Voluntary Disclosures and the Exercise of CEO Stock Options

Transcription

1 Voluntary Disclosures and the Exercise of CEO Stock Options Paul Brockman * College of Business 513 Cornell Hall University of Missouri Columbia Columbia, MO Tel: (573) brockmanp@missouri.edu Xiumin Martin Olin School of Business Washington University One Brookings Drive St. Louis, MO Tel: (314) XMartin@WUSTL.EDU Andy Puckett College of Business 508 Cornell Hall University of Missouri Columbia Columbia, MO Tel: (573) puckettw@missouri.edu April 2008 * Corresponding author. Acknowledgements: We would like to thank Bill Moser, Sterling Yan, Grace Hao, and seminar participants at the University of Missouri-Columbia for their valuable comments. 1

2 Voluntary Disclosures and the Exercise of CEO Stock Options Abstract We examine voluntary disclosures around the exercise of CEO stock options. Previous research shows that managerial incentives depend on the intended disposition of the exercised options underlying shares. When CEOs intend to sell the underlying shares of exercised options, they have an incentive to increase stock prices in the pre-exercise period. In contrast, when CEOs intend to hold the underlying shares, they have a tax incentive to decrease stock prices in the pre-exercise period. Consistent with these private incentives, we find a significant increase in the frequency and magnitude of good (bad) news announcements in the pre-exercise period when CEOs implement exercise-andsell (exercise-and-hold) strategies. We further show that CEOs propensities for opportunistic disclosures are positively related to the value of their exercised stock options. Lastly, we find that the Sarbanes-Oxley Act (SOX) generally reduces, but does not eliminate, this type of managerial opportunism. In one case (i.e., CEOs selling exercised shares back to the company), however, SOX might have inadvertently encouraged the use of opportunistic disclosures. Key Words: JEL: Voluntary Disclosures; Management Forecasts; Executive Stock Options G30; M43 2

3 1. Introduction The use of executive stock options has grown considerably over the past several decades. It is not uncommon for stock options and stock-related compensation to comprise well over half of the CEO s total pay package (Murphy (2003)). One motivation for the growing use of executive stock options is that this form of compensation mitigates owner-manager conflicts. Although stock options clearly reduce some types of agency problems, they also increase the opportunity for other types of agency problems. Recent studies find evidence of managerial opportunism associated with stock option grants (Aboody and Kasznik (2000)), stock option exercises (Bartov and Mohanram (2004)), and stock option backdating (Heron and Lie (2007)). The primary objective of this study is to examine voluntary disclosures around CEO stock option exercises. The option-exercise setting allows us to distinguish between CEOs who prefer high stock prices in the pre-exercise period and those who prefer low stock prices in the pre-exercise period. Our empirical results confirm that the timing and content of voluntary disclosures reflect CEO private incentives. The granting and exercising of executive stock options offer a rich environment for studying managerial behavior. Previous research suggests that corporate executives employ a variety of methods to maximize their compensation around both option grant dates and option exercise dates. These methods include the use of private information to time option grant and exercise dates, earnings management, voluntary disclosure opportunism, and backdating. 1 Around option grant dates, Yermack (1997) finds 1 Backdating refers to the manipulation of reporting requirements around the granting or exercising of stock options. Prior to the enactment of the Sarbanes-Oxley Act (SOX) on August 29, 2002, executives had considerable flexibility in selecting (i.e., backdating) both option grant and exercise dates on an ex-post basis. 3

4 evidence of the use of private information (i.e., setting grant dates in periods of low stock prices), Aboody and Kasznik (2000) find evidence of manipulative voluntary disclosures, and Heron and Lie (2007) find evidence of backdating. 2 Around option exercise dates, Aboody, Hughes, and Liu (2007) show that managers engage in the exploitation of private information, Bartov and Mohanram (2004) show that managers use earnings management, and several recent papers (e.g., Dhaliwal, Erickson, and Heitzman (2007), Cicero (2007), Cai (2007)) show that CEOs frequently backdate option exercises in order to maximize their private gains. Although there are some similarities in the types of incentive problems around option grant dates and option exercise dates, there is at least one important difference. Prior to option grant dates, managers private incentives always point in the same direction; that is, managers prefer their stock options to be granted when market prices and, consequently, strike prices are low. Prior to option exercise dates, in contrast, managers incentives depend on their intended disposition of the underlying shares. When managers intend to exercise and sell their underlying shares, they have a straightforward incentive to exercise when market prices are high. However, when managers intend to exercise and hold their underlying shares, they have a personal tax incentive to exercise when market prices are low. 3 These distinct and opposite incentives 2 Although managers can also use private information when implementing earnings management and opportunistic voluntary disclosures, they require no private information for backdating stock options. 3 On the exercise date, the difference between the stock price and the strike price is subject to ordinary income taxes, while any subsequent appreciation of the underlying shares (i.e., from an exercise-and-hold strategy) are subject to long-term capital gains provided the shares are held for at least one year. Therefore, the CEO who intends to hold the underlying shares of the exercised options has a tax incentive to reduce stock prices on the exercise date in order to substitute long-term capital rates for ordinary income rates. See Dhaliwal, Erickson, and Heitzman (2007) for additional details on the tax implications of exercise-and-sell versus exercise-and-hold strategies. 4

5 provide a natural experiment for investigating whether managers strategically issue voluntary disclosures around stock option exercises. Previous research finds evidence of managerial opportunism in the use (misuse) of voluntary disclosures around various corporate events, including insider trades and open-market share repurchases. Noe (1999) finds examples of self-serving voluntary disclosures around insider trades. Cheng and Lo (2006) examine insider trading and find that managers who intend to buy shares for their own account will time the release of bad news to fall during pre-purchase periods. Similarly, Brockman, Khurana, and Martin (2007) find that managers alter the timing and content of voluntary disclosures before repurchasing company stock in the open market. Given the opportunity for managerial opportunism around stock option exercises, we expect to find similar patterns between voluntary disclosures and the exercising of CEO stock options. That is, we expect that CEOs will strategically time voluntary disclosures in the pre-exercise period. We collect 9,021 CEO stock option exercises from 1,925 unique firms during the 11-year period From over 40,000 voluntary disclosures, we identify 3,936 management forecasts that occur within our event window of 30-days prior to the CEO s option exercise. Following Cicero (2007), we partition our sample according to the CEO s disposition of the exercised option s underlying shares. There are three (mutuallyexclusive) dispositions: (1) the CEO sells the underlying shares on a stock exchange or in a private, third party sale (Market or Private Sale Subsample); (2) the CEO sells the underlying shares back to the company (Company Disposition Subsample); or (3) the CEO holds onto the underlying shares (No Disposition Subsample). The first two 5

6 dispositions represent exercise-and-sell strategies, and the third disposition represents an exercise-and-hold strategy. Our testable hypotheses and empirical design build on the fact that the CEO s disclosure incentives are a direct consequence of his intended disposition. When the CEO intends to exercise and sell the underlying shares, he has an incentive to accelerate the release of good news (or delay the release of bad news) in the pre-exercise event window. In this manner, the CEO maximizes the private benefits of an exercise-and-sell strategy. In contrast, when the CEO intends to exercise and hold the underlying shares, he has a personal tax incentive to accelerate the release of bad news (or delay the release of good news) in the pre-exercise event window. In this opposite manner, the CEO maximizes the private benefits of an exercise-and-hold strategy. Our empirical results confirm the opportunistic use of voluntary disclosures around stock option exercises under both the exercise-and-sell and exercise-and-hold strategies. We find a significant increase in the frequency and magnitude of good news announcements during the pre-exercise period when the CEO subsequently exercises and sells the underlying shares. This exercise-and-sell result contrasts sharply with the exercise-and-hold outcome. When the CEO exercises and holds the underlying shares, we find a significant increase in the frequency and magnitude of bad news announcements during the pre-exercise period. It is important to note that any reduction in the CEO s tax liability caused by the acceleration of bad news releases is also likely to increase the firm s tax liability. 4 Similarly, any increase in stock prices caused by the acceleration of 4 The personal and corporate tax incentives associated with Non-Qualified Options (NONQ) are straightforward. A tax deduction accrues to the company on the exercise day equal to the difference between the market and exercise prices. If the exercise is timed (or backdated) to occur at a low market price, the company forfeits a portion of this deduction (or, alternatively, transfers it to the executive). The 6

7 good news releases will create an additional company cash outflow when the stock is sold back to the company. While our results are consistent with firms opportunistically timing voluntary disclosures prior to CEO option exercises, it is possible that the CEO s exercise decision is influenced by her disclosure decision. Thus, voluntary disclosure and CEO option exercise decisions may be endogenously determined. We address this endogeneity concern in two ways. First, we implement a two-stage simultaneous equations framework and find that our results are robust to this specification. Second, we analyze a subsample of option exercises where CEOs have little flexibility in their option exercise decisions (i.e. options are exercised in the month that they expire). Our results hold for the exercise-at-expiration sample. Overall, our findings strongly suggest that voluntary disclosure policy depends significantly on the CEO s intended disposition of exercised stock options. Next, we examine the two types of exercise-and-sell strategies in greater detail to distinguish the effects of opportunistic disclosures from those of backdating. It is unlikely that CEOs backdate option exercises when their stock disposition takes place in a private sale or on a stock exchange (i.e., Market or Private Sale Subsample) since the counterparty would purchase at an above-market price. It is much more likely, however, that CEOs backdate option exercises when the counterparty is the CEO s own company. personal and corporate tax incentives associated with Incentive Stock Options (ISO) are more nuanced. If the CEO exercises and immediately sells the underlying shares, then the tax treatment is similar to that of NONQs. However, if the CEO exercises and holds the underlying shares, then the granting corporation receives no tax deduction and the CEO incurs no tax liability at the exercise date. The CEO is taxed only on subsequent gains (stock price minus strike price) using the long-term capital gains rate, provided the shares are held at least one year. An additional complication can arise if the CEO is subject to alternative minimum taxes (AMT) in the year of an ISO exercise. Under the AMT regime, an ISO exercise is treated similarly to an NONQ. We examine and test the implications of these different incentives in our empirical results section. 7

8 Consistent with this analysis, Cicero (2007) finds evidence of backdating in the Company Disposition Subsample and little evidence of backdating in the Market or Private Sale Subsample. In a parallel manner, we posit an increasing propensity for opportunistic disclosures when the CEO s ability to backdate is constrained. Our empirical results confirm that CEOs employ significantly more opportunistic disclosures when they sell their exercised shares in the market or in a private sale (i.e. backdate-constrained CEOs) than when they sell their exercised shares back to the company. We analyze the impact of stock option values on voluntary disclosure behavior. Consistent with expectations, we find some evidence that the CEO s propensity for opportunistic disclosures is directly related to the value of his exercised stock options. We also examine the impact of the Sarbanes-Oxley Act (SOX) on voluntary disclosures around option exercises. Although the explicit reporting requirements of SOX clearly reduce the CEO s ability to backdate options, it is not clear what impact, if any, these requirements have on opportunistic voluntary disclosures. One possibility is that SOX will discourage opportunistic disclosures by sensitizing CEOs to the notion that their behavior around option exercises is under regulatory scrutiny. A second possibility is that SOX will unintentionally encourage opportunistic disclosures as CEOs rely more on this form of opportunism to offset their lost ability to backdate. We compare voluntary disclosures in the pre- and post-sox reporting periods and find that SOX reduces, without eliminating, disclosure opportunism. For the Company Disposition Subsample, however, we find significantly more opportunism in the post-sox period. We interpret this result as an unintended consequence of stricter (backdating) reporting requirements. 8

9 Finally, we examine the content of voluntary disclosures by testing for biases in management earnings forecasts before CEO option exercises. Our evidence confirms that managers issue upward-biased forecasts before exercising their options and selling the underlying shares to third-party buyers. We find no evidence of upward-biased forecasts when the buyer is the CEO s own company. Our study proceeds as follows. In Section 2, we discuss related research and construct our testable hypotheses. In Section 3, we describe our sample selection process and research methodology. In Section 4, we analyze our empirical results; and in Section 5, we summarize and conclude the study. 2. Related Research and Hypotheses Development 2.1. Voluntary Disclosures and Managerial Opportunism Recent research shows that managers use voluntary disclosures in a strategic manner, particularly before specific transactions or corporate events. Cheng and Lo (2006) find that managers increase the number of bad news announcements before they purchase company shares in the market for their personal accounts. Instead of viewing voluntary disclosures as exogenous to the transaction or event, Cheng and Lo (2006) consider management forecasts as a strategic choice variable that allows managers to maximize their insider trading profits. Managers have the incentive to accelerate (delay) the release of bad (good) news announcements in the period before they purchase company shares. Cheng and Lo s (2006) empirical results confirm that managers do not simply trade around pre-determined (i.e., exogenous) management forecasts; instead, 9

10 they actively manipulate the timing of disclosures to fit pre-determined trading objectives. In another related study, Brockman, Khurana, and Martin (2007) show that managers alter the timing and content of voluntary disclosures around stock repurchases in order to acquire company stock at relatively low prices. Managers accelerate (delay) the release of bad (good) news in the 30-day event window immediately before buying back company shares in the open market. They also show that managers alter the content of voluntary disclosures by providing downward-biased earnings forecasts in the prerepurchase period. As expected, managers propensity to engage in such opportunistic disclosure practices is directly related to their ownership interest in the firm. In the context of CEO stock option grants, Aboody and Kasznik (2000) find that CEOs make opportunistic disclosure decisions that maximize their stock option compensation (p. 73). They show that CEOs manage the timing of voluntary disclosures (i.e., accelerating bad news and delaying good news) in an effort to put downward pressure on stock prices before option grant dates. All else equal, lower market prices before option grants lead to lower strike prices and, therefore, higher CEO option-related compensation. Consistent with the previous two studies, Aboody and Kasznik (2000) also show that managers manipulate voluntary disclosures to fit pre-planned corporate events. Based on these studies, we expect that CEOs have both the motive and opportunity to manipulate voluntary disclosures in accordance with their private incentives. Next, we show that stock option exercises present a particularly rich environment in which to extend this line of research. 10

11 2.2. Stock Option Exercises Several studies show that managers engage in opportunistic behavior around stock option exercises. The specific types of opportunistic behavior that have been investigated to date include the use of private information (Carpenter and Remmers (2001), Huddart and Lang (2003), and Aboody, Hughes, and Liu (2006)), the use of earnings management (Bartov and Mohanram (2004)), and the use of backdating (Dhaliwal, Erickson, and Heitzman (2007), Cicero (2007), and Cai (2007)). 5 Although the use of private information to time option exercises and earnings management have important implications for disclosure requirements and corporate governance, the recent research on backdating has more direct implications for our study. In addition, whereas the evidence for exercise timing and earnings management is controversial or limited, the evidence on backdating is unequivocal. 6 The issue of option backdating was first uncovered in the context of option grants (Lie (2005) and Heron and Lie (2007)). In the pre-sox reporting environment, executives had up to 45 days after the company s fiscal year-end to report option grants. Heron and Lie (2007) show that this reporting flexibility gave CEOs ample opportunity to select grant dates with relatively low prices (on an ex-post basis). When SOX reduced the allowable reporting lag to just two business days, previously-documented abnormal return patterns (i.e., abnormally negative returns before grant dates followed by abnormally positive returns after grant dates) were significantly attenuated. 5 Brooks, Chance, and Cline (2006) and Wei (2004) provide additional evidence on private information and earnings management around stock option exercises. 6 Carpenter and Remmers (2001) and Huddart and Lang (2003), for example, come to very different conclusions regarding the degree to which private information can be used to time stock option exercises. Moreover, Bartov and Mohanram s (2004) earnings management evidence is limited to abnormally large option exercises. 11

12 More recently, several researchers have uncovered a similar, yet more nuanced, pattern around CEO stock option exercises. Dhaliwal, Erickson, and Heitzman (2007), Cicero (2007), and Cai (2007) show that the CEO s objective during the exercise of a stock option depends crucially on his intended stock disposition. If the CEO intends to exercise and sell (hold) the underlying shares, then he has an incentive to increase (decrease) stock prices in the pre-exercise period. All three studies find evidence that the CEO s backdating behavior is driven by his intended share disposition. That is, CEOs backdate their option exercises to periods of high (low) stock prices when they intend to implement exercise-and-sell (exercise-and-hold) strategies. 7 In this study, we employ a parallel framework to examine voluntary disclosures. Just as the above studies use the CEO s intended disposition of exercised shares to test for backdating, we use the CEO s stock disposition to test for opportunistic disclosures Hypotheses Our testable hypotheses build on the conceptual framework and empirical results of the voluntary disclosure literature and the executive stock option literature. The first two hypotheses link the timing and content of the firm s voluntary disclosures to the CEO s private incentives regarding share dispositions. H1: Firms will accelerate (delay) the release of good (bad) news in the preexercise period when CEOs exercise stock options and immediately sell their underlying shares. H2: Firms will accelerate (delay) the release of bad (good) news in the preexercise period when CEOs exercise stock options and hold their underlying shares. 7 In the pre-sox reporting environment, executives had up to 10 days after the month of their exercise decision to report the exercise date. In the post-sox period, they have just two business days. Similar to the option grant patterns, when SOX reduced the allowable reporting lag to just two business days, previously-documented abnormal returns were significantly reduced. 12

13 The empirical implication of the first hypothesis is that voluntary disclosures will generate abnormally-positive announcement returns around management forecasts in the pre-exercise period when CEOs implement exercise-and-sell strategies. In contrast, the second hypothesis implication is that voluntary disclosures will generate abnormallynegative announcement returns when CEOs implement exercise-and-hold strategies. The third hypothesis focuses on the specific disposition of exercise-and-sell strategies in greater detail. Our data allow us to distinguish between two types of dispositions: sales to third parties (i.e., on stock exchanges or in private sales), and sales back to the CEO s company. The widespread use of backdating in third party dispositions is unlikely since the third party would have to accept an above-market purchase price. If the CEO is constrained from backdating, then he might be more willing to engage in the opportunistic use of voluntary disclosures. H3: The CEO s use of opportunistic disclosures in the pre-exercise period is stronger for third-party dispositions than for company dispositions. The empirical implication of this hypothesis is that the frequency of abnormally-positive management forecasts will be greater for the Market or Private Sale Subsample than for the Company Disposition Subsample. Our fourth hypothesis examines the relation between voluntary disclosures and the magnitude of the CEO s private incentives. We expect a positive relation between opportunism and stock option values. H4: The degree to which CEOs engage in opportunistic disclosures is positively related to the underlying value of exercised stock options. 13

14 The empirical implication of this hypothesis is that the frequency and magnitude of good (bad) news voluntary disclosures will be positively related to the value of the CEO s underlying stock options in exercise-and-sell (exercise-and-hold) transactions. In addition, we also test the consequences of SOX reporting requirements on voluntary disclosure practices. Unlike in the hypotheses above, however, we do not have strong priors with respect to empirical outcomes. It is possible that SOX reduces opportunistic disclosures as managers become more aware of and sensitive to regulatory oversight. It is also possible that by restricting the use of backdating, SOX could inadvertently encourage the use of opportunistic disclosures. We therefore treat the expected impact of SOX on voluntary disclosures as an open empirical issue. Our final hypothesis examines the content of voluntary disclosures prior to CEO option exercises. More specifically, we expect an optimistic bias in voluntary disclosures when CEOs undertake exercise-and-sell strategies, and a pessimistic bias when they undertake exercise-and-hold strategies. H5: The content of voluntary disclosures will be positively (negatively) biased in the pre-exercise period when CEOs exercise stock options and sell (hold) their underlying shares. Our investigation analyzes the content of management earnings forecasts to determine whether these forecasts are upwardly (downwardly) biased in the period before CEOs exercise-and-sell (exercise-and-hold) decisions. 14

15 3. Sample Selection and Methodology 3.1. Sample Selection We form our sample from the intersection of (a) Thomson Financial Network Insider Filing Data which contains CEO option exercise data, (b) First Call database which contains management forecasts, (c) the merged Compustat annual industrial file, including the primary, secondary, tertiary, and full coverage research files, and (d) the return files from the Center for Research in Security Prices (CRSP). Moreover, we obtain CEO annual compensation data from Compustat ExecuComp. We construct our initial sample from the Thomson Financial Network Insider Filing Data database. This database provides information on insider transactions compiled from Forms 3, 4, 5, and 144 filed with the SEC. 8 Following Aboody and Kasznik (2000), our sample includes options exercised by individuals who indicate their highest title as CEO. We treat multiple exercises by the same CEO on the same day as a single observation. We include all option exercises with the following codes: ISO (Incentive Stock Options), Call (Call Options), DIRO (Director s Stock Options), EMPO (Employee Stock Options), NONQ (Non-qualified stock options), and OPTNS (options). We exclude any option exercises where the disposition is pursuant to a tender of shares in a change of control transaction, or those where the exercise is by will or laws of decent or distribution. Our exercised stock option sample spans the period from January 1, 1996 to June 30, 2006 and contains a total of 40,541 observations. 9 8 Insiders are required to file Form 3 to report initial beneficial ownership of shares, Form 4 to report changes in beneficial holdings, Form 5 to report annual changes in beneficial ownership and Form 144 to declare their intention to sell restricted shares. 9 The sample period begins on January 1, 1996 because this is the first date when data regarding the sale of underlying option shares are first available. The sample period ending date is chosen to coincide with the availability of voluntary disclosure data from First Call. 15

16 Next, we obtain management forecasts from the First Call database. The First Call database covers management forecasts for June 1994 through June Following Cheng and Lo (2006), we include all management forecasts, whether they are for earnings or other summary measures such as cash flows or revenues and whether the forecasts are for quarterly or annual periods. 10 Moreover, we treat multiple forecasts by the same firm on the same day (e.g., an earnings forecast for next quarter and for next year) as a single forecast event. As in Cheng and Lo (2006) and Brockman, Khurana, and Martin (2007), we distinguish between good news forecasts and bad news forecasts by focusing on abnormal stock returns around management forecasts. We obtain daily returns from CRSP and calculate the abnormal returns as the excess returns over the CRSP value-weighted index over the three-day window [-1, 1] around management forecasts. If the abnormal return is positive (negative), we classify the forecast as good news (bad news). We then merge management forecasts with option exercise data by requiring that for a firm to stay in our sample, it issues at least one management forecast within 30 days prior to an option exercise. The process results in a sample of 9,021 CEO stock option exercises from 1,925 unique firms. We then obtain management forecasts for this set of firms in periods other than the event windows during our sample period June 1994 to June By constructing the sample in this way, we are able to compare 10 Cheng and Lo (2006) note that over 99 percent of the forecast days in their sample contain an earnings forecast. 11 If a management forecast corresponds to multiple dates of option exercises for the same CEO, we treat this management forecast as one observation rather than multiple observations. For example, suppose that a CEO exercises her options on July 4 and July 12 of 2006, and that her firm issued a management forecast on July 1, This management forecast would fall in the event window of both option exercises, and we treat the forecast as one observation to reduce option-exercise clustering effects. 16

17 management forecasts within the event windows with those outside the event windows to detect any systematic difference in forecast news. Furthermore, we merge our data with Compustat and CRSP to get financial variables and returns, and impose the following selection criteria at the firm level: (1) must have the financial variables available to conduct multivariate regression analyses from the Compustat annual industrial file, and (2) must have returns data available from the Center for Research in Security Prices (CRSP). Given our interest in examining how firms strategically manage information flows, our focus is on management forecasts before CEO option exercises. Our hypotheses posit that CEOs disclosure policies will reflect the private incentives of their intended stock dispositions. Following Cicero s (2007) classification scheme, we separate option exercises into one of three (mutually-exclusive) categories based on the stock disposition: (1) exercises accompanied by a same-day private or market sale of the underlying stock (Market or Private Sale Subsample), (2) exercises accompanied by a same-day disposition of shares to the company only (Company Disposition Subsample), and (3) exercises not accompanied by same-day disposition of shares (No Disposition Subsample). The first two subsamples represent exercise-and-sell strategies, and the third subsample represents an exercise-and-hold strategy. 12 For each subsample, we compare management forecasts issued within a 30-day event window prior to the option exercise 12 Following Cicero (2007), we define the No Disposition Subsample to include options that are exercised without an immediate sale of the shares. Here we only require that the CEO holds the shares for at least one day after exercise. The rationale for this definition is to categorize exercises based only on executives revealed intentions as of the day of exercise. If the No Disposition definition were to require a longer holding horizon it might introduce a bias because the CEO s decision to hold shares over a longer period is based on a constantly-changing information set. Requiring that the executive only hold shares for one day, however, is not subject to this bias. Also, any noise that this definition introduces into the classification process should only work against our finding the hypothesized results. 17

18 date relative to all other management forecasts issued outside the 30-day event window by the same sample firms over the period. Table 1 provides details for our three subsamples. During the 30-day event window prior to option exercises, we identify 2,452 management forecasts for the Market or Private Sale Subsample, 604 management forecasts for the Company Disposition Subsample, and 880 management forecasts for the No Disposition Subsample. These event-window management forecasts are made by 941, 368, and 616 unique firms across the three subsamples, respectively. Also associated with the three groups of unique firms, we identify 17,611, 7,494, and 10,276 management forecasts, respectively, during our sample period that fall outside of the 30-day window prior to option exercises. Thus, we have a total of 20,063, 8,098, and 12,156 management forecasts for the three subsamples. From these management forecasts, 10,336 (9,727) are classified as good (bad) news for the Market or Private Sale Subsample; 3,988 (4,110) are classified as good (bad) news for the Company Disposition Subsample; and 6,058 (6,098) are classified as good (bad) news for the No Disposition Subsample There are significant differences between our sample and that in Cheng and Lo (2006). Their sample includes insider trades from officers and directors over the period , while our sample is restricted to CEO buys and sells associated with stock option exercises over the period There is no overlap between our purchase-related No Disposition Subsample and their insider purchase sample since Cheng and Lo (2006) exclude all purchases of shares through the exercise of options (p. 826). Where there is some overlap between our respective samples (i.e., on the sell side), Cheng and Lo (2006) find no evidence of opportunistic disclosures for their insider sale sample. During our sample period, CEOs sold a total of 10.8 billion shares worth approximately $693 billion. The related figures for CEO sales that are related to option exercises are 2.5 billion shares and $97 billion. Combining our results with those of Cheng and Lo (2006) suggests that managerial opportunism is concentrated in the stock option exercise subsample of CEO sales. 18

19 3.2. Research Design Testing Hypotheses 1 and 2 We follow Cheng and Lo (2006) and Brockman, Khurana, and Martin (2007) and estimate two models to examine how CEOs strategically time information flows prior to option exercises. In the first model, the dependent variable is an indicator variable (GN) which is equal to 1 if the management forecast is classified as good news, and 0 otherwise. As noted previously, positive abnormal returns during the three-day window [- 1, 1] around management forecasts are used to classify the forecast as good news. In the second model, the dependent variable is a continuous variable (SRET) which is the abnormal return over a three-day window [-1, 1] around management forecasts. GN captures the frequency (or percentage) of good news versus bad news around management forecasts, whereas SRET captures the magnitude of good news versus bad news around management forecasts. Specifically, we estimate the following models: 14,15 Pr(GN t ) = α + β 0 EXERCISE t + β 1 LOG_MKT t-1 + β 2 MB t-1 + β 3 ROE t-1 + β 4 ABRET t-1 + ε t (1) where SRET t = α + β 0 EXERCISE t + β 1 LOG_MKT t-1 + β 2 MB t-1 + β 3 ROE t-1 + β 4 ABRET t-1 + ε t (2) EXERCISE = 1 when management earnings forecast fall within the event window (30 days prior to option exercise); and 0 otherwise; LOG_MKT = natural logarithm of market value as of the fiscal year preceding the date of the management forecast; MB = market to book ratio as of the fiscal year preceding the date of the management forecast; ROE = return on equity as of the fiscal year preceding the date of the management forecast; and 14 For brevity, we suppress firm subscripts i. 15 We also estimate models (1) and (2) with industry (based on two-digit SIC codes) and year fixed effects. The results of these alternative specifications are quantitatively similar to those reported herein. 19

20 ABRET = cumulative abnormal returns computed as the excess firm returns over the CRSP value weighted index during the three months ending two days before the issuance of management forecast. We use robust logistic regressions clustered by year and industry (based on twodigit SIC codes) to estimate model (1). 16 We use pooled OLS with Roger s (1983, 1993) robust standard errors clustered by year and industry to estimate model (2). In both regression models, we control for several other variables that may affect our dependent variables. We control for the size of the firm (LOG_MKT) because larger firms are generally associated with greater availability of value-relevant information. We also control for growth opportunities by using the market-to-book ratio (MB) in the regression. The return on equity (ROE) captures firm performance and is included because forecast type may be related to firm performance when asymmetric information is present. Moreover, we include a cumulative abnormal returns variable (ABRET) to control for the momentum effect. In terms of our predictions, EXERCISE is the main variable of interest. We expect CEOs to release more good news during periods prior to option exercise when they intend to implement an exercise-and-sell strategy. Consistent with our first hypothesis, we expect the EXERCISE coefficient in models (1) and (2) to be positive and significant for both the Market or Private Sale Subsample and the Company Disposition Subsample. In contrast, we expect managers to release more bad news prior to option exercise when they intend to implement an exercise-and-hold strategy. 16 We also use robust logistic regressions clustered by firm to estimate model (1) and use pooled OLS with Roger s (1983, 1993) robust standard errors clustered by firm to estimate model (2). The results are quantitatively similar to those reported herein. 20

21 Consistent with our second hypothesis, we expect the EXERCISE coefficient in models (1) and (2) to be negative and significant for the No Disposition Subsample Testing Hypothesis 3 Hypothesis 3 posits a difference in voluntary disclosures between the two exercise-and-sell subsamples. To examine this hypothesis, we expand models (1) and (2) with a dummy variable, MP, to distinguish the two subsamples and its interaction with the variable EXERCISE: Pr(GN t ) = α + β 0 EXERCISE t + β 1 MP t + β 2 MP t * EXERCISE + β 3 LOG_MKT t-1 + β 4 MB t-1 + β 5 ROE t-1 + β 6 ABRET t-1 + ε t (3) SRET t = α + β 0 EXERCISE t + β 1 MP t + β 2 MP t * EXERCISE + β 3 LOG_MKT t-1 + β 4 MB t-1 + β 5 ROE t-1 + β 6 ABRET t-1 + ε t (4) Where MP = 1 if an observation is from the Market or Private Sale Subsample, 0 if an observation is from the Company Disposition Subsample, and other variables are as defined before. We pool the Market or Private Sale and the Company Disposition subsamples and estimate models (3) and (4). We also estimate models (3) and (4) based on an event sample with only those management forecasts that fall within the event window. The interaction between EXERCISE and MP is our primary variable of interest for the pooled subsamples, while MP is the variable of interest for the event sample. We expect the coefficients on both terms to be positive and significant Testing Hypothesis 4 To test our fourth hypothesis, we augment models (1) and (2) with the value of CEO exercised stock options as an additional independent variable: 21

22 Pr(GN t ) = α + β 0 VALUE t + β 1 LOG_MKT t-1 + β 2 MB t-1 + β 3 ROE t-1 + β 4 ABRET t-1 + ε t (5) SRET t = α + β 0 VALUE t + β 1 LOG_MKT t-1 + β 2 MB t-1 + β 3 ROE t-1 + β 4 ABRET t-1 + ε t (6) where VALUE = {(stock price at exercise date minus strike price) times the number of options exercised} divided by the CEO s total annual compensation. All other variables are as defined previously. We estimate models (5) and (6) using the three subsamples with only eventwindow observations to facilitate the cross-sectional comparison in terms of option value. If a management forecast corresponds to multiple dates of option exercises, we sum up the total value of the options exercised on the multiple dates. In both models (5) and (6), our primary variable of interest is VALUE. As stated in hypothesis 4, we argue that the larger the value of stock options that the CEO exercises, the stronger his propensity to alter information flows prior to the exercise. Thus, we expect the coefficient on the VALUE to be positive and significant for the two exercise-and-sell subsamples, and negative and significant for the exercise-and-hold subsample Testing Hypothesis 5 To examine our final hypothesis, we follow Ajinkaya et al (2005) in estimating the following model(s): BIAS1 (BIAS2) = α + β 0 EXERCISE t + β 1 LOG_MKT t-1 + β 2 MB t-1 + β 3 LITIGATION t-1 + β 4 LOSS t-1 + β 5 EARVOL t-1 + ε t (7) Where BIAS1 = (management forecast of earnings per share (EPS) predicted 17, 18 quarterly EPS)/price at the beginning of forecast month. 17 Predicted quarterly EPS is the predicted value from an EPS time-series model. More specifically, we use the one year lagged EPS for the same quarter as the predictor for the current quarter EPS. We use predicted EPS rather than actual EPS because Bartov and Mohanram (2004) find that managers inflate pre-option exercise earnings to increase the cash payout of option exercises. To the extent that both management 22

23 BIAS2 = (management forecast of earnings per share (EPS) Predicted quarterly EPS)/ absolute value of management forecast of earnings per share. LITIGATION = 1 for all firms in the biotechnology (SIC code and ), computers (SIC code and ), electronics (SIC code ), and retail (SIC code ) industries, and 0 otherwise. LOSS = 1 if the firm reported losses in the current period, and 0 otherwise. EARVOL = standard deviation of quarterly earnings over 12 quarters ending in the year before management forecast, divided by median asset value over the 12 quarters. All other variables are as defined previously. We estimate model (7) for all three subsamples, using both BIAS1 and BIAS2 as the dependent variable. Consistent with hypothesis 5 we expect an upward bias in management s forecasted EPS when CEOs subsequently exercise stock options and sell the underlying shares, and a downward bias when CEOs subsequently exercise stock options and hold the underlying shares. Our primary independent variable of interest is again EXERCISE, and we expect a positive coefficient on this variable for the exerciseand-sell subsamples, and a negative coefficient for the exercise-and-hold subsample. 4. Empirical Results 4.1. Descriptive Statistics Table 2 reports the descriptive statistics for variables used in the three subsamples. Descriptive statistics for all variables in Table 2 are similar across the three subsamples with few exceptions. We therefore limit our discussion to the Market or Private Sale Subsample. Approximately 12.2 percent of management forecasts are issued forecasts and actual earnings are inflated, our tests might not be able to capture opportunistic forecast behavior even when it exists. 18 Our results are not altered if we use one- or two-year lagged EPS values. 23

24 30 days prior to the option exercise date, which implies that about 87.8 percent of management forecasts are outside the event window. The average three-day abnormal return around management forecasts is -0.4 percent, which varies from -4.2 percent for the lower quartile to 4.5 percent for the upper quartile. The negative mean return is driven by larger negative abnormal returns around bad news forecasts. The average abnormal return for good news forecasts is 6 percent, while the average abnormal return for bad news forecasts is -7.1 percent. Overall, our results are consistent with Cheng and Lo (2006) and Brockman, Khurana, and Martin (2007) who find that management forecasts are associated with negative abnormal returns, on average. Market or Private Sale Subsample firms have a mean market value of $8.216 billion and a mean market-to-book ratio of The mean return on equity (ROE) is 14.5 percent, and the mean abnormal returns during the three months preceding the issuance of management forecasts is 3.5 percent. Our sample firms are, on average, larger and more profitable than the sample firms in Cheng and Lo (2006), who report mean market values of $362 million and ROE of 6 percent. However, our sample firms are smaller than those in Brockman, Khurana, and Martin (2007), who focus on the relation between voluntary disclosures and stock repurchases. Their sample firms have an average market value exceeding $10 billion, and an average ROE between 16 and 17 percent. Consistent with Cicero (2007), firm size is relatively larger for the Company Disposition Subsample than for the other two subsamples. 24

25 4.2. Univariate Results In Table 3, we present univariate test results that examine hypotheses 1 and 2: do CEOs use voluntary disclosures opportunistically prior to option exercises? In panel A, we segregate management forecasts for each subsample by news type (good versus bad) and whether the management forecast falls inside or outside of the option exercise event window. For both of the exercise-and-sell subsamples we find that the percentage of good news disclosures is greater for management forecasts issued 30 days prior to the option exercise than it is for management forecasts issued outside of the event window. For the Market or Private Sale Subsample, 64 percent of management forecasts issued during the 30-day event window are good news, compared to only 49 percent of management forecasts issued outside the event window (χ 2 -statistic=177.36). For the Company Disposition Subsample, the percentage of good news forecasts is 58 percent for the event sample versus 49 percent for the non-event sample (χ 2 -statistic=19.02). In contrast, we find that bad news disclosures are more frequent during the event period preceding No Disposition subsample exercises when compared to forecasts issued outside of the event window (55 percent versus 50 percent, respectively). All results are consistent with the hypothesis that managers alter voluntary disclosures prior to exercising options in order to fit specific disposition strategies. In Panel B of Table 3, we report average abnormal returns around management forecasts across all three subsamples for both event and non-event periods. For the Market or Private Sale subsample, the average abnormal return around event-window management forecasts is 2.33 percent, while abnormal returns around management forecasts outside the event window are percent (both are statistically significant at 25

26 the.01 level). The difference in abnormal returns between event-window management forecasts and non-event-window management forecasts is 3.12 percent and is statistically significant at the.01 level. For the Company Disposition subsample, average abnormal returns within and outside of the event window are 0.14 and percent, respectively. The difference in these abnormal returns is 0.92 percent (significant at the.01 level). For the No Disposition Subsample, the average abnormal returns within and outside of the event window are and percent, respectively. The difference in abnormal returns of percent is negative and statistically significant at the.01 level. Univariate results support our first two hypotheses by showing that CEOs release relatively more good news prior to option exercises, both in terms of frequency and magnitudes, when they intend to implement an exercise-and-sell strategy. In sharp contrast, CEOs release relatively more bad news prior to option exercises, both in terms of frequency and magnitudes, when they intend to implement an exercise-and-hold strategy. Moreover, univariate statistics presented in both Panel A and Panel B suggest that the opportunistic behavior of CEOs is stronger when they sell underlying shares to a third party rather than to their company Multivariate Results In Table 4, we present multivariate regression results for the three subsamples that test hypotheses 1 and 2, while controlling for other firm characteristics that potentially affect management forecasts. Our primary variable of interest across all three regressions is EXERCISE. In Panel A, we report the logistic regression results based on model (1), and find that the EXERCISE coefficients are positive and statistically significant at the 19 We present formal statistical tests for the difference in association between good news and event windows for the Market or Private Sale subsample and Company Disposition subsample using a multivariate setting in Table 7. 26

27 .01 level for both of the exercise-and-sell subsamples. These results show that managers release positive information prior to option exercises when they intend to sell the underlying stock. We also show that, consistent with expectations, the EXERCISE coefficient for the Market or Private Sale Subsample (0.594) is over 1.55 times larger than the EXERCISE coefficient for the Company Disposition Subsample (0.381). In contrast, we find a negative and significant EXERCISE coefficient for the No Disposition Subsample. This result shows that managers release more negative information prior to option exercises when they intend to hold the underlying stock. As for the control variables, we find negative but insignificant coefficients on firm size (LOG_MKT) for the Market or Private Sale and No Disposition Subsamples, and a positive and marginally significant coefficient (at the.10 level) for the Company Disposition Subsample. The coefficient on market-to-book ratio (MB) is negative and statistically significant at the.05 level across all the three subsamples, suggesting that growth firms tend to have higher frequency of bad news. The return on equity (ROE) coefficient is insignificant for the Market or Private Sale and No Disposition Subsamples. It is positive and marginally significant (at the.10 level) for the Company Disposition Subsample. The coefficient on ABRET is positive and statistically significant at the.01 level across all the three subsamples, which is consistent with notion that stocks with positive abnormal returns in one period continue to earn positive abnormal returns in the near future. In Panel B of Table 4, we report OLS regression results based on model (2). The coefficient on EXERCISE is positive and statistically significant at the.01 level for both the Market or Private Sale and Company Disposition Subsamples, and negative and 27