The Structure of Executive Compensation Contracts: UK Evidence

Long Range Planning 33 (2000) 478-503

www.elsevier.com/locate/lrp

The Structure of Executive Compensation Contracts: UK Evidence Martin J. Conyon, Simon I. Peck, Laura E. Read and Graham V. Sadler

In this article we examine CEO stock option contracts using UK data for the 1997 fiscal year. We show how the portfolio of options varies with firm wealth; describe the structure of the contract (in terms of vesting criteria related to performance targets); and illustrate whether the option performance criteria is historically ‘demanding’. Finally, we show how the pay–performance term varies with the structure of the option contract. Our new evidence shows the complex structure of UK option contracts for CEOs. We augment this data with rich interview data to show the complexity of CEO compensation contracts and how they are set. 쎻 c 2000 Elsevier Science Ltd. All rights reserved.

Martin J. Conyon is Assistant Professor at the Wharton School, University of Pennsylvania, US. He has taught at Oxford and Warwick Universities, UK. His research interests include corporate governance and incentives in organisations. Simon I. Peck is a Research Fellow at City University Business School, London, and visiting fellow at University St Gallen, Switzerland. He was

Introduction In this article we examine the nature of CEO compensation in UK listed companies for the 1997 fiscal year. In spite of the importance of stock options, and the controversy that they generate in public policy and media debates, little academic evidence exists detailing their importance in executive compensation contracts. In this article we provide evidence on the complexity of CEO compensation contracts using UK data. In addition, we canvass the views of senior management on the importance of the structure of pay packages for motivating executives. We use two complementary methods to probe and understand UK executive compensation contracts. The first method uses quantitative procedures to detail the structure of CEO compensation contracts in 200 large UK companies, answering the question, “what do compensation contracts look like?” Since the pub0024-6301/00/$ - see front matter 쎻 c 2000 Elsevier Science Ltd. All rights reserved. PII: S 0 0 2 4 - 6 3 0 1 ( 0 0 ) 0 0 0 5 4 - 6

lication of the Greenbury report1 companies have been disclosing increasing amounts of information in relation to UK executive compensation contracts, and this has afforded us a particularly rich data set, allowing us to calculate precisely the different components of executive ownership of equity assets. The second method uses qualitative procedures to answer the question, “why do compensation contracts look the way they do?” The former quantitative method allows us to get at the structure of compensation contracts for a relatively large cross-section of companies (in other words, the general case). The second qualitative method allows us to understand the underlying motivation behind choosing particular compensation arrangements for a smaller set of companies (some specific cases). Our article makes a number of contributions to the recent executive compensation and finance literature. Firstly, we detail the compensation received by UK CEOs, breaking it down into its primary components. We discuss the relationship between remuneration committees and providers of information such as external remuneration consultants. We highlight the empirical importance of stock options in CEO compensation contracts, and we distinguish between option compensation (the value of the current grant of options) and option wealth (the value of the portfolio of options held). Secondly, as non-cash elements of pay, particularly stock option plans, are now firmly part of the UK executive pay-setting scene, we show how sensitive the stock option portfolio is to changes in shareholder wealth (measured as firm stock market value)—the direct pay-for-performance link. CEO financial incentives from holding options are calculated as the slope of the Black–Scholes function (the so called ‘option delta’ used by finance economists) multiplied by the fraction of total outstanding options on common equity expressed as a percentage. This is termed the “stock option pay-for-performance term”. We can calculate this since (due to disclosure requirements following the Greenbury report1) we have complete information on the input variables to the Black–Scholes pricing formula. Thirdly, unlike US CEO option contracts, the stock options received by UK CEOs are often subject to performance criteria prior to vesting. That is, the right to exercise the executive options is contingent upon the achievement of company performance targets, and not simply elapsed time. This is an interesting institutional difference between the US and the UK. We detail the distribution of CEO stock options that are contingent upon performance criteria and illustrate what these performance criteria are. We also indicate the views of directors on this issue. Fourthly, the policy and media debate on stock options has argued that companies should make stock option awards contingent upon ‘demanding’ or ‘rigorous’ performance criteria in order to strengthen the link between pay and performance. It is, we believe, a priori difficult to practically specify what is “demanding” or “not demanding”. Instead, we document what the performance standard used by firms actually is and then

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previously at Warwick and Leeds Universities, UK. Corresponding address: City University Business School, 24 Chiswell Street, London EC1Y 4TY, UK. E-mail: [email protected] Laura E. Read is an Enterprise Fellow at Warwick University and founder of theUKHighStreet.com. She is completing a Research Fellowship at Warwick University on human resource practices and corporate performance. Graham V. Sadler is a Research Fellow at the Univeristy of Warwick. His research interests include corporate governance and economic performance. He previously worked as an investment analyst.

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as stock options are now part of the UK scene we calculate the direct pay-forperformance link

evaluate the likelihood that companies will achieve or better this goal. Again, we use our qualitative interview data to analyse directors’ views on this issue. Finally, we model the stock option pay–performance term. We test whether the sensitivity of the CEO stock option portfolio to firm wealth varies with the percentage of stock options held by the CEO that are performance related (along with other potentially important control variables). The idea we probe is that companies that are using performance criteria in option contracts link executive compensation more closely to company performance. The rest of the article is organised as follows: we outline our research design on executive compensation and incentives. This is followed by a discussion of the sample and data collection. The richness of the data is unique for the UK and allows us to address the above option issues that have been unexplored (using both quantitative and qualitative measures). In the section on UK executive compensation contracts, we suggest a motivation and offer a discussion of the results. This includes (i) data on CEO compensation and, in particular, the value of stock options; (ii) evidence on how the portfolio of options varies with firm wealth—the pay-for-performance sensitivity; (iii) the performance criteria attached to CEO stock options; (iv) an assessment of whether such performance criteria are “demanding”; and (v) an evaluation as to whether the pay–performance term is determined by the fraction of CEO stock options that are related to company performance. Finally, we offer some concluding remarks.

CEO compensation and incentives Executive compensation in the UK is typically comprised of the following elements: a base salary, an annual bonus element (typically related to accounting measures of performance), and long-term pay.a Long-term pay consists of share (or stock) options and long-term incentive plans (LTIPs) (Fig. 1). Stock options consist of the right (but not the obligation) to purchase shares at a fixed price at some date in the future. Executive options typically vest (can then be exercised) three years after the date they are granted and usually have terms, that is the period between the date they are granted and the last date on

a There are, of course, some residual benefit incomes but these are a tiny fraction of overall pay.

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Fig. 1. The components of average UK executive compensation

The Structure of Executive Compensation Contracts

Exhibit 1. Valuation of executive stock options In common with the US literature on executive compensation, we value CEO stock options according to the Black–Scholes2 pricing formula adjusted for continuously paid dividends. The standard Black–Scholes Eq. (1) calculates the value c of a single European call option as: c = SeqTN(d1) ⫺ Xe ⫺ rTN(d2)

(1)

where d1 =

ln(S/X) + T(r⫺q + σ2/2) σT1/2

and d2 =

ln(S/X) + T(r⫺q⫺σ2/2) . σT1/2

The six necessary inputs to the function are the share price S, the exercise or strike price X, the time to maturity T, the dividend yield q, the risk-free rate of interest r and the standard deviation of returns on the share σ.N( ) is the cumulative probability distribution function for a standardised normal variable. The terms S, q, r, and σ are all common to the firm, whereas the inputs X and T vary within the company across different option tranches. The value of an executive option tranche is simply the product of the call value and the number of options in the tranche. Since executives can hold many tranches of options, to accurately value the stock of share options held, each tranche needs to be valued separately and then the sum over all the tranches taken. The data that we use allows us to do this. We have information on all the inputs to the Black–Scholes function for each of the separate option tranches. To calculate total annual pay (as opposed to the CEO wealth from his portfolio of options) it is only necessary to value the grant of options in the current fiscal year. We note as important, however, that the valuation of executive options according to the Black–Scholes method is not without consequences. For example, unlike financial options, executive stock options are inalienable and the recipient of the option is risk averse. The implications of this for executive option valuation are considered by Murphy,3 Conyon and Murphy,4 Conyon and Sadler5 and Hall and Murphy.6

which they may be exercised, of between seven and ten years. LTIPs, on the other hand, consist of the award of free shares to be received at some future date contingent on various performance criteria. Our goal in this article is to unearth the compensation strategy pursued by firms by making clear the structure (or mix) between the various compensation elements. We have used the Black–Scholes pricing formula, adjusted for continuouly

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paid dividends, to value CEO stock options. This is explained in more detail in Exhibit 1.

ownership of equity provides a direct mechanical link between CEO and shareholder wealth

Executive incentives and shareholder wealth Executive compensation research treats CEO and executive incentives as the change in executive rewards brought about by a change in company performance. The performance measure is typically shareholder wealth.7 Most prior UK-based research has estimated incentives as the relationship between cash compensation and shareholder returns (more specifically, the slope coefficient in a panel data compensation equation of the log of cash compensation on total shareholder returns). It has also been shown that this relationship is small and often difficult to establish empirically.8 However, the link between cash compensation and shareholder returns demonstrates only an implicit link between one component of pay (namely cash in the form of salaries and bonuses) and shareholder returns. By comparison, executive ownership of equity assets provides a direct and mechanical link between CEO and shareholder wealth.9 It has been established using US data that the direct pay–performance link is much greater than the implicit (cash) pay–performance relation.10 Our approach treats the executive ownership of equity assets as made up, potentially, of three components: direct share ownership, share options and LTIPs. We focus on the direct incentives from equity contracts (namely the direct ownership of equity and equity held under option plans or LTIPs). We are able to compute the aggregate pay–performance sensitivity (PPS) term as follows (expressed as a percentage):

PPS=

shares held (options held)δoption (LTIP shares)δLTIP + + firm shares firm shares firm shares (2)

This equation is derived from Conyon and Murphy4 and decomposes the aggregate pay-for-performance term into three elements, each expressed as a percentage of the total firm shares. These are, from right to left of the right-hand side of Eq. (2), the effects of direct share ownership, share options and LTIPs respectively.

Direct share ownership effect The first term on the right-hand side of the equation gives the incentives from holding equity. If a CEO holds 5 per cent of the common equity and shareholder wealth increases by £100, then the CEO receives £5 of that increase. This 5 per cent is the “sharing rate” or “effective ownership” arising from a change in shareholder wealth that is translated into executive equity wealth. 482

The Structure of Executive Compensation Contracts

Share option effect The second term on the right-hand side of Eq. (2) is the option pay–performance term. In the empirical work below it forms the focus of our attention. The sharing rate for share options is not simply the percentage of outstanding options on common equity, since the change in value of the share option is not one-for-one with the change in the share price. This is clear from the Black– Scholes pricing Eq. (1). The derivative of the call value with respect to the price of the underlying asset is the delta of the option (δoption). For a European call on a share paying continuous dividends this is given as δoption=e⫺qTN(d1). The option delta varies between zero and one. Deep-in-the-money options (where the share price is way in excess of the exercise price) have deltas that are close to unity, whereas deep-out-of-the-money options have deltas close to zero.11 CEOs who only hold deep-out-ofthe-money options will, independent of the fraction of options on outstanding equity held, have low pay–performance sensitivities. CEOs hold many tranches of options and so it is necessary to calculate a pay–performance/sharing rate term for each tranche separately. These are then summed to arrive at the total pay– performance sensitivity from options. Alternatively, this can be thought of as the product of the share-weighted option delta and the ratio of outstanding options on common equity expressed as a percentage. Implicitly, accurate incentive calculation requires knowledge of the Black–Scholes inputs for each option tranche separately. Long-term incentive plan effect The third term in Eq. (2) represents the incentives from longterm incentive plan (LTIP) grants. These are the allocation of equity that is subject to performance criteria prior to vesting. LTIP shares are not equivalent to unrestricted shares, since they are potentially subject to forfeiture if certain employment and performance objectives are not achieved. Potentially, we can weight each LTIP share by an “LTIP delta” (δLTIP), which is a measure of the change in value of each LTIP share for an incremental change in the share price. Calculating analytical LTIP deltas for performance-contingent grants is potentially complicated and as a simplification we assume an LTIP delta of one, independent of performance-vesting contingencies. Clearly, future research would want to probe the validity of this assumption.

Research method and executive compensation data In this article we use two complementary methods to study UK executive compensation contracts. The first method uses quantitative procedures to detail the structure of CEO compensation contracts in 200 large UK companies in the 1997 fiscal year. This procedure answers the question, “what do compensation con-

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Greenbury disclosure requirements allow us to see what compensation contracts look like

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tracts look like?” The second method uses qualitative procedures to understand executive compensation contracts. This procedure answers the question, “why do compensation contracts look the way they do?” The former quantitative method allows us to get at the structure of compensation contracts for a relatively large cross-section of companies (in other words, the general case). The second qualitative method allows us to understand the underlying motivation behind choosing particular compensation arrangements for a smaller set of companies (some specific cases). Since the publication of the Greenbury report1 companies have been disclosing increasing amounts of information in relation to UK executive compensation contracts.12 In our data set we have the necessary information on all input variables to the Black– Scholes function for each separate tranche of options. Accordingly we can calculate precisely the components of Eq. (2)—but especially the option part of the PPS term. The primary (quantitative) sample consists of the largest 200 listed companies in the fiscal year 1997, ranked by market capitalisation, that satisfied the following selection criteria. Firstly, companies were excluded if they had not disclosed full information on all of the CEO’s option holdings. Secondly, companies not listed since 1st January 1990 were excluded; this is because we wanted to examine performance criteria associated with options, and so require a time-series element to the company performance data. Other inputs to the Black–Scholes function were collected (such as the interest rate, dividend yield and stock price volatility). The risk-free interest rate is measured as the five-year UK Euro-Sterling (middle rate) ruling at the company’s financial year-end date. The dividend yield represents the average of the daily dividend yields recorded on the first day of each of the preceding 48 months. Similarly, the volatility is estimated using four years of historical share price data. Monthly returns are calculated and these are used in turn to determine the annual volatility. Interest rates, dividend yields and share price data were all collected from Datastream. For each tranche of options held by the CEO, an indicator variable was added to show if the exercise of that particular tranche was conditional on the achievement of any performance criteria. Each tranche of options was assumed not to have any such criteria attached unless the annual report specifically stated otherwise. We also collected data to identify which specific performance measure the exercise of the options was conditional on, for example earnings per share or total shareholder return. In addition, the total number of outstanding options held by the CEO was collected and split into three categories: those held under save as you earn (SAYE) schemes; those held under executive option schemes but not subject to any performance criteria; and lastly, those held under executive schemes which were subject to performance criteria. Information was also collected on whether grants were still

The Structure of Executive Compensation Contracts

being made under an executive option scheme, or whether such schemes had been superseded or perhaps augmented by an alternative long-term incentive plan (LTIP). Finally, annual earningsper-share figures were collected for the sample companies for the eight-year period starting in 1989. This was in order to benchmark performance standards in CEO option contracts against actual performance data. We augmented the above quantitative method with a qualitative procedure to give us a secondary sample. In order to uncover and explore the dynamics of the executive pay-setting process a number of semi-structured interviews were undertaken in 1999. To establish the sample we identified 50 companies from the largest 250 on the London Stock Exchange. These were then approached with a request to participate in this study. The basis for company selection was not simply company size and sector alone, but the characteristics of the company’s remuneration policy, or more precisely decisions over the issue of long-term pay; we wanted to include companies that used both LTIP and stock option strategies in their overall remuneration policies. Thus 25 of the selected companies tended to use share options as a means of rewarding executives, the other half preferring LTIPs. Eight companies agreed to participate in this study. These companies have a combined market capitalisation of some £165 billion, and represent over 10 per cent of the total stock market valuaton. They are significant players. As indicated, these eight companies varied according to their use of stock options or LTIPs as a mechanism for long-term remuneration. Interviews with remuneration committee members and senior human resource personnel were subsequently conducted. While the companies included in the sample are all listed on the London Stock Exchange, they operate in global markets and their boards reflect this. The interviews took place both in the UK and US (New York). There were typically six high-profile non-executive directors—usually including the Chair of the remuneration committee—and two human resource directors who were responsible for providing information to the remuneration committee. All participants received a copy of the interview pro forma in advance of the interview, though they were encouraged to mention other issues they felt were relevant. The pro forma is detailed in Appendix A. At the start of each interview permission was sought to record the interview, and the recordings were subsequently transcribed. This clearly leads to a considerable amount of data. The quotations presented in here are representative and illustrative quotes designed to demonstrate participants’ views and opinions. Due to the commercial sensitivity of much of the information, and to guarantee candid responses, the anonymity of respondents was guaranteed. Hence no quotations are attributed in this article.

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interviews answered the ’why do they look this way?’ question

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Table 1. CEO compensation contracts CEO compensation element

Mean

25th Percentile

Median

75th Percentile

CEO current salary (£000) CEO bonus paid (£000) CEO total cash pay (salary, bonus, benefits and other cash pay) (£000) CEO total cash pay in the previous year (£000) Value of current grant of CEO options (£000) Value of current grant of LTIP awards (£000) Value of stock of CEO stock options (£000) Sensitivity of CEO portfolio of options to changes in shareholder wealth (%) Sensitivity of all CEO equity share stakes to changes in shareholder wealth (%)

293 132

193 30

264 83

375 151

451

273

390

534

369 117 115 822

228 0 0 117

318 2 0 287

450 80 127 722

0.176

0.031

0.088

0.189

0.591

0.070

0.179

0.432

UK executive compensation contracts

b

Figures are rounded to the nearest £00 throughout the text.

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CEO compensation and remuneration committees In Table 1 we document CEO compensation in our sample of 200 large firms. We report the mean, 25th, 50th and 75th percentiles to get a clear picture of the CEO compensation distribution. An important point to note is that each element of the compensation package is identified. Prior to the Greenbury report1 only the combined cash emoluments of the non-named highest-paid director was available.8 The improved recent disclosure allows researchers (and stockholders) to examine the mix between these various elements. In our data the mean (median) salary is £293,300 (£264,000), the mean (median) bonus is £132,400 (£82,500) and the mean (median) total cash pay is £451,400 (£389,500).b Bonus payments to CEOs represent, then, about 20 per cent of total cash compensation. Mean (median) total cash pay in the previous year was £369,103 (£318,000). Mean and median CEO compensation have both therefore risen by approximately 22 per cent in our data set. It is clear from Table 1 that salaries are a significant part of executive cash compensation (about 80 per cent) and of total compensation (adding the value of the current grant of options and LTIPs to the total cash compensation figure). It is important to understand how and why salaries are determined. Who actually sets executive pay? An issue surrounding executive compensation is the perception in some quarters that executives are able to set their own pay. In fact, in most companies, non-executive directors who are acutely aware of potential conflicts of interest between managers and shareholders over the level and structure of compensation make decisions about executive pay. In practice, the procedure for arriving at pay recommendations and outcomes is devolved to a remuneration committee: a sub-committee of the main board. Existing evidence indicates that the overwhelming majority of quoted com-

The Structure of Executive Compensation Contracts

panies have established remuneration committees and that they are comprised entirely of non-executive directors. Currently most remuneration committees take advice and derive information from the company itself. Remuneration committee proposals to the main board about pay levels and structures are based on information received from the company’s human resource department. The information collected by the company is done in conjunction with advice from professional advisors outside the company. These outside advisors are typically accountants or specialist remuneration consultants. PricewaterhouseCoopers states that “in most circumstances currently, the executives and/or the HR department of the company contract advice for the committee.”13 In consequence, the remuneration committee does not usually hire its own separate advisers, or influence its terms of reference. Instead, the committee considers the recommendations of its advisors and can send them back for revision if and when necessary. Once accepted, the remuneration committee itself passes its recommendations for approval to the main board. Two major issues are the effect of the volume of information disclosure in annual reports about executive pay, and the role played by external consultants in setting compensation. A view has been expressed that the current amount of remuneration disclosure in UK annual report and accounts has led to a “ratcheting up” effect on directors’ pay. Similarly, the use of external compensation consultants can result in upward pressure on executive pay. At its simplest, the “ratcheting up of pay” hypothesis suggests that with more information about pay levels on public display, there are reasons to believe that those directors who are relatively underpaid will press for pay increases. The Hampel report similarly surfaced concerns regarding the potential for the ratcheting up of executive pay. “Remuneration levels are often set with the help of comparisons with other companies, including remuneration surveys. We urge caution in their use. Few remuneration committees will want to recommend lower than average salaries. There is a danger that the uncritical use of comparisons will lead to an upward ratchet in remuneration with no corresponding improvement in corporate performance.”14 This issue is also mentioned in the Combined Code.15 The aversion of companies to paying below average salaries prompted the Institute of Directors to advise its members serving on remuneration committees to “avoid setting remuneration packages that are generous in relation to market levels and beware of pressure always to be in the upper quartile.”16 If companies continually attempt to pay in the upper quartile, the going market rate will increase, probably leading to the spiral in executive pay persisting. There is some current evidence to support the hypothesis of “ratcheting up”. Ezzamel and Watson,17 in a recent study of UK firms, contend that executives paid below the going market rate are more likely to have their compensation increased. Con-

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there is still the perception that executives can set their own pay. Evidence shows this not to be true

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versely, those above the prevailing market rate are less likely to see their compensation reduced.

“it really comes down to long-term

Clarke et al.,18 in a 1997 survey of 342 UK-listed companies, focus on whether chairmen believe that the amount of information disclosure in company reports has led to a ratcheting-up of directors’ pay. The respondents are pretty evenly split on this issue. Indeed, about half of the respondents (43 per cent) believe it has done so, with the remainder either neutral or disagreeing. In support of recent survey findings, all companies interviewed here made use of external remuneration consultation during the pay setting process. The ability to hire their own external consultants, in line with Hampel,14 was appreciated. Often individual consultants had developed relationships with key people within the organisation that had proved important. One director, whose views on the role of external advice were fairly typical, noted that consultants provide:

incentives—what sort of alternatives there are”

pretty accurate assessments of, let’s say, median salary levels for a particular type of company with a turnover of a certain amount in a particular type of sector…. They will put forward their view of what they think is appropriate: it then really comes down to long-term incentives—what sort of alternatives there are. Also, as firms become increasingly internationalised, remuneration committees are demanding comparative international pay data. This can be problematic, as one director noted: There isn’t a huge number of consultants that can deliver to me globally and… it’s not just data, you want to get a feel for [company] performance as well. On the business side, I wish I could get the data we get on the American firms for the European firms, but there is no requirement by law for them to publish that data. It will come. Although every business used external advisors, not every director was convinced of their consultants’ effectiveness beyond objective salary data. One expressed some scepticism regarding the information provided, suggesting that their involvement helps to “ratchet up the pay levels”. Similarly, another director suggested that external consultation is susceptible to becoming a “self-fulfilling prophecy”. [Consultants] keep promoting what they think is the industry norm, and we ask, “Is it the industry norm that you have suggested?” And then they promote to another company and then to a third company… so it’s become an industry norm. We are very suspicious of that.

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The Structure of Executive Compensation Contracts

CEO stock options and pay-for-performance sensitivities We also document the value of options and LTIPs in Table 1. We distinguish between option compensation (the value of the current grant of options) and option wealth (the value of the portfolio of options). The mean (median) value of the current grant of options is £116,600 (£1,800) for this sample of firms. This figure tells us the amount of compensation awarded by the board to the CEO in the current year in the form of options. Many CEOs will not have been awarded options in the current year, but nevertheless hold a portfolio of options. This portfolio represents the wealth of the CEO (as distinct from current compensation). It may be thought of as the accumulated option assets allocated to the CEO by the firm. The value of the option assets (CEO option wealth derived from the company) is much higher than the current grant. The mean (median) value of the stock of stock options is £821,600 (£287,400). Table 1 also indicates that the mean value of LTIP awards is £114,600. The median value turns out to be zero since the number of participating CEOs and values are commensurably low. The final two rows of Table 1 tell us how CEO wealth changes for given changes in firm wealth. The mean (median) sensitivity of the CEO portfolio of options to changes in shareholder wealth is 0.176 per cent (0.088 per cent). This is a calculation of the second term in Eq. (2), which is the direct link between CEO option wealth and company performance. The estimate implies that the (mean) CEO receives 0.176 per cent of any increase in shareholder wealth (in other words, this is the effective sharing rate between the CEO and the company stockholders). The stock option pay–performance term is only one part of the aggregate pay–performance sensitivity. From Table 1 the mean (median) value of the aggregate PPS (defined in Eq. (2)) is 0.591 per cent (0.179 per cent). The mean value of the aggregate PPS, then, is about three times that of the mean stock option PPS. In this data, then, other elements of equity-based compensation provide the majority of incentives (that is, equity and long-term incentive plans). There are clear financial incentives for CEOs to increase shareholder wealth. It appears that an important way to achieve this is the allocation of long-term pay instruments like options, LTIPs and equity shares. Such remuneration strategies found wide support with our interviewees. One director claimed good practice in long-term compensation as being:

there are clear financial incentives for CEOs to increase shareholder wealth

a salary much lower in proportion to the whole, a benefit package substantially less attractive than what is available here, but with enormous so-called incentive elements …. Similarly, another director indicated the importance of share options and incentives in the remuneration package in order to motivate people. We almost never increase base pay for people who haven’t had a job increase. We try and focus all the increase into

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long-term incentives and share option plans. Base pay has not increased around here for some time. Yet another director stressed the importance of developing an ownership culture within the company. If we were to remind ourselves of the overall objective here: it’s to have compensation plans which provide economic opportunities in a competitive economy, in terms of attracting and maintaining and motivating its people. It’s quite true, and yet for some reason either related to [company] performance, or related to the market generally, stock prices go down; it can hurt.

our data suggests LTIPs are generally substitutes for CEO participation in the company executive option plan

As indicated, then, long-term incentive pay formed a key part of the remuneration strategies of all the companies interviewed, though opinions were a little divided on its efficacy and role. One senior director claimed: Pay people a really top-dollar basic salary, none of this jigging around with not such a good basic salary. No! Pay them properly and have a very, very tough bonus system in which you cap the bonus. This section, then, has illustrated both the importance of financial incentives from long-term pay in the compensation contract, and the importance of generating a culture of ownership share stakes. CEO stock options and LTIPs In Table 2 we examine further the incidence of CEO stock option contracts. The first row of Table 2 indicates that the overwhelm-

Table 2. CEO stock options Structure of CEO compensation

Mean

Percentage of companies that operates an option scheme for the board Percentage of CEOs who now participate in the current executive option scheme Percentage of companies that have introduced a long-term incentive plan (LTIP) scheme Percentage of companies that have introduced LTIPs and the CEO participates in the executive option plan (complement) Percentage of companies that have introduced LTIPs and the CEO does not participate in the executive option plan (substitute) Percentage of current company executive option schemes that attach a performance criteria Percentage of CEO’s stock of options held under SAYE scheme Percentage of CEO’s stock of options held under an executive scheme with no performance criteria Percentage of CEO’s stock of options held under an executive scheme with some performance criteria

98.50

–

67.00

–

49.50

–

36.36

–

63.64

–

61.50 11.04

– 1.00

57.42

71.41

31.54

1.99

490

Median

The Structure of Executive Compensation Contracts

ing majority of companies within the sample have in place an executive stock option scheme for the board and senior management (98.5 per cent). However, this does not imply that the CEO will necessarily participate within such a scheme. A reaction to the Greenbury report1 was the move away from stock options as a reward mechanism for CEOs. The Greenbury report focused on the potential drawbacks of executive option schemes and highlighted a clear preference for Long-term Incentive Plans (LTIPs), stating that introducing such plans “may be as effective, or more so, than improved share option schemes in linking rewards to performance”.1 Grants under LTIPs were suggested as an alternative route for supplying executives with incentives. Row 2 of Table 2 indicates that only 67 per cent of CEOs currently participate (in other words, are still eligible for new grants under an executive stock option scheme). On the other hand, companies are making more use of grants under LTIPs. Row 3 indicates that 49.5 per cent of companies have now introduced an LTIP scheme. An important issue is whether LTIPs are substitutes or complements for CEO stock options. Rows 3 and 4 of Table 2 address this issue. The univariate statistics reveal that of those companies that have introduced an LTIP scheme, in 36 per cent of the cases the CEO continues to be eligible for grants under the executive stock option plan. This suggests that in approximately one third of companies, LTIPs have been introduced as complements to the executive option plan. The corollary is that, of those companies that have introduced an LTIP scheme, about 64 per cent of CEOs participate in the company’s (current) executive stock option plan. This suggests that in the majority of companies, LTIPs are substitutes for CEO participation in the company executive option plan.19 Our interviews with company directors found that long-term compensation was important in all cases. We were keen, therefore, to probe why companies chose stock options in preference to LTIPs, or the other way around. This is especially important in the light of the above evidence (particularly the substitution that appears to occur in the choice of stock option or LTIP). The choice then becomes one of choosing between the two main forms of long-term scheme, stock options or LTIPs. The split in opinion on the efficacy of the two main strategies is revealing: one director, in support of his company’s LTIP scheme, claimed it is:

the split in opinions on the efficacy of stock options versus LTIPs is revealing

a fairer, better measure of performance than an option, because I think options are a lottery: if the stock market goes to hell, your options won’t pay out, or [will] pay out very little. Conversely, what we’ve got going now is pretty mediocre companies doing relatively well in stock market terms, and therefore the options being worth a lot of money. On the other hand, another director sees share options as an “obvious method for rewarding directors.”

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It works extremely well…. Some of the more complicated LTIP schemes, quite frankly, are so complicated that I didn’t even understand them myself, having studied them for some time. I like the very straightforward share option approach. It’s simple; everybody understands it. Another director uses share options to provide long-term incentives. He explains: We see the share option as [a means] to add value to the shareholder over the long term. It’s not a 3 year plan where you just cash in every 3 years and get a few more, hang on to them, …LTIPs can pay out even if the share price went down… with performance criteria relative to other companies, you pay people and the shareholder gets no value. Whilst employing a stock option scheme, yet another director explains his concern with regards to them. There is a concern with… the elements in stock option rewards that have nothing to do with individual skill or performance. It may not be fair in that [the executive] is over-benefited or under-benefited because of market forces, but so has the shareholder [been]. So they go together. This is the so-called “line of sight” argument whereby executives may not always understand how their actions affect stock prices. One director explained how his company moved away from an option-based scheme towards an LTIP “at the time all the corporate governance was coming in”, but has since re-introduced the option-based scheme. He explains the merits: The [LTIP] didn’t really get valued by people. It didn’t have a value: it was five years, they couldn’t get a feel if they were worth anything, and therefore it was discounted in their package…. That is not smart because what you want to do is deliver something that means value to people. There is no doubt that a share option is more tangible: they understand it better, they can relate to it and value it better. Thus, our overall analysis of LTIPs and stock options indicates some of the complexities involved in putting into place longterm incentive and reward mechanisms. Performance criteria attached to stock options Unlike boards in the US, the majority of boards in the UK are now attaching performance criteria to CEO stock option contracts. Although a few UK companies have been attaching performance criteria to executive options from as far back as 1988, such practices were few and far between prior to 1994. In 1995 the Greenbury code recommended that all long-term incentive schemes, including executive share option schemes, should be 492

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subject to “challenging performance criteria”. In response to this, many of the companies now using performance criteria introduced these conditions for the first time in the period 1994 to 1995. The Greenbury report argued that remuneration committees should “consider criteria which measure company performance relative to a group of comparator companies in some variable, or set of variables, reflecting the company’s objectives such as total shareholder return.” Finally it recommended that “directors should not be rewarded for increases in share prices or other indicators which reflect general price inflation, general movements in the stock market, movements in a particular sector of the market or the development of regulatory regimes.” These recommendations met with widespread approval, as did their rapid implementation. However, in the past eighteen months, many critics have begun to question the effectiveness of the current performance criteria in limiting the gains made by directors for modest or below average company performance. Organisations such as the Local Authority Pension Fund Forum (LAPFF)20 are now calling on companies to toughen up the performance targets for their executive incentive schemes. The final three rows of Table 2 indicate the distribution of CEO stock options according to performance and non-performance criteria. We calculate the proportion of the CEO option portfolio that is held under SAYE and the proportions that are held under an executive stock option scheme categorised by performance or non-performance criteria. The three means sum to 100 per cent. However, because some CEOs hold (nearly) only SAYE options, the means of the fractions can overweight the importance of SAYE options. Accordingly, we present the medians too. The picture that emerges is that the majority of options held within the CEO’s portfolio are not subject to any performance criteria.

unlike the US scene, the majority of boards are now attaching performance criteria to options

Table 3. CEO stock option performance criteriai Performance measure attached to CEO stock options

No.

%

Earnings per share Share price Profits Net assets per share Net asset value Return on net assets Total shareholder return Earnings per share and total shareholder return Share price and total shareholder return Total

82 8 2 1 3 1 13 3 1 114

71.93 7.02 1.75 0.88 2.63 0.88 11.40 2.63 0.88 100

i

This table is constructed for the 114 companies which have performance criteria attached to the stock of options, and for which the performance criteria could be identified.

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Table 3 details the distribution of performance criteria that are attached to options contingent upon the company using an option scheme and being able to identify the criteria. As is clear, the overwhelming majority of companies use earnings per share as the performance criteria to attach to stock options. The next largest category is a market-based measure, namely total shareholder return. The typical condition that has to be met before options can be exercised is that growth in earnings per share over a consecutive three year period between the grant date of the option and the (anticipated) exercise date of the option must exceed the growth in the retail price index by a total of 6 per cent. The specific details, of course, vary from firm to firm (although not always in an easily classifiable manner due to some opaqueness and ambiguity in reporting), but a typical example is given below from Medeva plc: Options granted under the 1996 Executive Share Option Scheme will only become exercisable if the growth in earnings per share exceeds the Retail Price Index by 2 per cent per annum over a three year period between the date of grant and date of exercise. The PIRC and LAPFF have questioned the use of annual 2 per cent real growth in earnings per share thresholds, stating “EPS growth of 2 per cent a year is easily achievable for most companies while median position represents only average performance. These are flabby targets which we, as shareholders, regard as unacceptable.”21 In Table 4 we have presented the distribution of EPS (calculated from Datastream) for our sample of companies. It indicates that performance criteria are very rarely binding (based on historical data) and consequently will have little impact on Table 4. Earnings per share growth ratesi Percentile

1st 5th 10th 25th Median 75th 90th 95th 99th

1. Maximum of the three year real EPS growth rates between 1992 and 1997 ⫺3.81 13.24 22.05 37.06 66.69 112.31 222.58 394.58 3435.2

2. Three year real EPS growth rate (1995 through 1997)

3. Three year real EPS growth rate (1994 through 1996)

⫺1965.01 ⫺60.55 ⫺21.81 3.49 29.71 59.23 101.5 185.78 938.26

⫺1932.38 ⫺83.98 ⫺20.77 10.175 40.725 76.16 123.32 209.46 867.72

i

EPS data from Datastream. Real annual growth rates computed first as the gross rate minus the annual inflation rate. Inflation rate computed at January of each year (from Datastream). Three year real rates of growth are computed as the sum of the annual real rates (for example, from 1994 to 1996).

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the valuation of the stock of options held by the CEO or the related PPS. For example, column 2 plots the distribution of the 3-year real EPS growth to 1997. The median growth rate is 29.71 per cent. In column 3, the 3-year real growth rate to 1996 is 40.72 per cent. In column 1—which details the maximum of the 3-year real growth rates between 1992 and 1997—the figure is 66.69 per cent. The constraint would seem to bite at only low points on the EPS distribution, but from column 1 the firm at the 5th percentile has an EPS growth of 13.24 per cent. We also investigated our data further to establish what factors influence the linkage of option rewards to company performance. Our analysis is contained in Appendix B. The results indicate that the stock option pay-for-performance term (defined earlier) is smaller in larger companies. This is mainly because large companies tend to hold a smaller fraction of options. Companies that pay their CEOs more in cash pay compensation also tend to have higher financial incentives from long-term pay. We also show that the linkage of option rewards to performance is not sensitive to whether these option plans are performance-contingent. In our data it appears that having options generally raises the linkage to performance. Given the importance placed on the linking of rewards to performance, we sought to explore in our interviews with directors the process by which performance standards and targets are set for directors’ pay. These are the conditions that determine the award of bonuses or LTIPs. Several issues emerged. Firstly, should companies link awards to performance against a particular group of (similar) companies, or should they use comparisons with the market as a whole? Secondly, should companies use market-based measures of performance or accounting-based measures? One director, in the pharmaceutical sector, explains his company’s strategy: I think there will be a fairly strong argument in my mind that any performance condition that is there to protect investors should be related to other companies they could invest in generally. Why as a shareholder should I be happy if I invested in a company and they performed at the bottom deck of the FTSE 100 but were the best performing pharmaceutical company? But internal performance measures should be against the pharmaceuticals. This sums up a number of views. Another director finds as much difficulty in setting appropriate internal performance standards and targets: All the executives think our targets are too aggressive and all the non-executives think they are too easy …. I find a great deal of difficulty in setting targets because we are so strongly influenced by management’s recommendations. This company also put a lot of weight on accounting performance standards (earnings per share growth), primarily because:

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We think the market has been intolerant, blind or misunderstands us. We can’t trust the market to appraise this company … the engineering group is a very strange group. I think the marketplace is a very fickle animal. For many remuneration committees, the issue of the appropriate comparator group is far from obvious. A director notes the problem for his company:

financial incentives and share-stake culture matter for increasing the payfor-performance sensitivity

You can look at what is in the leisure sector, say, in a published list, but some of them are not really leisure. I see another company in it and it may have one or two businesses similar to ours, but equally an awful lot it does isn’t similar—for example, brewing. Our analysis here has revealed not only that accounting performance targets are common in stock option contracts, but that the process of establishing targets is complex. We have indicated that firstly that identifying, establishing and communicating the performance target and standard are central to a robust remuneration strategy, and secondly that identifying the appropriate comparator groups is central to the pay-setting process.

Discussion and conclusions This article has investigated the structure of CEO stock option contracts. We have used rich data from the largest 200 UK-listed companies in the 1997 fiscal year. In addition we have used rich interview data gleaned from senior personnel at leading UK companies. Our analysis has yielded new results and insights on the nature of CEO compensation contracts. First of all, the data on CEO compensation and, in particular, the value of stock options shows that current option awards for UK CEOs are only a fraction of total pay, but that CEOs’ wealth from their portfolio of options is higher. Financial incentives and share stake culture matter for increasing the pay-to-performance sensitivity. Secondly, the evidence on how the portfolio of options varies with firm wealth (the pay-for-performance sensitivity) is calculated as about 0.18 per cent. This shows the fraction of any increase in shareholder wealth received by the CEO. Thirdly, the performance criteria attached to CEO stock options are typically earnings per share growth figures (relative to a market-based figure). Fourthly, an assessment of whether such performance criteria are “demanding” shows that the majority of companies beat the “typical” EPS target (when measured by historical data). Finally, and based on our analysis in Appendix B, the linkage of pay to performance, at least in our data set, does not appear to depend upon whether the stock options are performance-contingent. Companies tend to substitute LTIPs for stock options rather than treat these different reward instruments as complements. Overall, our new evidence

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for the UK shows the complex structure of CEO compensation contracts. Our qualitative analysis has revealed some of the views and motivations of key directors and senior HR personnel in setting directors’ pay. What was also clear from our discussions with directors (and not so apparent from the raw data) was the internationalisation of executive compensation. We suspect that this will be an important issue for future research. What effect, if any, has the growing internationalisation of companies and markets for executive talent had on the pay-setting process at the top of UK companies? The effect is obviously difficult to quantify, and is arguably a variable that may be an important but overlooked element in many of the studies of executive pay, requiring future research. Our sample of directors clearly saw this as a factor and a challenge for the UK. One director in our interviews believes that

the American influence is clearly

This is increasingly a global market for executives and Britain is not a pay leader. We do see more people on headhunters’ books that are Americans… and I think we need to bring international pay comparisons into account.

being felt in UK boardrooms

The American influence is clearly being felt in UK boardrooms. One director notes that in order to attract world-class talent, “we really need to ask what an American compensation strategy looks like, because it is being driven very much off of American practice.” He sees this as inevitable, though wants to see a key part of recent UK experience retained: It is a very fluid situation at the present time and the impact of American-style remuneration practices is going to just fuel the debate we have in this country about fat cats and all that sort of stuff. The single big negative as far as we are concerned is the practice in America of giving non-performance related incentives… and I would loathe going away from performance-related structures. Another director sees the performance condition on option grants as a potential handicap on recruitment from the international pool of executives: The reality is none of our competitors anywhere in the world have performance conditions on their options … we are the only country which insists on putting it there and it reduces the value of options to the executive. Whether it is right or wrong, it’s an option with a performance condition on it, and is less in value than an option without the performance condition on it. Since the ultimate performance condition is that if the shareholders didn’t make any money, you didn’t make any money, then why do we need more performance conditions in there? From the competitive viewpoint we have got performance conditions and find

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We would like to thank Weedie Sissons and seminar participants at Tilberg (Eindhoven) and Wharton for useful discussions and comments during the preparation of this article. The advice and comments from practitioner colleagues at PricewaterhouseCoopers is much appreciated. We gratefully acknowledge the financial support provided by the Economic and Social Research Council (award number R000237246).

it a very serious inconvenience when we are recruiting people. We would not have performance conditions ideally. Whilst the growing internationalisation of executive labour markets has been making itself felt in remuneration committees, it may also require them to look at their own composition in order to ensure that international comparisons are not misleading. As one director (an American) notes, Every time they [the executives] can, they justify an American compensation standard. What does this mean? That the American standard is richer and more liberal than any other standard. I suppose if they had their way they’d have American stock-based compensation and European salaries and social benefits. It’s human nature …. We [the non-executives] have to put it into perspective. Overall, our article has added to the debate on executive compensation-setting in UK companies. We have highlighted the current structure of compensation (the mix between salary, bonus and long-term pay such as options and LTIPs). We have shown the incentives that are derived from this using the methods outlined by Murphy3 and Conyon and Murphy.4 We have also used interview data from key individuals in Britain’s largest companies to show the complexity of compensation contracts and their implementation. We have shown that there is diverse opinion on the best ways to use long-term incentive pay. But, as our discussion here illustrates, the growing globalisation of commerce appears to have implications for compensationsetting policies. This may, in the future, result in a harmonisation of policies and compensation practices to attract and motivate an increasingly mobile and talented executive labour force.

Appendix A. The interview pro forma sent to directors Corporate performance and executive pay-setting The following seven key questions form the basis of our forthcoming interview. We look forward to obtaining your views on them. The bullet points give guidance to the areas we are looking to explore, but they are not meant to be exhaustive. 1. Would you outline the key elements of a good executive remuneration strategy? You may wish to comment on: 앫 recruitment and retention issues; 앫 the mix between the various components of compensation. 2. Can you describe the process by which board pay was set last year? You may wish to comment on: 498

The Structure of Executive Compensation Contracts

앫 앫

key stages in pay-setting (for example, reviewing director performance); the remuneration committee and the main board relationship.

3. Can you describe the sources of information that the remuneration committee uses in setting directors’ pay? You may wish to comment on: 앫 the use of salary surveys; 앫 the use and choice of external consultants; 앫 the use of internal company-provided information. 4. Can you describe the importance of long-term pay (such as stock options or long-term incentive plans) for the overall remuneration strategy? You may wish to comment on: 앫 long-term pay as a motivator of directors; 앫 the appropriate valuation of long-term pay; 앫 the advantages or disadvantages of share options versus LTIPs. 4a. Would you consider issuing out-of-the-money options (exercise price greater than the share price)? If so, why? 5. Can you describe how performance standards and targets are set for directors’ pay? You may wish to comment on: 앫 the appropriate target (for instance, EPS growth?); 앫 the length of performance cycle; 앫 the use of performance standards for LTIPs and options separately. 6. Is the institutional/legal/governance framework about right to enable companies to set pay appropriately, or are more reforms needed? You might comment on: 앫 the ABI “four times salary” rule for share options; 앫 shareholders “voting on pay”; 앫 other desirable reforms; 앫 other non-desirable reforms. 7. Has the market for executive talent become more active in recent years, and how is this affecting pay? You may wish to comment on: 앫 the globalisation or internationalisation of the managerial labour market; 앫 the advantages or disadvantages of directors holding directorships elsewhere; 앫 legislation regarding the “capping” of reward packages.

Appendix B. Stock option pay–performance and performance criteria In this appendix we consider whether the sensitivity of the portfolio of options with respect to firm wealth varies according to

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the CEO’s mix of performance and non-performance related options. Namely, is the calculated option portfolio different if the CEO has a higher fraction of options that are performance related? One hypothesis may be that companies that tie options to performance criteria have a higher gearing in relation to pay and performance. We estimate the following equation: PPSi = α + β1PRSi + β2NPRSi + β3LTIPi + β4controlsi + ⑀i (3)

c

The omitted term is the fraction of SAYE options.

500

where PPS is the sensitivity of the CEO option portfolio with respect to firm wealth (the stock option pay–performance sensitivity calculated above); PRS is the percentage of CEO stock options that are performance-related; NPRS is the percentage of CEO stock options that are not performance-related; and LTIP is a dummy variable indicating that the company operates an LTIP scheme. Companies that have adopted LTIPs as substitutes for options will have a lower option pay–performance sensitivity. Various control variables are included: size (log of market value) is included to control for the fact that CEOs in larger companies may be constrained in the fraction of options held (yielding a lower pay–performance term); total pay is included to control for potential differences in the effort/risk/talent of CEOs; industry dummies are included to control for sector heterogeneity. The equation is estimated by OLS and simultaneous quantile regression methods. This is because the distribution of the option pay–performance term is non-normal and forecasting different points of the distribution is therefore informative. The 25th, 50th and 75th percentile regressions are performed using bootstrapping techniques, re-sampling the data 1000 times. The results are contained in Table 5 and are easy to summarise. In all regressions the size term is negative and significant: the option pay–performance term is smaller in larger firms. This effect is due to larger firms holding a smaller fraction of option claims on total outstanding equity. Total cash pay is positive and significant: CEOs who receive higher base compensation (perhaps due to differences in talent) have higher option pay– performance terms. The results also indicate that there is a positive relation between the performance-related fraction of the CEO’s stock of options and the stock option pay–performance term (controlling for scale factors, industry effects, CEO differences and the structure of compensation). Similarly, there is a positive relation between the non-performance-related fraction of the CEO’s stock of options and the stock option pay–performance term. In all regressions these effects are positive and significant: raising the fraction of either the performance or non-performance options in the portfolio is associated with higher option pay– performance terms.c In these regressions the coefficient estimates on the performance and non-performance-related terms are not significantly different from each other. For example, even in the mean regression a formal test that the performance and non-

The Structure of Executive Compensation Contracts

Table 5. CEO stock option portfolio sensitivity and indicators as to whether stock options are subject to performance criteriai Independent variables

Mean regressionii

25th percentile regressionii

Median regressionii

75th percentile regressioni

Constant

0.657 (0.150) −0.088 (0.019) 0.235 (0.098) 0.142 (0.039) 0.062 (0.045) −0.062 (0.037) Yes 200 0.186

0.159 (0.043) −0.023 (0.006) 0.058 (0.018) 0.049 (0.019) 0.048 (0.021) −0.023 (0.010) Yes 200 0.138

0.329 (0.078) −0.045 (0.011) 0.133 (0.071) 0.044 (0.021) 0.043 (0.024) −0.047 (0.017) Yes 200 0.157

0.577 (0.138) −0.077 (0.018) 0.262 (0.125) 0.081 (0.037) 0.039 (0.043) −0.066 (0.039) Yes 200 0.172

Log (market value) Total cash pay (coefficient ×1000) Percentage of CEO stock options that are not performance-related Percentage of CEO stock options that are performance related Company uses LTIP (dummy variable) Industry effects No. of observations R2 i

Models estimated as OLS with heteroskedastic robust standard errors (mean regression) and simultaneous quantile regression methods (25th, 50th and 75th percentiles). ii Standard errors in parentheses.

performance variables are the same cannot be rejected (F=2.56, p>F=0.111). Raising either fraction contributes positively to the option pay-for-performance sensitivity.d Finally, companies that have introduced an LTIP have a lower recorded value of the option pay–performance term. This is consistent with companies substituting as incentives LTIPs in place of options. Companies that move away from options have a lower fraction of them in the total portfolio.

References 1. R. Greenbury, Directors’ Remuneration: Report of a Study Group Chaired by Sir Richard Greenbury, Gee, London (1995). 2. F. Black and M. Scholes, The pricing of options and corporate liabilities Journal of Political Economy 81, 637–654 (1973). 3. K. J. Murphy, Executive compensation in O. Ashenfelter and D. Card (eds), Handbook of Labor Economics, vol. 3. North Holland, Amsterdam (1999). 4. M. J. Conyon and K. J. Murphy, The prince and the pauper? CEO pay in the US and UK, working paper, University of Southern California (1999). 5. M. J. Conyon and G. V. Sadler, CEO compensation, option incentives and information disclosure, working paper, University of Warwick (1999). 6. B. Hall and K. Murphy, Optimal exercise prices for executive

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In other tests we introduced a dummy variable into the model if the company had a performancerelated option. The variable was not significant.

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7.

8.

9.

10. 11. 12.

13. 14. 15. 16.

17.

18. 19.

stock options, paper presented at the American Economics Association, Boston, MA (2000). Murphy, (see Reference 3); J. Core and W. Guay, Estimating the value of stock option portfolios and their sensitivities to price and volatility, working paper, Wharton School, University of Pennsylvania (1999); W. Guay, The sensitivity of CEO wealth to equity risk: an analysis of the magnitude and determinants, Journal of Financial Economics 53, 43–71 (1999); D. Yermack, Do corporations award CEO stock options effectively? Journal of Financial Economics 39, 237–269 (1995). M. J. Conyon, P. Gregg and S. Machin, Taking care of business: executive compensation in the UK Economic Journal 105, 704–715 (1995). Murphy, (see Reference 3); Conyon and Murphy (1999) (see Reference 4); B. Hall and J. Liebman, Are CEOs really paid like bureaucrats? Quarterly Journal of Economics 113, 653– 691 (1998). Hall and Liebman, (see Reference 9) (1998). J. C. Cox and M. Rubenstein, Option Markets, Prentice-Hall, Englewood Cliffs, NJ (1985). M. J. Conyon, C. Mallin and G. V. Sadler, The disclosure of directors’ share option information, Applied Financial Economics, forthcoming; Association of British Insurers, Long Term Remuneration for Senior Executives, ABI, London (1994); ABI, Share Options and Profit Sharing Incentive Schemes, ABI, London (1995); R. Hampel, Committee on Corporate Governance: Final Report, Gee, London (1998). PricewaterhouseCoopers (1999). Hampel, (see Reference 12) (1998). The Combined Code, The Committee on Corporate Governance: The Combined Code, June, section B1.2, Gee, London (1988). Institute of Directors, The Remuneration of Directors: A Framework for Remuneration Committees, Institute of Directors, London (1995). M. Ezzamel and R. Watson, Market comparison earnings and the bidding-up of executive cash compensation: evidence from the United Kingdom Academy of Management Journal 41, 221–231 (1998). Clarke et al. (1998). To be more formal, we ran a probit model of the likelihood that the CEO participates in the executive stock option plan as a function of the company introducing an LTIP scheme. We controlled for company size (measured as the log of market value and log of market value squared, and a set of industry dummies). The estimated equation (reporting the marginal effects) is: CEO in option scheme = ⫺0.64LTIP + 0.52log(MV)⫺0.03 log(MV)2 + industry dummies = (0.06) + (0.27)⫺(0.03) + (pseudoR2 = 0.423). The LTIP coefficient (transformed to a marginal estimate)

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indicates whether the company has introduced an LTIP plan. The estimate is ⫺0.64. This suggests that after controlling for size and industry factors, companies that introduce an LTIP plan are 64 per cent less likely to have their CEOs participate in the executive stock option programme. Of course, this is entirely consistent with the company operating an executive option programme but excluding the CEO from participating in it. 20. LAPFF (1999). 21. PIRC (1999).

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