good news or postponing good news announcements after the grant date. We hypothesise that average CARs are significantly negative before the grant date, and significantly positive after the grant date. 14

15 Stock Options Schedules and Stock Price Movements There are two types of schedules available for companies when granting stock options -i.e., fixed or variable. In Singapore, there are no rules stipulating which one companies should adopt. Yermack (1997) and Collins et al. (2005a) find that the magnitude of CARs both prior to and after the grant date are larger for companies with variable schedule. This is due to the ease of manipulating stock options with variable schedule because the options can be granted at favorable dates, without attracting too much attention. As such, we expect a negative relationship between companies adopting variable schedules and CARs before the grant date, and a positive relationship between companies adopting variable schedules and CARs after the grant date. Impact of Ownership Structure on Timing Opportunism and Type of Schedule Managerial ownership Agency theorists argue that low level of managerial stock ownership is a reason for agency problems. One way of aligning the interests of managers and shareholders is to increase their ownership, which according to Jensen and Meckling (1976), will help mitigate these agency problems. We expect with higher managerial ownership, managers interests will be more aligned with the stockholders. In turn, they will be less likely to engage in selfdealing, including engaging in timing opportunism in granting stock options. Similarly, managers with higher ownership may refrain from granting stock options on a variable schedule to limit timing opportunism. On the other hand, managers with significant ownership may have a huge influence on how compensation packages are structured (Hambrick and Finkelstein, 1995). This is because when managerial ownership is high, managers can use their voting rights to control the composition of the board and the compensation committee, making it easier to engage in timing opportunism when granting stock options. Similarly, in order to extract more 15

16 compensation, managers with higher ownership may advocate granting stock options on a variable schedule. Managers will only need to time the option grant dates which are less conspicuous than, say, the timing of the earnings announcements. In Singapore, companies are required to announce their annual results and interim results with 60 and 45 days respectively after the end of the financial period, and abrupt changes in the actual date of these announcements may arouse suspicion. Further, it is common practice for companies to pre-announce the date of the results announcement date and some companies also include a financial calendar in the annual report indicating expected announcement dates for annual and interim results. 10 Therefore, there are conflicting expectations regarding the impact of managerial ownership on CARs and the type of schedule adopted. Government ownership Unlike the U.S., a distinct feature of the Singapore economic environment is the presence of government-linked companies (GLCs) whereby the government, mainly through an investment holding company, Temasek Holdings, holds controlling stakes in these GLCs ranging from about 20 percent upwards. 11 This point is also echoed by Claessens et al. (2000) who point out that state control of companies in Singapore is significant. Although stateowned companies ownership are often associated with poor corporate governance and financial performance, this is not the case, at least for the public-listed GLCs. GLCs often win major corporate governance and transparency awards in Singapore and the region, and are some of the best performers on the Singapore stock market. As such, we expect that GLCs will be less likely to engage in timing opportunism when granting stock options. Similarly, in order to prevent timing opportunism, GLCs may be less inclined to grant stock options using a variable schedule. 10 Of course, it is possible for companies to time other type of corporate announcements, but again, granting stock options just after bad news announcements or just before good news announcements may lead to outrage costs because they are not well camouflaged. Th These GLCs are now often called Temasek-linked companies or TLCs. 16

17 Impact of Board Structure on Timing Opportunism and Type of Schedule CEO/chairman duality A company s board is the main internal corporate governance mechanism responsible for monitoring senior management. The board can be seen to act as the first line of defense in protecting stockholders interests and the person at the forefront of this line of defense is the chairman of the board. According to Conyon and Peck (1998), the role of the chairman is to take the lead in hiring, firing and compensating the CEO. As such, it is increasingly seen to be very important for the CEO and the chairman to be two separate persons, with no family or business relationships, in order to avoid a potential conflict of interests. When the CEO and chairman is the same person, he will have more power to pursue personal interests instead of stockholders interests (Jensen, 1993). In addition, Jensen argues that this will lead to failure of internal control systems as the board cannot effectively perform its key control functions. A similar point is highlighted by Yermack (1997) and Core et al. (1999) who find that agency problems are higher when the CEO is also the chairman. As such, we expect that when the CEO is also the chairman, he will have a greater influence on the level, structure and the method of determining executive compensation packages. Therefore, the extent of timing opportunism is expected to be greater. Collins et al. (2005a) find that the CEO is more likely to be the chairman of the board for companies that adopt a variable schedule. Similarly, we expect a company with a single Chairman-cum-CEO to adopt a variable schedule for granting stock options. Percentage of independent directors In Singapore, the Code of Corporate Governance ( the Code ) recommends that independent directors should make up at least one-third of the board. This is based on the argument that a higher proportion of independent directors will improve monitoring of management. 17

18 Having a higher proportion of independent directors is especially important in cases whereby the CEO is the chairman of the board. According to Core et al. (1999), boards with more independent directors reduce managerial opportunism in the form of excessive compensation. Previous studies such as Yermack (1997) and Byard and Li (2004) have also highlighted that the magnitude of ARs around stock options grants is higher when there is a lack of board independence. These results suggest that boards that are less independent allow greater timing opportunism with respect to the granting of stock options. According to Collins et al. (2005a), they find that companies with more independent boards are less likely to have variable schedule. This is probably because the CEO will have a harder time in influencing the directors when there are more independent directors on the board. As such, we expect that with a larger number of independent directors on board, companies will tend to adopt a fixed schedule. Board size According to Jensen (1993), large boards are less effective in monitoring management because they are more susceptible to the influence of the CEO. When there are too many directors on boards, relationships may get complex as personal interests may be intertwined. As reported by Yermack (1996) and Mak and Yuanto (2005), smaller boards improve the value of the company. The authors find an inverse relationship between board size and Tobin s Q. These results suggest that smaller boards are more effective in monitoring management. We therefore expect smaller boards to be more effective in limiting the extent of timing opportunism and to be more likely to be associated with fixed schedule option grants. 18

19 Impact of Stock Option/Compensation Committee on Timing Opportunism and Type of Schedule Independence of the stock option committee The SGX listing manual has long required the stock option scheme to be administered by a committee of directors of the company. After the implementation of the Singapore Code of Corporate Governance in 2003, many listed companies have established compensation committees. The Code recommends the compensation committee to be in charge of determining or advising on the compensation packages of the directors, including the CEOs. It recommends that the compensation committee should comprise a majority of nonexecutive directors who are independent of management and free from any business relationships. 12 With the establishment of the compensation committee, this committee has taken over the administration of the stock option scheme in many companies. Therefore, prior to 2003, the stock option scheme tends to be administered by a stock option committee, while after 2003, this function has been taken over by the compensation committee in many companies. However, some companies continue to have both a stock option committee and a compensation committee at the time of our study. The independence of the stock option scheme/compensation committee is very important as it will affect how well the committee structures senior executive compensation. According to Byard and Li (2004) and Collins et al. (2005a), compensation committees which lack independence will result in significant ARs around ESO grants. These suggest that compensation committees which have a lower proportion of independent directors are less able to limit the extent of timing opportunism. 12 Prior to the adoption of the Singapore Code of Corporate Governance, the listing rules already require companies adopting stock option schemes to set up a committee to administer the stock option scheme. With the adoption of the Code in 2003, many companies have folded the stock option scheme committee into the compensation committee, while others continue to have a separate committee to administer the stock option scheme. In this study, we measure the composition of the stock option scheme committee where there is such a separate committee, and the composition of the compensation committee if there is no separate stock option scheme committee. 19

20 Collins et al. (2005a) find that companies with more independent compensation committees are less likely to have variable schedule. This is because a more independent compensation committee will be less influenced by the CEO or other insider directors and they are more inclined to adopt the fixed schedule. In our study, we examine the independence of the committee which is responsible for administering the stock option scheme. Where a company has a separate stock option committee, we focus on the independence of this committee. Where a company does not have a separate stock option committee but only has a compensation committee, we focus on the independence of the compensation committee. We expect that a more independent stock option/compensation committee to be associated with less timing opportunism and the use of fixed schedules for granting stock options. Existence of CEO and/or executive chairman in stock option/compensation committee The Code in Singapore recommends that the compensation committee should be chaired by an independent non-executive director so that there will be no conflict of interest. According to Finkelstein and Boyd (1998), the role of committee members in setting CEO pay may depend on the CEO s power over these committee members and on the amount of discretion the CEO can exercise. Therefore, we expect that even when the CEO is not the chairman of the compensation committee, his presence on the committee may allow him to influence executive compensation packages, including his own package. This is because the directors may not want to offend the CEO. Yermack (1997) finds that out of 13 cases in his sample which he identifies as having a CEO serving in the committee, 10 of them experience positive ARs after the grant date. Besides the CEO, the other person with a similarly large influence in many Singapore companies is the executive chairman. The executive chairman chairs the board and there may 20

21 be a separate CEO, but as the executive chairman is an executive, he is in fact part of the management team which the board is supposed to oversee. According to Mak and Singh (2005), when the CEO and executive chairman are sitting on the board, the management may be controlled by them and the separation of functions between the board and management is blurred. Likewise, if either of these persons is in the stock option/compensation committee, there may be greater timing opportunism in granting stock options. According to Yermack (1997) and Bebchuk and Fried (2004), many companies proxy statements show that the compensation committee takes into account recommendations from CEOs regarding their own compensation. We expect that the presence of the CEO or executive chairman to be related to the use of a variable schedule in granting stock options. Control Variables In this study, we control for regulated industries, company size, debt and year of grant of options in the multivariate analysis. Regulated industries According to Demsetz and Lehn (1985), the range of managerial discretion is reduced in highly regulated industries. As such, agency conflicts in these industries will be lower as compared to those which are not as highly regulated. Similarly, opportunism in the granting of stock options may be reduced, especially financial institutions which are closely supervised by the banking authority. Company Size The management of smaller companies may be more likely to engage in self-dealing because they are generally subject to less scrutiny and have less analyst coverage. Collins et al. (2005a) find that smaller companies are more likely to grant stock options with a variable 21

22 schedule. As such, opportunism in granting options may be less prevalent in larger companies. Debt A company with external debt is subject to greater monitoring by debtholders and managers may have less discretion (John and John, 1993). Companies have more debt may therefore be less likely to engage in opportunism when granting stock options. Time Effect We also control for differences across years using year dummies. In Singapore, the Code of Corporate Governance became effective in January 2003, i.e., during the study period, which may affect the corporate governance practices of companies in the period after METHODOLOGY Sample Selection The sample for the study consists of companies listed on the Singapore Exchange from 2002 to Only companies which are incorporated in Singapore and which have granted stock options are included in the study. In Singapore, it is not mandatory for companies to disclose in their annual reports the dates on which specified employees have been granted stock options. Most often, the names and the grant dates will be listed in separate tables and it is difficult to compare both tables to identify when a CEO has received stock options. As such, our study focuses on the stock options granted by the company in general, although CEOs tend to be the main beneficiaries of these options. In order to identify the types of schedule adopted by the company, we assume that no one recipient will be able to receive multiple grants within a fiscal year. If a company has multiple grants within a fiscal year, the date of the grant with the lowest exercise price is included in the sample. This is used to determine the type of schedule adopted by the company. Although companies are not specifically required to disclose dates 22

23 of grants, many report the information voluntarily. In any event, the date of grants can always be inferred from required disclosures of the expiration dates of grants. We excluded observations which involved the granting of stock options during periods when the stock was not traded as we are unable to calculate the CARs for those grants. The final sample comprises 280 observations. Data Sources The data for each company s ownership, corporate governance characteristics and dates of stock options grants were hand-collected from the annual reports of each company. Data for each company s stock price and control variables such as debt and company size were obtained from DataStream. All the data collected correspond to the year in which stock options were granted. Variable Measurement Estimating abnormal returns (ARs) In order to ascertain if a company engages in timing opportunism of ESO grants, we calculate the cumulative abnormal returns (CARs) around the date of grants. In essence, the CARs act as the proxy for timing opportunism. To calculate the CARs and their level of significance, we employ the market model methodology of Dodd and Warner (1983), as described below. First, we use the daily stock prices of each company to calculate the daily stock returns. Next, we use the daily stock return data to estimate the ARs around the grant dates whereby each option grant date is defined as day 0. The AR it of each company i for each event day t is calculated as shown: AR it = R it - R it = R it - α i - β i R mt 23

24 where R it = rate of return to company i at event day t, R mt = rate of return from Singapore All-Sing Equities Index at event day t. Note: R it and R mt are calculated using the following formulas: P t - P t-1 P t-1 where P t = stock price (Price index) of company (Singapore All-Sing Equities Index) at event day t, P t-1 = stock price (Price index) of company (Singapore All-Sing Equities Index) at event day t-1. The α i and β i parameters are estimated from Ordinary Least Squares regressions of R it against R mt. Specifically, we used 150 days 13 of daily trading data prior to and after the grant date (inclusive of the grant date itself) to estimate parameters of the market model. Henceforth, we designate this time span as the option period. Aggregating abnormal returns across time and companies We then assign d 1i and d 2i to represent two points in time within the option period. For example, d 2i can represent the grant date and d 1i can represent the date 5 days prior to the grant date or day -5. Thus the measure of CARs between the two dates is given by the following formula: t = d 2i CAR i (d 1i, d 2i ) = Σ AR it t = d 1i 13 In some cases, there are less than 150 days prior to the grant date because the company granted stock options soon after being listed. 24

25 For a sample of N observations 14, the measure of abnormal performance between two designated dates is given by the average CARs. N Σ CAR i CAR (d1, d2) = i = 1 N where N = the number of observations in the sample. Testing the significance of CARs A series of steps is required in order to test the significance of the CARs. Firstly, the AR it in the option period under study are standardized by the square root of its estimated forecast variance to form a standardized AR, SAR it, SAR it = AR it / s it, where 1/2 s it = s i /L i + (R mt - R m ) 2 L i Σ (R mt - R m ) 2 τ = 1 where s 2 i = estimated residual variance from the market model regression for company i, R m = average rate of return from Singapore All-Sing Equities Index (computed over the number of days used for the regression), R mt = rate of return from Singapore All-Sing Equities Index at event day t, L i = number of days used for the market model regression. 14 Number of observations is the total number of options granted by all the companies. 25

26 For each observation i, the SAR for each of the (d 2i - d 1i + 1) days of the prediction interval under study are summed to a standardized CAR, W i, t = d 2i 1 W i = Σ SAR it X t = d 1i d 2i - d 1i + 1 To test the significance of the average standardized CAR in a sample of N observations, we then compute: Z = W i N Where W i = N 1 Σ N i = 1 W i The main prediction interval of this study is 20 days before the grant date through 50 days after the grant date or (-20, 50). Type of schedule employed by companies To identify whether a company grants stock options using a fixed or variable schedule, we classify a grant as fixed if it occurs within 365 +/- 30 days of the prior year s grant. If there is only one grant within the sample period, we examine the annual reports prior to the sample period so as to identify the type of schedule adopted. If the company has granted only one ESO since the establishment of the scheme, it is classified as unidentified. Therefore, our original sample is divided into three sub-samples as shown in Table 1. Insert Table 1 here The type of schedule adopted by a company is then measured as a binary variable, SCHED, which is coded as 1 if the company has a variable schedule and 0 if the company 26

27 has a fixed schedule. Where the type of schedule is unidentified, the observations are dropped from the study, unless stated otherwise. Managerial ownership The level of dependent director ownership is used as a proxy for managerial ownership (MANOWN). It is computed as the percentage of ordinary shares held directly and indirectly by the dependent directors. Dependent directors are defined as all directors not deemed to be independent as stated in the companies annual reports. Government ownership A binary variable (GOVTOWN) is used for government ownership. It is coded 1 if the government has significant ownership (more than 20% of the ordinary shares) and 0 otherwise. CEO/Chairman duality A binary variable (CEOCHR) is used to measure CEO/Chairman duality. It is coded 1 if the CEO and chairman are the same person and 0 if otherwise. Percentage of independent directors on the board The percentage of independent directors (BDINDEP) is computed by dividing the number of independent directors by the total number of directors on the board. Board size Board size (BDSIZE) is measured by the total number of directors on the board. 27