Information distribution within firms: evidence from stock option exercises $

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1 Journal of Accounting and Economics 34 (2003) 3 31 Information distribution within firms: evidence from stock option exercises $ Steven Huddart a, *, Mark Lang b a Smeal College of Business Administration, Pennsylvania State University, University Park, PA , USA b Kenan-Flagler Business School, University of North Carolina, Chapel Hill, NC , USA Received 15 January 2001; received in revised form 24 January 2002 Abstract We examine the stock option exercise decisions of over 50,000 employees at seven corporations to provide evidence on the distribution of price-relevant non-public information among employees. When option exercise (adjusted for other factors affecting exercise) is low, stock returns in the coming 6 months are 10% higher than when option exercise is high. The exercise decisions of relatively junior employees contain at least as much price-relevant information as the exercise decisions of more senior employees. r 2002 Elsevier Science B.V. All rights reserved. JEL classification: D82; G28; J33; K22 Keywords: Accounting; Compensation; Disclosure; Regulation; Securities 1. Introduction We examine the distribution of price-relevant information using data on option exercises that cover over 50,000 employees at seven corporations. Specifically, we $ Seminar participants at the Pennsylvania State University, the University of Missouri at Columbia, the University of North Carolina at Chapel Hill, the 2000 Big 10þ Conference, and the 2001 Journal of Accounting & Economics Conference provided many useful comments. We particularly thank Anne Beatty, John Core, Gerald Feltham, Paul Fischer, Rich Frankel, Wayne Guay (the referee), Ron Kasznik (the discussant), Bin Ke, S.P. Kothari (the editor), Tony Kwasnica, Luann Lynch, Karl Muller, Charles Plott, Eddie Riedl, and Jerry Zimmerman for helpful insights. Alan Jagolinzer provided able research assistance. *Corresponding author. Tel.: ; fax: address: huddart@psu.edu (S. Huddart) /03/$ - see front matter r 2002 Elsevier Science B.V. All rights reserved. PII: S (02)00071-X

2 4 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) 3 31 examine whether employees exercise decisions predict subsequent excess returns. While it is plausible and consistent with the empirical evidence that top executives often possess price-relevant information, it is unknown whether lower-ranking employees are privy to and act on such information. Thus, our data allow us a unique opportunity to document whether and how price-relevant information is distributed in an organization. To our knowledge, this is the first investigation of the distribution of price-relevant information outside the executive suite. We find that low firm-wide stock option exercise in a month is associated with large excess stock returns in the subsequent 6 months. Correspondingly, high levels of stock option exercise are associated with negative raw and market-adjusted returns in subsequent months. When option exercise (adjusted for other factors affecting exercise) is above the highest tercile, the stock underperforms by 4.3% over the next 6 months. When exercise is below the lowest tercile, the stock outperforms by 6.0% over the next 6 months. The exercise decisions of relatively junior employees are shown to contain at least as much price-relevant information as the exercise decisions of more senior employees. While there is some evidence that excess returns persist for as long as 6 months, exercise activity predicts stock returns mainly over the 3 months after the exercise decision. In timing ordinary stock purchases and sales, an informed trader benefits from buying before a stock price increase and selling before a decline. Similarly, private information likely affects option exercise decisions. An option holder expecting a drop in share price profits by exercising his options and selling the underlying shares before the drop in price. 1 Conversely, an option holder expecting an increase in price profits by holding the option and postponing payment of the strike price. 2 Ex ante, it is not clear whether exercise should be related to future stock returns. We assume semistrong market efficiency, i.e., stock prices reflect all publicly available information. Given this assumption, finding that exercise predicts stock returns is evidence that employees base their decisions, at least in part, on non-public information. 3 Certain factors argue in favor of informed exercise by lower-level 1 Although an employee exercising an option need not immediately sell the shares acquired on exercise, grant administration personnel at our sample firms and other companies tell us that exercises are generally cashless, especially among lower-level employees. In a typical cashless exercise, a broker facilitates the exercise and immediate sale of the underlying shares, so the employee receives the difference between the current stock price and strike price, less the broker s fee and withholding taxes, in cash. Cashless exercise is common because the employee often does not have the ready cash to pay the exercise price and taxes. 2 Essentially all the options in our study are non-qualified, meaning that the difference between the option s strike price and the market price of the stock on the date of exercise is taxed as ordinary income. In the rare case that the employee does not immediately sell the stock acquired on exercise of the option, subsequent stock appreciation is taxed at capital gains rates. One sometimes hears that it can be advantageous to exercise stock options early so that subsequent stock price appreciation is taxed as capital gains rather than ordinary income. For our sample companies and time period, this strategy is rarely attractive because (i) the strike prices of options written on the stock of publicly-traded companies are substantial, and (ii) in the time period of our study, the difference between the ordinary income tax rate and the capital gains tax rate is relatively small. For a more complete analysis, see Huddart (1999, pp ). 3 Corporate annual reports and proxy statements disclose total option grants and exercises across all employees in the fiscal year. Consistent with the efficient impounding of public information about exercises

3 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) employees and, hence, a link between exercise and subsequent returns. Because the exercise of options by lower-level employees is not publicly reported, it cannot be interpreted by the market as a signal. Consequently, lower-level employees may face less external pressure to avoid exercise than top executives whose exercise and trading activity must be publicly disclosed. Further, because the definition of illegal insider trade is complicated, evolving, and in some ways vague, employees may condition exercise on certain kinds of information in certain circumstances without exposing themselves to legal liability. As a practical matter, exercise decisions that are a response to a general sense about company prospects, as opposed to an imminent corporate disclosure, may not be investigated because they are not detected by the SEC (Bainbridge, 2000). Also, actions by lower-level employees may attract less regulatory attention because (i) their holdings and transactions typically are small; and (ii) lower-level employees may be less likely to be presumed to have foreknowledge of major events, like a merger or acquisition, that typically trigger SEC scrutiny, and hence will not be suspected of acting improperly on that information. Finally, because stock ownership targets typically apply only to executives, non-executive employees are freer to exercise their options and immediately liquidate their positions. However, other factors argue against pervasive information-based trading in our sample. First, price-relevant information may be concentrated in the hands of a few top executives, while the option holders in our sample are mainly lower-level employees. Second, certain insider trading provisions in securities law apply to all employees. Insider trading is illegal when a person trades a security while in possession of material non-public information in violation of a duty to withhold the information or refrain from trading. For instance, employees who exercise options on the basis of certain kinds of information may be in violation of section 10(b) of the Securities Exchange Act of 1934 or Rule 14e-3 promulgated under the Act. These provisions damp information-based motivations for exercise. While a few employees may exercise options in violation of securities law, widespread exercise by employees of a corporation could attract the attention of the SEC and other market regulators. Third, the option exercise and stock trading decisions of insiders and other employees also depend importantly on other motives for trade and exercise that are unrelated to private information. For employees to enjoy the income they receive in option form, they must exercise their options and sell stock. They may also exercise options and trade stock to rebalance their portfolios, maintain or achieve stock ownership targets set by their employers, meet needs for personal liquidity, manage taxes, or undertake estate planning. Thus, factors besides private information motivate employee trades. These other factors may weaken or obscure the link between information and exercise. As a consequence, whether lower-level employees (footnote continued) into price, Core et al. (1999) find evidence that stock prices are lower at firms with greater potential dilution from stock option exercises. On the other hand, Garvey and Milbourn (2001) find that a trading rule based on the probable dilution associated with stock option exercises yields abnormal returns.

4 6 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) 3 31 exploit private information in timing the exercise of their options is an empirical question. Research on informed trade has focused on corporate officers and directors. These individuals routinely trade in the stock of the company with which they are affiliated. Seyhun (1992a) presents compelling evidence that such trades are legal, widespread, and increasing in frequency. The evidence suggests that these insiders trade on the basis of information that is only subsequently revealed in price. Stock trades by corporate insiders are associated with mean abnormal returns on the order of 5 10% over periods of about 12 months after the trades (Givoly and Palmon, 1985; Seyhun, 1986,1992b,1998; Lakonishok and Lee, 2001). This evidence on stock trading by insiders is based on publicly filed information and, hence, is limited to persons subject to the filing requirements of section 16(a) of the Securities and Exchange Act of Our data, in contrast, cover thousands of employees at the larger companies in the sample. At the smaller companies in some years, all employees receive options, so the entire workforce is represented in the data. The limited evidence on the information content of option exercises is mixed. In examining insiders SEC filings, Carpenter and Remmers (2001) find (i) statistically significant positive abnormal returns following option exercises by insiders prior to 1991, and (ii) no significant abnormal returns following insider exercises since then, except among top managers of small firms. Using firm-level data on option grants and exercises measured annually, Core and Guay (2001) and Vargus (1998) find no evidence that option exercises by non-executives reflect private information about futurereturns. Like these three studies, we consider option exercises, not stock sales. Different from Carpenter and Remmers, we study the exercise decisions of lower-level employees whose stock option exercises are not part of the public record of insider transactions. Option exercise decisions of employees not subject to the filing requirements of section 16 of the 1934 Securities and Exchange Act are not publicly available in a timely fashion. Since SFAS 123 Accounting for stock-based compensation became effective, enhanced disclosure of aggregate option exercises is available in the annual report, but the time lag between exercise and disclosure in the annual report is generally 3 to 15 months. Different from Vargus and Core and Guay, we base our analysis on disaggregated data that indicate individual exercise decisions recorded daily. This is particularly important if the information advantage that prompts exercise is short-lived, since such an effect would be difficult to detect in data cumulated over a year. Different from studies that examine returns following insider trades or option exercises, we count as an observation any month where exercise could take place. Low or no exercise potentially is informative. This information is lost in studies of returns only around trading or exercise events. Our detailed data on option characteristics allow us to take into account characteristics specific to the option grant, such as its moneyness and time until expiration, that influence exercise whether or not information effects also are present. As these factors change, the opportunity cost of exercising the option, namely the foregone opportunities to (i) delay payment of the exercise price and (ii) continue leveraged participation in future stock price appreciation, change also.

5 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) Thus, in our tests we control for differences in exercise driven by changes in this opportunity cost. Similarly, we control for aspects of the stock price series through the observation month that, according to behavioral theories, motivate employee exercise. We rely on controls identified by Huddart and Lang (1996), and Heath et al. (1999) to form an expectation of the amount of employee stock option exercise that is typical in a month. Exercise above or below that amount implies some additional factor is affecting exercise. We find there is substantial correlation between future returns and this residual component of exercise. Our findings have potential implications for several audiences: Underpinning organizational theory and compensation design is the notion that information is asymmetrically distributed throughout firms. Consequently, managers must consider how information is distributed and used. There is, however, little empirical evidence on the nature of non-executive employees information, primarily because publicly-available data lack the detail necessary to examine this issue. While we are not able to identify the specific information known to employees, price-relevant information appears widely distributed across employees outside the executive suite, at least for the sample of companies we study. Compared to internal (and external) accounting reports, stock option exercise may be a useful statistic for inferring information that is prospective in nature and cannot be credibly and reliably measured by other means. This is because employees exposure to stock price fluctuations provides them with an incentive to act on their information. While an individual employee s information is likely to be noisy and poorly communicated by option exercise, aggregating option exercises across employees improves the signalto-noise ratio. Thus, it is possible that top executives would find stock option exercises to be incrementally informative about the near- to mid-term prospects of thefirm. Another implication stems from the personal benefits that employees receive by acting on this information. Economists argue that allowing employees to trade on their information is a form of compensation (Manne, 1966). Whether this perquisite exists and which employees receive it are important empirical questions. Roulstone (2000) documents that firms that do not restrict insider trading pay their executives $54,000 less each year, on average, than firms that restrict insider trading to a period following earnings announcements, implying that compensation levels take into account the opportunity to trade on information. We find that lower-level employees benefit from a similar opportunity. Finally, these findings have implications for the valuation of stockbased compensation. To the extent employee exercise decisions are conditioned on private foreknowledge of stock returns, classical valuation formulas (like Black Scholes), which assume stock prices follow a random walk, understate option value. Thus, like Hemmer et al. (1996), our study provides evidence on the relevance for employee stock option valuation of factors excluded from classical valuation formulas. Next, in Section 2 we describe the data. Section 3 contains our analysis. Section 4 concludes.

6 8 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) Data Our data are employee-by-employee option grant and exercise records for seven companies spanning a period of approximately 10 years. The companies supplied these data on the condition that they and their employees remain anonymous. Four companies are listed on the NYSE (a manufacturer, two financial institutions, and a high-technology company) and three are NASDAQ high-technology companies. The data area subset of thedata in Huddart and Lang (1996). Theonenon-publicly traded company examined in that paper is excluded because there is no marketdetermined price for its stock. Several times a year, each company awards varying numbers of options to varying individuals. All options a company awards on a given date have identical terms (e.g., time to expiration, strike price, and vesting schedule), but awards made on different dates may have different terms and typically have different strike prices. We refer to all the options awarded by a company on a single date as a grant. Across the seven companies over the time period covered by our data, there are 175 distinct grants with 10 or more recipients. Our empirical analysis is limited to exercise from these grants. For each option recipient from each grant, the data record the number of options exercised each day of the sample period. The sample period varies by company. The earliest and latest dates in the sample are August 2, 1985 and December 23, Options in the sample have no unusual characteristics; their contractual terms are representative of broad-based options programs in general. The sample options have strike prices equal to the grant date stock price. Most have terms of 10 years, although some have 5-year terms. Most of the options vest over 4 years, most commonly at the rate of 25% per year. The data do not span the life of every option. For instance, the data record less than 3 years of exercise activity for options granted in 1991, but substantially all of the exercise activity for options granted in Definition of variables One general issue is how to aggregate the raw data on exercise. Each employee can decide daily whether to exercise. To balance tractability against the possibility that employee exercise decisions are prompted by information that is reflected in price soon after exercise, we aggregate all exercises from a given grant within a given month. So, for example, if options on 20,000 shares are exercised in a month from an option grant covering 1,000,000 shares, the amount exercised in the month is Defining the unit of analysis to be the options exercised in a month from a given grant has theadvantageof controlling for multicollinearity across individuals who witness the same stock price path. 4 It is awkward, but more precise, to write shares on which options are exercised in place of options exercised. To avoid this awkwardness, we adopt the convention that an option is the right to buy one shareof stock.

7 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) The dependent variable for the first set of regressions is EXG gt ; the options exercised in month t from grant g as a fraction of all options awarded in grant g: An alternate approach would be to use future returns as the dependent variable and exercise as the independent variable to focus on the predictive power of exercise for future returns. Initially, we make exercise the dependent variable because our primary goal is to examine determinants of option exercise. This specification is also consistent with the existing literature on option exercise and allows us to assess the robustness of our results to inclusion of behavioral and economic variables and compare the explanatory power of future returns to other factors. Finally, this approach allows us to include 6 monthly return variables separately in the same regression, along with the control variables to assess the incidence of the effect across months. Later results, reported in Table 5, indicate that conclusions are consistent if we use future returns as the dependent variable. A grant of options that expires in 10 years potentially contributes 120 monthly observations of exercise to our regression analysis. However, we exclude months when less than 1% of the grant is available for exercise. This filter eliminates grantmonths where no options are vested or where substantially all of the vested options have been exercised. Also, we exclude grant-months where the stock price on the first day of the month is less than 115% of the strike price to eliminate grant-months where the options cannot be exercised because they are under water, or there is little gain to exercise. Over the observed lives of the grants, there are 4,454 monthly observations of exercise activity for which in-the-money options available for exercise. We consider two sets of explanatory variables. First, we include the return (either raw or market-adjusted, depending on the specification) on the underlying stock over each of the 6 months following the observation month. If employees condition their exercise decisions on information not currently reflected in price so as to profit from that information, then the coefficient estimates on the return for the month when the information becomes public should be negative when EXG is regressed on subsequent returns. A pattern of negative coefficient estimates on the return variables indicates employees exercise options relatively less (more) when the stock price will increase (decrease) in those months. Employees likely seek to exercise stock options before a stock price drop, regardless whether the drop is due to market-wide or firm-specific factors. For this reason, we concentrate our initial analysis on raw returns. A finding that employee exercise precedes negative raw returns suggests that employees profit from private information about the firm. To check the robustness of the results, we also consider market-adjusted returns. Second, since exercise is driven partly by the stock price level, option characteristics, and employee-specific factors, the tests incorporate control variables that capture non-information motives for exercise. Qualitatively, the results are not sensitive to the exclusion of any of the control variables. Below, we explain each variablein turn. One potential problem with using our data to infer discretionary option exercise is that some exercise is driven by option cancellation. Commonly, employee stock

8 10 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) 3 31 options are cancelled when option holders cease to be employed by the firm that granted theoptions. Thedata, which aredrawn from companies internal stock option plan administration computer files, include the date, if any, on which an employee s options were cancelled. The timing of the cancellation in relation to the date of separation varies by firm and depends on the reason for separation (e.g., whether the employee quit, retired, or was fired). In most cases, options are cancelled 90 days after the separation date. Since our interest is in discretionary option exercise decisions and cancellation may confound the results by prompting exercise, we include a measure of soon-to-be-cancelled options in all tests. CANCEL gt is the options to be cancelled in the 90 days following month t from grant g; as a fraction of options granted. Because in-the-money options should be exercised before they are cancelled, the coefficient estimate on CANCEL should be strongly positive. 5 The more options available for exercise (i.e., vested and unexercised), the more exercise we expect. Because we express exercise as a fraction of the options granted, we control for options that are available for exercise using AVAIL gt ; which is the options available for exercise in month t from grant g as a fraction of options granted. We expect a positive coefficient estimate for AVAIL. VEST gt represents options that vested in the 6 months prior to month t as a fraction of thetotal options awarded in grant g: Prior to vesting, employees are precluded from exercising their options, and therefore soon after options vest, one might expect higher exercise as pent up decisions to exercise are given effect. This implies a positive coefficient estimate for VEST. When employees exercise their options early, they forgo the payoff from holding the options until later. Exercise due to liquidity needs or risk aversion is likely to be greater when option-holders capture value close to the payoff they would receive from holding the options until later. To control for the effects of early exercise prompted by risk aversion and liquidity needs, the controls include RATIO gt ; the ratio of theintrinsic valueof an option from grant g (i.e., the market price of the stock less the option s strike price) to the expected value of the option at time t; estimated using the Barone-Adesi and Whaley (1987) formula. 6 Themeasurehas the following properties: it is always between 0% and 100%; at expiration, if the options are in the money, the measure is 100%; the measure gets bigger as the market price rises above the strike, the time to expiration of the option decreases, or the volatility of thestock decreases. The forgoing control variables are predicted to be related to exercises for reasons that relate to models of utility maximization. In addition, behavioral factors have been shown to be associated with exercise. Consistent with behavioral models of 5 CANCEL gt is significantly but weakly (in the range of ) positively correlated with the return in month t þ 1; and weakly (and generally insignificantly) negatively correlated with returns in subsequent months, perhaps reflecting layoffs as growth slows. 6 This is a formula for valuing American options on dividend-paying stocks. Regression results are similar when RATIO is computed using the Black Scholes value or when the inputs of formulas for valuing options, including thestock volatility, timeto expiration, and theratio of thestock priceto the strike replace RATIO as explanatory variables.

9 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) values, Heath et al. (1999) and Core and Guay (2001) find that stock option exercise increases when the stock price is above a 12-month high. To control for the increase in exercise associated with periods when the stock price is above this psychologically salient reference point, the regressors include a dummy variable, MAX gt ; that is onewhen theclosing stock priceon thefirst day of theobservation month is abovethemaximum closing priceover trading days 21 to 260 (i.e., the maximum over the prior year, excluding the month prior to the observation month), and zero otherwise. Heath et al. (1999) also find that stock option exercise is greater following short-term stock price run-ups. Controls therefore include returns during the observation month, RETM0, and the month preceding the observation month, RETM1. Positive coefficient estimates on RETM0 and RETM1 are consistent with behavioral models of beliefs in which option holders expect short-term mean reversion, i.e., option holders who have seen the stock price go up expect the stock to fall, and so exercise their options. Including prior returns also addresses the possibility that option holders are momentum traders. Momentum traders expect that past winners continue to be winners and past losers continue to be losers. A negative coefficient estimate on the stock return preceding the observation month is consistent with momentum trading, i.e., option holders who have seen the stock price go down expect it to continue to fall, and so exercise their options. Whatever the influence of prior stock price movements on exercise decisions, the focus of this paper is on subsequent stock returns. Given semistrong market efficiency, negative coefficient estimates on stock returns following the observation month are evidence in support of options holders possessing and using privateinformation Descriptive statistics Table 1 reports descriptive statistics for the regression variables. On average, 0.81% of an option grant is exercised in a sample month, consistent with thefact that most of theoptions havea 10-year (roughly 120 month) life. This variable is highly skewed: the mean is substantially larger than the median, implying that exercise activity is concentrated in a subset of months, although the fact that the median is positive indicates that some exercise occurs in most sample months. 7 On average, 35.47% of a grant is available for exercise, 8.96% vested in the prior 6 months and 1.27% will be cancelled in the next 90 days. In the average sample month, the ratio of intrinsic value to expected value is 74.23%, implying that exercise in an average month would provide the employee with 74 cents per dollar of expected value from continuing to hold the option. The median raw and 7 In later analysis, we group grant-months into terciles by exercise activity, so extreme values of EXG do not exert undue influence on the results. In addition, results are robust to estimation in ranks, indicating that skewness does not distort inferences.

10 12 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) 3 31 Table1 Descriptive statistics on regression variables Variable Mean Standard 25th Median 75th deviation percentile percentile EXG CANCEL AVAIL VEST RATIO MAX RAWRET MARET The unit of observation is a grant-month. All grants with more than ten grantees where at least 1% of the grant was available (i.e., vested and unexercised) and the market price of the underlying stock on the first trading day of the month exceeds 115% of the option s strike price are included. There are 4,454 monthly observations of options exercised from various grants. EXG and AVAIL measure the number of options awarded from a single grant that, in the observation month, are exercised and available for exercise, respectively. CANCEL measures the number of options to be cancelled within 90 days. VEST measures the number of options that have vested in the prior 6 months. EXG, CANCEL, AVAIL, and VEST are expressed as a fraction of the total number of options granted. MAX is an indicator variable that takes the value1 if thestock priceon thefirst trading day of theobservation month is abovethemaximum price over the prior year, excluding the month prior to the observation month. RAWRET is the raw return on the stock over the observation month. MARET is the market-adjusted stock return over the observation month. market-adjusted returns for the observation month are 1.68% and 0.21%, respectively. Table 1 also shows substantial variation in each of the variables. 3. Empirical analysis 3.1. Regression of exercise on subsequent returns Table 2 presents the results of a regression of the fraction of a grant exercised in a given month on subsequent monthly stock returns and control variables: EXG ¼ b 0 þ X6 i¼1 b i RETi þ b 7 CANCEL þ b 8 AVAIL þ b 9 VEST þ b 10 RATIO þ b 11 MAX þ b 12 RETM0 þ b 13 RETM1 þ e: Grant and month subscripts are suppressed in the regression equation. Each grantmonth with in-the-money options (i.e., the stock price on the first day of the month is at least 115% of the option strike price) where more than 1% of the grant is available for exercise contributes an observation to the regression. The number of grantees ranges from 10 to more than 11,000 across grants. To address the resulting heteroskedasticity in the residual, observations are weighted in the regression. As in

11 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) Table2 Weighted least-squares regression of fraction of grant exercised on returns and control variables EXG ¼b 0 þ X6 i¼1 b i RETi þb 7 CANCELþb 8 AVAILþb 9 VESTþb 10 RATIOþ b 11 MAXþb 12 RETM0 þ b 13 RETM1 þ e: Raw returns Market-adjusted returns (1) (2) (3) (4) (5) (6) Predicted VariableSign Coeff. t Coeff. t Coeff. t Coeff. t Coeff. t Coeff. t Intercept? RET RET RET RET RET RET CANCEL þ AVAIL þ VEST þ RATIO þ MAX þ RETM0 þ RETM1 þ Adjusted R RETi is the stock return (raw or market-adjusted) over month i following the observation month. RETM0 and RETM1 are the contemporaneous and lagged monthly raw stock returns. Other variables are defined in Table 1. The weight on each observation is proportional to the square root of the number of employees included in the grant. Firm dummies control firm-specific fixed-effects (coefficients not reported). There are 4,454 observations in each regression.

12 14 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) 3 31 Huddart and Lang (1996), the weight on each observation is proportional to the square root of the number of employees included in the grant. All specifications control for firm-specific fixed effects (coefficients on firm indicator variables not reported). Two sets of results are reported: one using raw returns and the other using market-adjusted returns as explanatory variables. For each choice of returns, we report results for three sets of control variables: CANCEL alone (specifications 1 and 4), the control variables motivated by models of utility maximization (specifications 2 and 5), and all control variables (specifications 3 and 6). When control variables are included, the explanatory variables account for more than half thevariation in EXG. The results strongly contradict the null hypothesis of no relation between stock option exercise in a month and subsequent stock returns. With the exception of RET4 and RET5 in the regressions including all control variables, the coefficient estimates on RET1 RET6 are significantly negative across specifications. This implies that, on average, employees exercise if they anticipate a stock price drop and hold if they anticipate a run-up. For instance, specification (1) implies that a 10% raw stock return over the third month following the observation month increases stock option exercise in the observation month by Given a median value for the EXG variable of , this hypothetical return implies a more-than-twofold increase in exercise activity in a typical observation month. Since the coefficient estimates on the returns variables are consistent across specifications, the results are not sensitive to inclusion of other factors known to influence option exercise. Coefficient estimates on returns are larger in months 1 3 after the observation month than in months 4 6, which suggests that the option holders information is primarily revealed in price over the coming 3 months. While the coefficient for the first month following the observation month is reliably negative, the largest coefficient is on RET3. This suggests that a general sense as to company prospects rather than an imminent corporate disclosure generally motivates employee exercise. This observation is consistent with studies of purchases and sales by section 16 insiders, which find underperformance after insider sales extends over several months. In an examination of periods beyond 6 months, returns show no clear pattern. In a supplemental analysis, the relation between returns and exercise is significant for 10 of 12 calendar months. There is no evidence that results are driven by a specific point in the earnings reporting cycle, e.g., the first month in the quarter, when the previous quarter s earnings are typically announced. This suggests that employees do not exercise based on anticipation of a near-term earnings announcement. Overall, the pattern of coefficient estimates may also explain why informed exercise does not attract regulatory scrutiny: it may be difficult to establish misuse of specific material non-public information when that information relates to a stock pricedrop 3 months after thetransaction. Relative to specifications (1) and (4), specifications (2) and (5) control for economic factors that prior research shows are important in explaining option exercise. These coefficients are generally significant in the predicted direction: more options tend to be exercised when there are more available to be exercised, following a vesting date, and when the employees are able to capture more of an option s value

13 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) at exercise. Most importantly, inclusion of these factors does not affect results for the variables of interest. 8 Similarly, including past returns and an indicator variable for whether the price is above a prior high does not change the tenor of the results. As in Heath et al. (1999), a recent price run up that carries the stock past a previous high leads to increased exercise activity, but conclusions for future returns are generally unaffected. This result is interesting for several reasons. First, it suggests that a mix of factors is important in employee exercise decisions. It may seem surprising that economic tradeoffs, psychological factors and information could all affect employee exercise decisions. Because we aggregate across large numbers of employees, it could be that no individual employee considers all three sets of factors simultaneously (i.e., there may be a subset of employees exhibiting each). Or, it could be that all three sets of factors affect exercise decisions simultaneously. Reference point theory suggests that an employee facing a share price below the prior maximum requires a greater inducement to liquidate his position (i.e., he perceives more value from holding the option when the stock price is below his reference point than when the stock price is above his reference point). However, a stock price that is expected to continue to drop may be sufficient inducement to prompt exercise since it reduces the value to the employee from holding the option. Similarly, the results suggest that employees are less likely to exercise if doing so would sacrifice more of the option s value (e.g., the option is near the money or has a long remaining life). However, if the employee has information that thestock priceis likely to fall in thenear future, theadvantage of exercising today and avoiding the stock price drop may more than offset the value sacrificed by exercising early. Another interesting aspect of Table 2 is that the sign of the relation between exercise and returns switches around the observation month: past returns are positively correlated with exercise, whereas future returns are negatively correlated with exercise. This suggests that risk factors are not driving the results since the relative riskiness of a stock is unlikely to change around exercise decisions. Further, it indicates that the results do not reflect a naive but profitable exercise strategy or some atypical characteristic of sample stock returns. The results are inconsistent with momentum trading by employees since the positive coefficients for the pre-exercise returns indicate that employees are generally contrarian. Further, the continued significance of the negative relation with future returns indicates that it is not simply 8 The robustness of the results for the economic and behavioral factors to inclusion of future returns is consistent with the sensitivity analyses noted in Heath et al. (1999) and Huddart and Lang (1996). Those studies included future returns to address concerns that exercise might be in anticipation of near-term news correlated with the variables of interest. In Heath et al., for example, the dependent variable is weekly exercise and future weekly returns were included to control for the possibility that the relation between behavioral factors and exercise was actually driven by employees trading in anticipation of near-term news announcements. Because our interest was in weekly exercise and weekly returns prior to exercise, we included weekly returns following exercise. As noted in that paper, the relation between exercise and behavioral factors was robust to inclusion of returns and there was no clear pattern in weekly exercise and subsequent weekly returns, implying that there is not a subset of weeks that drive the results. Aggregating exercise and returns over longer periods as in this paper strengthens the relation between exercise and future returns, but does not change the conclusions with respect to economic and behavioral factors.

14 16 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) 3 31 the case that a contrarian strategy happens to be profitable during the sample period because results are robust to conditioning on past returns. It is also possible that employees are contrarian with respect to longer-term returns and this is not captured by returns over the preceding two months. Jegadeesh and Titman (1993) indicate that returns tend to be negatively autocorrelated over longer windows, so employees may simply exercise more when past returns are higher, exploiting this negative autocorrelation. To address that possibility, we reestimate the relation including returns for 6 months and 1 year prior to exercise. The relation between exercise and subsequent returns tends to be equally strong when longer-term past returns are included as additional explanatory variables, suggesting that a longer-term contrarian strategy does not drive the results. Table 2 also presents results for market-adjusted returns. Results are very consistent with those for raw returns. In addition, we estimated a regression in which we replace firm-specific returns with market returns. In this regression, the relation between market returns and exercise is weakly negative, but only significant in month 1. Thus, information in exercise is primarily firm-specific rather than marketwide and employees ability to time the overall market is limited. Again, results are robust to inclusion of controls. A potential concern with panel data is correlated residuals. The level of autocorrelation in exercise is less than 20% results for all specifications; are virtually identical after applying a Cochrane Orcutt adjustment. It is also possible that exercise in a given month is correlated across grants. To address that possibility, we re-estimate the regressions using one observation per firm-month, by averaging all variables across grants within the same firm and month. A disadvantage of this approach is that the RATIO and VEST variables, which capture economic factors that affect exercise and which differ across grants, are muddied because they must be averaged. While the number of observations is reduced, the explanatory power of the regressions generally increases and results are similar with all months returns remaining significant at the 0.05 level except for month 5, which is significant at the 0.10 level in specifications (1) and (2). Results might differ across types of companies because, for example, there may be greater information asymmetry between employees and other stock traders at hightechnology firms; however, stock price movements may be more difficult to predict at such firms. While splitting the sample too finely raises confidentiality concerns at some sample firms, we can report that the negative relation between future returns and exercise is statistically significant for four of the seven firms and is negative, but not significant for a fifth. The main factors that differentiate the firms for which therelation is significant from theothers arethenumber of observations and the number of employees. Results are significant for the largest firms with the most observations, consistent with the issue being a lack of power for the smaller firms. Further, results are consistent splitting the sample between hightechnology and other firms (t-statistic on 6-month returns of 12:4 for thehightechnology sample and 6:2 for the others). Results are stronger for ranked than unranked data, suggesting that the effect is not driven by a relatively small number of observations.

15 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) Published record of insider trades It is possible that option holders exercise decisions are driven in part by the stock trades made by section 16 insiders at the same company: employees might exercise in response to the public disclosure of insider trades or employees might exercise after learning of insider trades and before those trades are made public. To test whether option exercise is predicted by insider trading and whether the information about future price movements in stock option exercises is subsumed in the information contained in reports of trades by section 16 insiders, we include as explanatory variables contemporaneous and lagged values of (i) the number of purchase transactions by insiders (net of the number of sales transactions), and (ii) the number of shares purchased by insiders (net of the number of shares sold) at each company in the regressions reported in Tables 2 and 3. These results (not reported) indicate that the first and second lags of the stock purchase variables are significantly negatively associated with option exercise. Since insider stock purchases are associated with excess future stock returns, the regression results are consistent with option holders inferring future stock price movements from the public record of insider trades. The coefficients on RET1 to RET6 in the regressions remain very similar to those reported, however. This indicates that future stock prices have explanatory power incremental to insider trades with respect to the option exercises. In turn, this implies that non-insider employees condition their exercise decisions on additional price-relevant information distinct from the information contained in the trades of section 16 insiders Nature of information and the regulatory framework An interesting question is what kind of information prompts employee exercise. The information does not primarily relate to imminent corporate announcements since, consistent with studies of stock returns following insider trades, excess returns extend for months after the observation month. As noted earlier, results from rank regressions (not reported) are stronger than those in Table 2, suggesting that information does not affect only a few extreme observations, but rather pervades exercise decisions. The exercise variable EXG is constructed to aggregate the decisions of thousands of employees. This may mean that noise in individual employees decisions is averaged away but the signal (i.e., the informed component) is preserved. As an example, any individual salesperson s view of market conditions may not be very informative, but aggregating those views across the sales force, as revealed by option exercises, may yield a precise and informative indicator of thedemand for thefirms products. Carpenter and Remmers (2001) study of officers and directors presents an interesting counterpoint to this study. They find that executive option exercises from 1984 to 1990 precede significantly positive abnormal stock returns. Since 1991, they find that abnormal stock returns following insider option exercises are insignificant, except for top managers of small firms, where they are negative. Differences in regulation over time and across option holders are important to the reconciliation of

16 18 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) 3 31 Carpenter and Remmers s findings and our own: before May 1991, the SEC effectively required section 16 insiders to hold the shares they acquired upon option exercise for at least 6 months (Boyajian, 1991). Stock returns in this 6-month holding period therefore accrued to the insider. Under rules that apply after 1991, insiders may sell immediately the shares acquired on exercise of stock options. Therefore, under the pre-1991 rules, an insider who expects good performance and knows that he will want to rebalance his portfolio following the price run-up by selling stock may choose to exercise now so that he can rebalance at the end of the 6-month holding period. Thus, positive returns following option exercise in the early period is consistent with exploitation of private information by insiders. In the later period, where the holding period requirement is eliminated and insiders incentives are similar to those of lower-level employees, the evidence in Carpenter and Remmers is weakly consistent with ours. Note that the option holders in our sample were never subject to the section 16 insider trading rules. Public disclosure affects the exercise decision of insiders and lower-level employees differently. The insiders studied by Carpenter and Remmers are required to disclose their trades after the fact. These trades are subject to scrutiny and public comment. Top management, wary of adverse market reaction or publicity, may trade strategically so that the public record of insider trades signals or conceals information. 9 Lower-level employees decisions are not contaminated by market signalling considerations because individual option exercises for non-section 16 insiders are not publicly reported. As a result, lower-level employees may be more likely to exercise before price drops and a stronger relation between exercise and returns may obtain. Carpenter and Remmers results also might be affected by incomplete or late-filed insider trading reports. It is commonly alleged that the reports were deficient prior to the 1991 rule changes. This, in part, prompted the SEC to stiffen sanctions for noncompliance. Our data, which come from employer records, are complete because an employee must notify his employer to exercise a stock option Regression of exercise on subsequent returns by employee level We next turn to the question of whether senior and junior employees exercise decisions are similarly informed. One might expect that senior employees have access to more precise information about the prospects of the firm than junior employees. If employees at different levels who know the same information would make the same exercise decision (controlling for other factors affecting exercise), then different coefficient estimates on the returns variables imply different information. 9 One observer describes insiders as moving toward more orchestration of their trades. The observer goes on to suggest that insiders at only a small handful of companies seem to engage in this activity, but that these companies seem to stand out the most. (Bob Gabele, The inside story: Increased scrutiny makes interpreting their trades tougher Barron s, April 6, 1998). In another recent example, the Alpnet Inc. president needed cash to exercise 150,000 stock options this summer, but didn t want to sell any of his Alpnet shares, worried that it would send a negative signal to investors. (Ruth Simon and Cassell Bryan- Low, Insiders rue borrowing on single stock holding The Wall Street Journal, November 29, 2000).

17 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) Our data do not include direct measures of employee rank or position within every company. Since more senior employees tend to be granted more options, we use the total number of options granted to the employee over the sample period as a proxy for theemployee s rank within theorganization. For four firms for which wehave data on 1993 salaries and administrative level within the company, the number of options granted tends to be highly correlated with pay and rank, suggesting the proxy is reasonable. The employees whose total grants rank in the top 5% of awards at each company we label level 1. Employees whose total grants rank between the 5th and 25th percentile we label level 2; those between the 25 and 50th percentile, level 3; and thosein thebottom half of thedistribution, level 4. After assigning employees to levels, we form observations in the same manner as for all the data combined. The returns variables, RATIO, and MAX are the same across levels within the same grant-month. Vesting, cancellation, and exercise activity within each grant-level is used to compute dependent and independent variables, so variables EXG, CANCEL, AVAIL, and VEST may differ across levels within a grant-month due to differences in current and prior exercise and cancellation activity across levels. As before, each grant-month-level with in-the-money options (i.e., the stock priceon thefirst day of themonth is at least 115% of theoption strikeprice), wheremorethan 1% of thegrant is availablefor exercisecontributes an observation to the regression. Also as before, the weight on each observation is proportional to thesquareroot of thenumber of employees included in thegrant. Table 3 presents separate regressions of exercise on subsequent returns and control variables for each employee level. On the whole, the results are quite similar across levels. 10 This suggests that even quite junior employees in the organization have access to valuable information about future stock returns and that their exercise decisions, on average, are conditioned on this information Regression of subsequent returns on residual exercise The foregoing analysis shows that the aggregate exercise decisions of employees at all levels in the corporation who receive options is negatively associated with subsequent stock returns. We now examine the implications of varying levels of exercise on future stock returns. We divide grant-months into three equal-sized groups according to the size of the residual from a first-stage regression of the independent variable, EXG, on the control variables (CANCEL, VEST, AVAIL, RATIO, MAX, RETM0, and RETM1). Our goal is to purge the exercise variable of the effects of other motivations for exercise to focus on information effects. We use the residuals from these regressions to rank the amount of exercise in each month according to the exercise activity not explained by option and employee characteristics. A large (small or 10 The are several reasons why the number of observations varies by level. Some grants are extended to employees in a subset of the levels. Prior exercise within each level affects whether options are available for exercise. Also, grant-month-levels with fewer than ten employees holding vested, unexercised options are discarded.

18 20 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) 3 31 Table3 Weighted least-squares regression of fraction of grant exercised on returns and control variables, by employee level EXG ¼ b 0 þ b 1 CRET þ b 2 CANCEL þ b 3 AVAIL þ b 4 VEST þ b 5 RATIO þ b 6 MAX þ b 7 RETM0 þ b 8 RETM1 þ e: Raw returns Market-adjusted returns (1) (2) (3) (4) (5) (6) Predicted Variablesign Coeff. t Coeff. t Coeff. t Coeff. t Coeff. t Coeff. t Level 1 top 5% of option recipients ðn ¼ 3; 293Þ Intercept? CRET CANCEL þ AVAIL þ VEST þ RATIO þ MAX þ RETM0 þ RETM1 þ Adjusted R Level 2 next 20% of option recipients ðn ¼ 4; 019Þ Intercept? CRET CANCEL þ AVAIL þ VEST þ RATIO þ MAX þ RETM0 þ RETM1 þ Adjusted R

19 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) Level 3 next 25% of option recipients ðn ¼ 3; 252Þ Intercept? CRET CANCEL þ AVAIL þ VEST þ RATIO þ MAX þ RETM0 þ RETM1 þ Adjusted R Level 4 bottom 50% of option recipients ðn ¼ 2; 750Þ Intercept? CRET CANCEL þ AVAIL þ VEST þ RATIO þ MAX þ RETM0 þ RETM1 þ Adjusted R The regressions and variable definitions in this table parallel those in Table 2, except: in forming observations, employees are first classed by level; then vesting, cancellation, and exercise activity within each grant-level are used to compute dependent and independent variables. The independent variable, CRET, is the stock return over the 6 months subsequent to the observation month. While the returns variables and RATIO are the same across levels within the same grantmonth, variables EXG, CANCEL, AVAIL, and VEST may vary by level within a grant-month due to differences in current and prior exercise and cancellation activity. The weight on each observation is proportional to the square root of the number of employees included in the grant. Firm dummies control firmspecific fixed-effects (coefficients not reported). The 5% of employees who received the largest option grants at each company are grouped in level 1. Employees whose option grants rank between the 5th and 25th percentile are grouped in level 2; those between the 25 and 50th percentile, level 3; and thosein the bottom half of the distribution, level 4. The number of observations varies by level for reasons explained in the text.

20 22 S. Huddart, M. Lang / Journal of Accounting and Economics 34 (2003) 3 31 negative) residual from the first stage regression indicates that option exercise is high (low) after controlling for various characteristics of the options. Observations where residual exercise is greatest (least) are in the high (low) group. Results reported below are not sensitiveto exclusion of any of thecontrol variables from thefirst-stageregression. Panel A of Table 4 presents weighted mean cumulative excess returns for each tercile. The weights are the number of employees who received options from that Table4 Cumulative FF-adjusted returns following the observation month, by residual exercise intensity Exercise tercile Month Low Medium High Panel A Panel B All levels combined Level 1 top 5% of option recipients Level 2 next 20% of option recipients Level 3 next 25% of option recipients Level 4 bottom 50% of option recipients