On the benefits of allowing CEOs to time their stock option exercises.

This article examines the costs and benefits of permitting executives to use inside information to time their stock option exercises. Whereas prior research has focused on the negative effects of timing discretion, I show that such discretion can have beneficial incentive effects in that it leads to improved project abandonment decisions. This result follows because at-the-money options used to induce managerial effort tilt the CEO's preferences toward project continuation. When the CEO is free to unload stock options at will, he will do so exactly in those states where the continuation bias is most detrimental (i.e., in the event of bad news), making the CEO willing to abandon the project.

1. Introduction

* In the past decade, stock options have become the major instrument for providing top-level management with incentives to enhance shareholder value. However, in the past few years, criticism has emerged that many compensation practices associated with stock option awards serve executives' interests rather than those of shareholders. One compensation practice that has recently received some attention is executives' broad freedom to unload vested stock options and to choose the exact time of such unloading (Bar-Gill and Bebchuk, 2003a, 2003b). This discretion has been criticized because it provides executives with an opportunity to take advantage of their inside information. In particular, executives are able to avoid losses by cashing out vested stock options if they learn negative private information. This arrangement is detrimental because it decouples pay from performance, diluting the positive incentive effect these options were initially meant to generate. U.S. security laws restrict but do not totally prevent insiders from trading on inside information (Carlton and Fischel, 1983; Fried, 1998). This explains why insiders are indeed able to make abnormal profits when they trade in company stock (Seyhun, 1986, 1992, 1998). (1) It is therefore somewhat surprising that corporate boards hardly try to restrict executives' ability to time their trades or at least require early disclosure of those trades (Bebchuk, Fried, and Walker, 2002; Bebchuk and Fried, 2004). One explanation that has been offered in the literature is that corporate boards are captured by powerful executives and hence are more concerned about pleasing executives than maximizing shareholder value. (2)