Out-Of-The-Money CEOs: Private Control Premium And Option Exercises

Vyacheslav Fos

Boston College – Department of Finance

Wei Jiang

Columbia Business School – Finance and Economics

September 8, 2015

Review of Financial Studies, Forthcoming


When a proxy contest is looming, the rate at which CEOs exercise options in order to sell (hold) the resulting shares slows down by 80% (accelerates by 60%), consistent with their desire to maintain or strengthen voting rights when facing challenges. Such deviations are closely aligned with features unique to proxy contests, such as the record dates and nomination status, and are more pronounced when the private benefits are higher or when the voting rights are more crucial. The distortions suggest that incumbents value their stocks higher than the market price when voting rights are valuable for defending control.

Out-Of-The-Money CEOs: Private Control Premium And Option Exercises – Introduction

On August 13, 2010, Leonard Riggio, Chairman of the Board and former CEO of the New York-based bookseller Barnes & Noble, Inc (ticker: BKS) exercised his option to acquire 990,740 shares at a price of $16.96 a piece. The stock’s closing price on that day was $14.46, and the daily high was $15.00. That is, Riggio paid a premium of at least $1.96 for each share, or 13.1% over the then market value, for the purchase. Moreover, the expiration date of this option package was eight months away. Why? Apparently the company was facing a proxy battle from Ronald Burkle, an activist investor. Riggio was one of the current directors up for re-election, and the extra 1.7% of the votes could matter in proxy contest that everyone anticipated to be close.

The anecdote exposes an intriguing phenomenon: The option exercise behavior of CEOs (or other insiders with control power) could be affected by a desire to maintain control, which in turn reflects a “private control premium.” Such a premium is broadly defined as the incremental value of shares to an insider relative to the value public investors assign to the shares when the shares carry the voting rights needed to reinforce control.

Based on Riggio’s action, we can infer that his willingness to pay (i.e., his private valuation) for the marginal share was at least $16.96, while the market valued the stock no more than $15.00 on that day, and around $15 in the following days, presumably after digesting the public disclosure of Riggio’s share acquisition. Therefore, 13.1% premium Riggio paid over the market price reflects the lower bound of the valuation wedge between an insider and public investors.

The case described above might appear extreme, but it exemplifies how challenges to control distort insiders’ option exercise behavior because they drive a spread in firm’s valuation to insiders and outsiders. A proxy contest reveals that at least some shareholders consider the incumbent CEOs or directors to be “out-of-the-money,” i.e., their value to the firm is lower than what they cost the firm. As such, the out-of-the-money CEOs may exercise vested options (including in-the-money options) in a way that differs from what the benchmark models that do not account for a private control premium would predict. The emergence of a proxy contest, usually after more moderate and negotiations-based forms of activism failed to accomplish a resolution, indicates that the voting powers of the two opponents are similar ex ante. Hence, changes in insider ownership via option exercises are, a priori, a meaningful supplement to other tactics the incumbents deploy to enhance voting power or to influence voting outcomes.

Indeed, after controlling for the standard variables that prior literature has shown to affect early exercises of insider options, we find that the presence of proxy contests reduces the frequency of exercise-and-sell transactions by 80%, and increases the frequency of exercise-and-hold transactions by about 60%. These phenomena represent two sides of the same coin: Because she values the shares higher than the market, an insider is less willing to sell shares at the market price, keeping other motives such as liquidity needs and diversification constant. On the other side, the insider is more likely to exercise the option with the intention to hold the shares because the voting rights are equivalent to a lumpy dividend. If the difference in valuation is high enough, an insider may even exercise options that are out-of-the-money relative to the market price (but presumably still in-the-money relative to his private valuation), as Riggio did, if there are no easier ways to acquire the shares promptly.

A battery of tests affirm the connection between proxy contests and abnormalities in CEO exercise behavior. First, we show that the demonstrated deviations from normal exercises are indeed driven by circumstances (i.e., proxy contests) rather than by unobserved firm or CEO characteristics (such as CEO overconfidence).

Option Exercises

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