For Some CEOs, No Price Is Too High To Retain Control In A Proxy Battle

In new research from Columbia Business School, CEOs are three times as likely to value shares above market value to avoid getting pushed out

Jul 31, 2014, 09:50 ET from Columbia Business School

NEW YORK, July 31, 2014 /PRNewswire/ -- Would you pay $120 for shares valued at $100? Irrational as this financial decision may seem, some CEOs of U.S. companies are doing just that. A new study by Columbia Business School examines the behavior of CEOs when a looming proxy contest threatens their leadership, and finds that CEOs will almost always exercise their options out-of-the-money in order to boost their voting power.

"CEOs embroiled in a proxy contest are determined, even desperate, to retain control," said Wei Jiang, Arthur F. Burns Professor of Free and Competitive Enterprise at Columbia Business School and co-author of the research. "Our findings show that in the battle for the boardroom, CEOs will do whatever it takes to maintain or strengthen their voting rights, including halting sales of their shares, increasing option exercises in order to hold resulting shares, and even, in the most extreme cases, resorting to exercising options to acquire shares out-of-the-money."

The study, titled "Out-of-the-Money CEOs: How Do Proxy Contests Affect Insider Option Exercises," was co-authored by Jiang and Professor Vyacheslav Fos of the University of Illinois and a graduate from Columbia Business School's Ph.D. program.

The researchers examined the effects of proxy challenges on incumbent CEOs' behavior, as reflected in their option exercises.  To prove that changes in CEO option-exercise behavior was driven by proxy battles, Jiang and Fos also looked at activity surrounding the record date—the latest date by which to acquire shares to earn voting rights.

"Embattled CEOs are using their option exercises at the last minute as another weapon against increasingly aggressive shareholder activists," explained Jiang. "This calls into question the checks and balances that exist to allow board members and shareholders to oversee corporate governance."

Among the key findings of the research:

  • When a proxy contest is looming, the rate at which CEOs sell their shares slows down by 80 percent, while the rate at which they hold shares accelerates by 60 percent—by keeping the shares, they also keep their votes.
  • To avert takeover, CEOs facing a contest are three times as likely to exercise options out-of-the-money—an irrational strategy under conventional models. In these cases, CEOs' valuation of their stocks exceeds that of the market price by up to 20 percent.
  • Irregular option-exercise behavior intensifies before the record date. To maximize voting rights, CEOs completely stop exercising and selling shares and quintuple their rate of exercising and holding shares before the record date. After the record date, CEOs start to exercise options to sell again, reverting back to normal exercise-and-hold rates.

The Research

Jiang and Fos' research focuses exclusively on CEOs, analyzing their option-exercise behavior to examine the effects of proxy contests and determine private benefits of control. The motivation for the research was to gain a further understanding of the motives underlying executives' option exercises.

The researchers compared data from several public CEO databases, including data on CEO options packages vested from 1995 to early 2013—resulting in 997,034 observations in total. Researchers analyzed two key action variables: Exercise&sell, defined as an option exercise followed by a sale of at least 25 percent of the shares within three months, and Exercise&hold, defined as an exercise not followed by such a sale and including out-of-the-money exercises.

They then collected information about 1,029 proxy contests between 1996 and 2012—to examine their effects on incumbent CEOs' behavior. To further demonstrate the force of proxy contests on CEO behavior, the researchers controlled for CEO-specific traits, such as overconfidence, to demonstrate the causal role of proxy contests on abnormal option exercises.

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About Columbia Business School
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