The Effect of Internal Revenue Code Section 162(m) on the Issuance of Stock

Options

Steven Balsam215-204-5574

steven.balsam@temple.edu

David Ryandavid.ryan@temple.edu

215-204-8131

Temple UniversityFox School of BusinessPhiladelphia, PA 19122

The Effect of Internal Revenue Code Section 162(m) on the Issuance of Stock Options

Abstract

IRC section 162(m) limits tax deductibility of executive compensation to $1 million per

covered executive, with an exception for performance based compensation. Consequently, firms

that wish to pay an executive more than $1 million either have to forfeit deductions or structure

the compensation package so that the excess over $1 million qualifies under the performance

based exception. While a variety of compensation forms can qualify as performance based, they

vary in the difficulty of qualification and the degree of risk that qualification imposes on the

executive. Amounts paid under a bonus plan, for example, qualify as performance based, if the

payout does not exceed that determined based upon objective plan parameters set at the

beginning of the year. In contrast, almost any stock option grant qualifies as performance based.

While there clearly is risk associated with both stock option and annual bonus compensation, the

requirements of section 162(m) changed the risk associated with annual bonus compensation

relative to what it was prior. Consequently, section 162(m) may have encouraged the use of

stock options vis-à-vis other forms of compensation.

Using the population of firms available on the Standard & Poor’s ExecuComp database,

we find that the propensity to issue stock options has increased for affected executives, both in

absolute terms and as a percentage of total compensation. In additional analysis, we find

evidence that is consistent with this increase in stock option compensation substituting for lower

increases in salary for affected executives. But, we find no evidence of stock option

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compensation substituting for annual cash bonuses. We interpret this as indicating firms and

their executives act in a way consistent with the incentives provided by section 162(m).

Keywords: IRC section 162(m), executive compensation, tax deductibility, costs and benefits

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The Effect of Internal Revenue Code Section 162(m) on the Issuance of Stock Options

INTRODUCTION

The Revenue Reconciliation Act of 1993 added Internal Revenue Code section 162(m),

limiting the corporate tax deduction for executive compensation to $1 million per individual for

the top five executives of a corporation, providing an exception for compensation in excess of $1

million if it qualifies as "performance-based." Consequently, firms that wish to pay an executive

more than $1 million either have to forfeit deductions or structure the compensation package so

that the excess over $1 million qualifies under the performance based exception. While a variety

of compensation forms can qualify as performance based, they vary in the difficulty of

qualification, the risk qualification imposes on the executive, etc. For example, for amounts paid

under a bonus plan to qualify as performance based, the payout must not exceed that determined

using objective plan parameters set at the beginning of the year. In contrast stock option plans

are relatively easy to qualify, and as long as the exercise price is set at or above the market price

on the date of grant, are assumed to be performance based. The Financial Economists

Roundtable (2003, 5) has called for the repeal of this provision. The group believes that this tax

provision has spurred the increase of stock option compensation and argues that “this rule is a

clumsy attempt to regulate the level and structure of executive compensation.”

This paper extends the prior research on the effect of Internal Revenue Code section

162(m) on executive compensation by focusing on the use of stock options. Specifically, we

examine the proposition that section 162(m) has led to an increase in stock option compensation.

Using the population of firms available on Standard & Poor’s ExecuComp database, we find

evidence to support this. Our results show that the propensity to issue stock options has

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increased for affected executives, both in absolute terms and as a percentage of total

compensation. In additional analysis, we find evidence that is consistent with this increase in

stock option compensation substituting for lower increases in salary for affected executives.

But, we find no evidence of stock option compensation substituting for annual cash bonuses. We

interpret this as indicating that firms and their executives are acting in a way consistent with the

incentives provided by section 162(m).

This study continues in section 2 with a discussion of section 162(m), and a review of the

relevant literature in section 3. Section 4 develops our research question and model, while

section 5 discusses our sample selection. Section 6 presents the empirical results. The findings of

the study are summarized in section 7.

SECTION 162(m)

Internal Revenue Code section 162(m) was a response to the concern about the perceived

link between the international competitiveness of United States industry and the substantial salaries

paid to United States executives (Brownstein and Panner 1992). Corporate governance critics (e.g.,

Crystal 1992; McCarroll 1993) argued that executive compensation was excessive, both in

comparison to that paid lower level employees and that paid overseas executives; and that

executives were setting their own pay with no shareholder input. Congress believed that this

provision (section 162(m)) would reduce excessive, non-performance based compensation (U.S.

Congress, House 1993).

Section 162(m) places a $1 million cap on the annual deduction for non-performance

based compensation to the top five executives (the chief executive officer (hereafter CEO) and

the next four highest compensated officers). Executive compensation generally consists of

salary, fringe benefits, annual cash incentives, and long-term cash or stock-based incentives. The

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section 162(m) limit does not apply to (1) commissions, (2) non-taxable fringes and qualified

retirement plan contributions, and (3) performance-based compensation.

Prior to the imposition of section 162(m), most firms claimed to tie compensation to

performance, however compensation committees had substantial discretion in awarding executive

bonuses. Specific goals and performance criteria were rarely set in advance and even more rarely

made public. Under section 162(m), to qualify bonus plans for the performance-based exception,

firms are required to adopt a performance-based plan that is based on the executive's attainment of

one or more performance goals that were established ex-ante by a compensation committee

composed solely of independent directors. The performance goals must be based on objective

formulae and the material terms of the plan must be disclosed to and approved by shareholders. The

compensation committee, which has the discretion to award less, but not more than the objectively

determined amount, must certify that the performance goals have been met before payment is made.

Any compensation awarded by the committee based on discretionary assessments of performance

that is in excess of the objectively determined amounts does not qualify.

By definition, salary will not qualify as performance-based since it is not contingent on the

attainment of any criteria. Thus, any salary amounts earned in excess of $1 million are not

deductible unless payment is deferred until after the executive's retirement or unless paid under a

contract executed prior to February 17, 1993. Annual bonuses will qualify under the performance-

based exception as long as the firm adopts a bonus plan consistent with the section 162(m)

requirements discussed above. Employee stock options qualify as performance-based under section

162(m) as long as the options have exercise prices equal to or greater than the market price at the

time the award is made and the plan states the maximum number of shares that can be granted

during a specified period.

LITERATURE REVIEW

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There is a growing body of research that shows section 162(m) has had some impact on

firms’ compensation practices, albeit perhaps not the intended impact. For example, Balsam and

Ryan (1996) examined the propensity of firms to qualify their short-term bonus plans to meet

the requirements of section 162(m), finding that many firms were sensitive to the potential tax

and political costs of not qualifying. However, they showed that firms more likely to make the

requisite modifications were those where compensation was most related to performance -- a

formalization of existing policy. Further, approximately half of the firms in their sample chose

not to modify, and many of those that did, expressly reserved their right to pay nondeductible

compensation. Reitenga et al. (2002) observed that many firms elected not to qualify their

compensation plans on the grounds that executive performance could not be evaluated using a

fixed formula and that reserving the use of discretion in determining executive pay was in the

best interest of the firm.

Prior research (see e.g., Balsam, 2002; Perry and Zenner, 2001) found that all components

of the compensation package increased after 1993, with the largest increase coming in the form of

stock option grants. This finding that compensation increased post section 162(m) is consistent

with the theoretical predictions of Halperin, et al. (2001). However while both show the increase

post section 162(m) neither show that the increase in stock options is disproportionate to affected

executives and firms. Harris and Livingstone (2002) examined firms whose CEOs earned less than

$1 million, “unaffected firms,” and found it had the perverse effect of raising the compensation of

those CEOs. Harris and Livingstone conclude that section 162(m) set a target compensation

amount and that firms whose CEOs earned less than that target, raised compensation.

While research shows that section 162(m) has not led to a reduction in executive

compensation, there is some limited (and mixed) evidence that compensation has become more

responsive to firm performance. Examining the sensitivity of pay to performance, Johnson et al.

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(2001), Perry and Zenner (2001), and Balsam and Ryan (2004) all found some evidence of an

increased sensitivity of compensation to performance after 1993. While Johnson et al. (2001) did

not attribute this increased sensitivity to section 162(m), Perry and Zenner (2001) did, "especially

for firms with million-dollar pay packages." Similarly, Rose and Wolfram (2000, p. 201) provided

some evidence that the 162(m) limit "has led firms near the $1 million cap to restrain their salary

increases and perhaps to increase the performance components of their pay packages." However in

a later paper, Rose and Wolfram (2002, S138) concluded “There is little evidence that the policy

significantly increased the performance sensitivity of chief executive officer (CEO) pay at

affected firms. We conclude that corporate pay decisions have been relatively insulated from this

policy intervention.”

A more recent trend is for researchers to examine the details of firms’ responses to

section 162(m). Balsam and Yin (2005) examine the actual tax status of executive compensation,

finding that almost 40 percent of their sample firms forfeit some tax deductions because of

section 162(m). Interestingly, they found that in 90 percent of the firm years in which a

forfeiture occurred the firm had at least one plan that met the requirements of section 162(m),

and consistent with our research expectations, they had a qualified stock option plan in the vast

majority of cases.

RESEARCH QUESTION

In firms where the CEO or other top officers are earning in excess of $1 million in annual

compensation, the after-tax cost of performance based compensation such as bonuses and stock

option grants is reduced relative to other forms of compensation. As discussed above, the firm

must take a number of steps and put compensation at risk for an annual cash bonus to qualify for

the performance based exception under section 162(m). In contrast, stock option plans can be

easily qualified with no change in compensation risk. Option grants are performance-based

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compensation if the options have exercise prices equal to or greater than the market price at the time

the award is made and the plan states the maximum number of shares that can be granted during a

specified period. Most firms already met these requirements when section 162(m) was imposed.1

Thus, unlike annual cash bonus plans, section 162(m) required minimal modifications to

compensatory option plans. That being said, depending upon the firm, options may still be riskier

than annual cash bonuses. However, as illustrated by Reitenga et al. (2002), qualifying a bonus

plan makes it riskier than it was before. In contrast, qualifying a compensatory option plan has

little effect on its risk. Hence, section 162(m) increased the risk of annual cash bonuses relative to

options. Consequently, the firm may find it desirable and easier to shift compensation into options

if the executive is subject to 162(m) and earns more than $1 million a year.

Model

We use the following pooled, cross-sectional Tobit regression model to test the

hypothesis that section 162(m) has lead to the increased use of stock options in the compensation

packages of affected individuals. The dependent variable in our primary analysis, the ratio of

stock option to total compensation, is bounded by zero and one; consequently, we use Tobit.

Our formal model is:

PERCENTOPTit = 0 + 1DUM1it + 2DUM2it + 3-6RANKit + 7VALUEit-1 + 8DIVYIELDit + 9SIZEit + 10TRSit + 11ROAit + 12VARROAit + 13RISKit

+ 14CONSTRAINTit + 15FCFit + 16BKMit + ∑YEAR + ∑IND + it (1)

where the dependent variable is:

PERCENTOPTit = the Black-Scholes value of options grants to executive i in year t divided by executive i's total compensation, where both the Black-Scholes value and total compensation are provided by ExecuComp;2

and the independent variables are:

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DUM1it = an indicator variable taking the value of 1 if cash compensation of executive i is greater than $900,000 in year t, 0 otherwise;3

DUM2it = an indicator variable taking the value of 1 if cash compensation of executive i is greater than $900,000 in year t and year t is 1994 (1995 if non December fiscal year end) or later, 0 otherwise;

RANKit = a series of indicator variables for executive rank, where rank is based on the level of salary plus bonuses;4

VALUEit-1 = value of executive i’s shares held plus the intrinsic value of exercisable and unexercisable options deflated by total direct compensation, all measured at the end of year t-1;

DIVYIELDit = the dividend yield of executive i's firm in year t;SIZEit = the log of assets of executive i's firm in year t;TRSit = the return to shareholders of executive i's firm in year t;ROAit = net income before extraordinary items and discontinued operations

deflated by total assets for executive i's firm for year t;5

VARROAit = variance of net income before extraordinary items and discontinued operations, deflated by total assets for executive i’s firm for year t ;

RISKit = the volatility measure (60 month) used by ExecuComp to calculate the Black-Scholes values for executive i's firm in year t ;

CONSTRAINTit = indicator variable taking the value of 1 when retained earnings plus the value of cash dividends and stock repurchases in the current year divided by cash dividends and stock repurchases is less than two and 0 otherwise;

FCFit = ratio of free cash flow to total assets measured as common and preferred dividends less cash flow from operating and investing activities deflated by total assets for executive i’s firm in year t;

BKMit = the ratio of book value to market value for executive i’s firm in year t ;

YEAR = a series of indicator variables for years, 1 in year t, 0 otherwise for years 1993 – 2002.6

IND = a series of indicator variables for two digit SIC codes.

Our test variable is DUM2. The coefficient on DUM2 represents the incremental effect of

section 162(m) on the percentage of stock options in the compensation package of individuals who

are affected by the requirements of section162(m). A positive coefficient on this variable would be

consistent with section 162(m) leading to an increase in stock option compensation for this group.

Control Variables

The previous literature has shown that executive compensation is related to both

executive and firm related factors. Consequently, we include the following control variables in

our model: DUM1, RANK, VALUE, DIVYIELD, SIZE, TRS, ROA, VARROA, RISK,

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CONSTRAINT, FCF, BKM, YEAR, and IND.

Executive related controls

We include DUM1 because, independent of section 162(m), the composition of the

compensation package may be more heavily weighted towards options for more highly paid

individuals. Consequently we expect a positive coefficient on this variable. We include a series

of indicator variables for executive rank, RANK, because the composition of an executive’s

compensation package has been shown to vary with rank (Balsam, 2002, table 2.11). We also

include VALUE as a proxy for the preexisting holdings of managers because there is an optimal

level of equity holdings and compensation can be used to adjust for deviation from that optimum

(Core and Guay, 1999). The measure that we use is the value of the shares held plus the intrinsic

value of both unexercisable and exercisable options deflated by total compensation. We expect a

negative coefficient for this variable.

Firm related controls

We include DIVYIELD as the value of a firm’s stock options is less, all else equal, the

higher the dividend yield. Thus, managers in firms with high dividend yields are less likely to

prefer stock option compensation (Lambert et al. 1989). We expect a negative coefficient for this

variable. We include SIZE, measured as the log of assets, because prior research has shown that

the portion of options in an executive compensation package increases with firm size (Balsam,

2002, table 2.6). Thus, we expect a positive coefficient on SIZE.

We include TRS and ROA because performance may affect the composition of the

compensation package. However, the direction of the effect is not clear. While Murphy (1985)

finds a negative association between stock option compensation and firm performance, Liang

and Weisbenner (2001) find a positive association between stock option compensation and stock

price. Consequently we do not predict the direction of the association between stock option

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compensation and firm performance.

We include variables to proxy for the relative risk of compensation tied to market and

accounting measures. RISK, measured as the 60 month volatility measure used by ExecuComp

in calculating the Black-Scholes values, controls for market related risk. We are ambiguous on

its effect on the compensation package. That is, while RISK increases the value of an option

under the Black-Scholes model, implying a positive coefficient, it also may make the option less

desirable to an under-diversified executive. For example, Meulbroek (2001) estimates that for

Internet firms, the estimated value of stock options to undiversified managers is only 53% of

their cost to the firm. However, a recent paper (Hodges et al., 2005) shows that managers

overvalue options relative to the Black-Scholes model. Which effect predominates is an

empirical question. We include VARROA, the variance of ROA as the proxy for the risk

associated with accounting measures of performance. We expect VARROA to be positively

related to our dependent variable because the greater the volatility of a firm’s income, the greater

the risk of compensation tied to accounting measures of performance7.

Prior research (Yermack, 1995; Dechow et al., 1996; Core and Guay; 1999; Carter et al.,

2004) shows that firms with less free cash flow are more likely to use equity instead of cash

compensation since equity compensation requires no cash payment. Following Core and Guay

(1999) and Carter et al. (2004), we include free cash flow, FCF, as a control variable,

constructed such that a larger value represents less free cash flow. Consequently, we expect a

positive coefficient on this variable. We also include a proxy for a firm’s investment opportunity

set, BKM because firms with greater investment opportunities may be more likely to conserve

cash and use stock option compensation instead. (Core and Guay, 1999; Carter et al., 2004) We

measure this as the ratio of firm book value to the market value of its equity. We expect a

negative coefficient on this since a greater value indicates a lesser opportunity set.

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Core and Guay (1999, 160) also argue that “firms that are constrained with respect to

earnings will grant more stock options” because cash compensation is expensed while stock

option compensation has, until now, only been required to be disclosed in footnotes to the

financial statements. Consequently, consistent with Core and Guay, we include the control

variable, CONSTRAINT. We expect a positive coefficient on this variable.

To account for any macro-economic year-to-year or industry wide effects, we include

indicator variables for each year and industry (2 digit SIC codes) in the sample. Tables 1 & 2

provide the sample distribution by year and industry.

Insert Tables 1 & 2 here

SAMPLE SELECTION

The source for our sample is Standard & Poor’s ExecuComp, which includes the firms in

the S&P 500, Mid-Cap, and Small-Cap indexes. We augment the data available on ExecuComp

with financial data from Standard & Poor’s Compustat and we hand collected data on bonus plan

qualification from corporate proxy statements. As our sample firms are the largest publicly held

U.S. corporations, they are the ones most likely to be affected by section 162(m). At the time we

conducted our analysis, ExecuComp had compensation data on 125,122 executives over the period

1992 to 2002. Our test sample is reduced to 59,698 observations due to missing data. In particular,

we lose almost 40,000 observations due to the lagged data required for the VALUE variable8.

However, as we show in the right hand column of table 4, rerunning the analysis without the

VALUE variable and hence on the larger data set does not affect our results.

Table 3 provides some descriptive statistics about our sample. In roughly 20 percent (the

mean of DUM1 is .20) of executive year observations the individual earned more than $900,000 in

cash compensation, making him/her affected (according to our definition) by section 162(m).

Options were a significant part of the compensation package (PERCENTOPT), as they comprised a

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mean (median) 53 (28) percent of total compensation and 117 (48) percent of cash compensation,

with the mean (median) grant valued at $900,050 ($223,850). The mean (median) dividend yield is

1.36 percent (0.54 percent) and the mean (median) one-year return to shareholders is 18.03 (8.44)

percent. The mean (median) income before extraordinary items and discontinued operations

deflated by total assets (ROA) is 4 (5) percent, while the mean (median) change in ROA (income

before extraordinary items and discontinued operations deflated by total assets) was 0 (1) percent.

The mean (median) variance of ROA (VARROA) is 1 (0) percent. Sixteen percent of the firm year

observations in the sample had a loss in the current year, 37 percent had income lower in the current

year than in the prior year, and 62 percent of the sample is earnings constrained (the mean of

CONSTRAINT).9 The mean (median) ratio of free cash flow to total assets is 1 (0) percent and the

mean (median) value book to market value is 51 (43) percent.

Insert Table 3 here

EMPIRICAL RESULTS

Table 4 presents the results of the Tobit regression analysis for model (1), as well as a

model which excludes VALUE and hence allows us to incorporate 1992 into our analysis.10,11 In

both regressions the coefficient on DUM2 is, as predicted, positive and significant.12 This

provides support for the hypothesis that there was a positive incremental effect of section 162(m)

on the amount of stock options in the compensation package of affected individuals. The

coefficient on the indicator variable, DUM1 is significant, but surprisingly negative. The sign of

this coefficient may be driven by our way of defining highly paid executives, which is based

upon cash compensation – ceteris paribus the higher cash compensation the lower stock-based

compensation. When we redefine highly paid executives based upon total compensation the

coefficient on DUM1 becomes positive and significant, while that on DUM2 remains positive

and significant. The results for the RANK indicator variables are as expected. Higher ranked

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executives receive a higher proportion of their compensation in the form of options; thus we find

both RANK1 and RANK2 to be significant and positive, RANK3 to be insignificant and

RANK4 to be significant, but negative. The control variable, VALUE is negative as expected,

but only marginally significant (p<0.11).

All of the firm related control variables are significant. The coefficients on DIVYIELD

and SIZE are negative (p<0.0001) and positive (p<0.0001) respectively, consistent with the

proportion of stock in the compensation package being inversely related to dividend yield and

positively associated with firm size. The coefficients on the performance measures are mixed, as

the coefficient on ROA is positive and significant (p<0.0001), while the coefficient on TRS is

negative and significant (p<0.0001). The coefficient on RISK is positive and significant

(p<0.0001) consistent with the positive effect of risk on the value of the option being associated

with an increase in the proportion of stock in the compensation package. The other risk related

measure, the variability of income, VARROA is also positive and significant (p<0.0001),

consistent with an increased use of options when accounting based bonuses are more risky.

Consistent with the findings of prior research, FCF and CONSTRAINT are positive and

significant and BKM is significant and negative (p<0.0001). These results indicate that firms are

more likely to use stock options to compensate managers when they have less free cash flow, are

constrained with respect to earnings, or have greater investment opportunities.

The year and industry indicator variables provide a control for industry wide and macro

economic effects. While we omit the coefficients on these indicator variables for brevity, we

discuss them here. The coefficients associated with the years 1994 and 1995 are insignificant, for

the years 1996 through 2001 are significant and positive and for the year 2002 is significant and

negative. With a lag, these coefficients seem to track overall market stock price movements.

That is, while stock returns were flat in 1994, beginning in 1995 stock prices increased through

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the beginning of 2000, at which point a bear market began. The results are consistent with

overall market performance affecting the desirability of stock options to executives and their use

by corporations. While most of the coefficients on the industry controls are significant and

negative; consistent with expectations, those associated with high technology industries are

significant and positive.

Insert Table 4 here

Sensitivity Analysis

Murphy (1998) notes that about 40 percent of firms grant a fixed number of options each

year, while another 40 percent of firms grant options with fixed value each year. In the former

situation there would be a mechanical relation between the Black-Scholes value of option grants

and share price. Consequently in a rising market, independent of any other incentives we would

observe, on average, an increase in BLK_VALU and PERCENTOPT. For that reason we rerun

our analysis in Table 5 using three alternative dependent variables; PERCENTOPT2,

BLK_VALU, and SOPTGRT. PERCENTOPT2 is the Black-Scholes value of options granted

divided by the executive’s total cash compensation, while BLK_VALU is simply the Black-

Scholes value of the options granted, and SOPTGRT is the total number of options granted to

the executive. While the first two alternative measures are subject to the same mechanical

relation between option value and share price, the last is unaffected by it. That is, any changes

observed in SOPTGRT are the result of a conscious decision by the compensation committee to

increase or decrease the number of options granted. The results for all three alternative

dependent variables are consistent with our original model. In all of the analyses, the coefficient

on DUM2 is positive and significant (p<0.0001). Except for the variable, VALUE, the control

variables remain significant; although some signs change. For instance, the coefficient on the

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DUM1 variable is positive and significant, in the regressions with BLK_VALU and

SOPTGRNT as dependent variables.

Insert Table 5 here

We also examine the effect of some alternative performance measures, which we report

in table 6. For accounting based performance measures, we replace ROA first with LESS (an

indicator variable equal to one if net income before extraordinary items and discontinued

operations is less than in the prior year) and then with LOSS (an indicator variable taking the

value of one if net income before extraordinary items and discontinued operations was less than

zero). For stock based performance measures, we replace total return to shareholders over one

year with total returns to shareholders over three (TRS3YR) and five (TRS5YR) year periods. In

all permutations, the coefficient on DUM2 is positive and significant (p<0.0001). The major

difference when we vary our accounting performance variable is the coefficient on that variable.

That is, in the base model, the coefficient on ROA is positive and significant, as it is when we

use LESS as our performance measure. But when we use LOSS, the coefficient becomes

negative, but not significant. The major difference when we vary our market variable is that,

while in the one year window, the coefficient on TRS is negative and significant, in the longer

windows, TRS3YR and TRS5YR, it is positive and significant.

Insert Table 6 here

Additional Analysis

Our tests of model (1) show that affected executives are receiving a greater portion of

their compensation in the form of stock options in the post 162(m) period. Our finding of

increased stock option compensation post-section 162(m) may have occurred for two reasons.

The first possibility is that stock options increased because section 162(m) gave it additional

imprimatur and consequently compensation committees simply added more options to

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compensation packages without any offsetting reduction elsewhere in the package. In fact, this

theory is consistent with the pattern observed by Balsam (2002, table 2.7), whereby stock option

grants increased over time, but so did the other components of the compensation package. The

other alternative is that the increase in stock options was offset by reductions, or if not

reductions, lesser increases in the other components of the compensation package than would

have been observed in the absence of section 162(m). In effect, did firms substitute stock option

compensation for other forms of compensation in the pay packages of affected executives? Risk

and taxes provide opposing incentives to substitute options for bonuses. If the plan is non

qualified then there is no change in the risk of the bonus, hence there is no reason from a risk

perspective to shift from bonuses to options. However if the plan is non qualified the firm may

shift compensation from bonuses to options to preserve deductions. Alternatively if the plan is

qualified, then the risk of the bonus has increased relative to the risk of the options (which may

still be riskier). Consequently for risk reasons we may observe a shift from bonuses to options.

However since both are deductible there is no tax reason to expect a shift. To test which of the

two alternatives are more likely, we run the following modified version of model (1) focusing on

changes in compensation from the pre to post section 162(m) period.

∆BSVit = 0 + 1∆SALi + 2∆BONUSi + 3DUM2i + 4DUM3i + α5∆SAL*DUM2i + α6∆BONUS*DUM2i + α7∆BONUS*DUM3i + 8-11RANKi + 12∆RANKi + 13∆DIVYIELDi + 14∆SIZEi + 15∆TRSi + 16∆ROAi + 17∆VARROAi + 18∆RISKi

+ 19∆CONSTRAINTi + 20∆FCFi + 21∆BKMi + 22∆VALUEit-1 + ∑IND + it (2)

One difference between models (1) and (2) is that while model (1) is a levels regression,

model (2) is a changes regression.13 Further since the change can be either positive or negative,

we use ordinary least squares rather than the Tobit model used above. Instead of using the

percentage of the compensation package comprised of stock options as the dependent variable

we use ∆BSV, the percentage change in the Black-Scholes value of the option grants as the

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dependent variable. This change allows us to include as independent variables ∆SAL, the

percentage change in salary, i.e., (salary-lag(salary))/lag(salary) and ∆BONUS, the percentage

change in bonus and their interactions with DUM2 as independent variables. That is, we could

not use the change in the percentage of compensation package comprised of stock options as the

dependent variable and the corresponding changes in percentage of compensation package

comprised of salary and bonus as independent variables because, by definition, there would have

to be a negative relation between them. The coefficient on DUM2 indicates the incremental

change in the Black-Scholes value of the options granted to affected executives independent of

any changes in the salary and bonus components of compensation, while the coefficients on

∆SAL and ∆BONUS will indicate the unconditional association of the change in salary and bonus

on the change in the Black-Scholes value of the options granted to executives – which we would

normally expect to be positive. We collect data on whether our sample firms qualified their annual

bonus plans14 to include two additional variables – an additional indicator variable taking the value

of one if the executive is affected and if the firm qualified its short term bonus plan (DUM3), and

an interaction variable, ∆BONUS*DUM3. The coefficients of primary interest are those on the

interactions between DUM2 and ∆SAL, DUM2 and ∆BONUS, and DUM3 and ∆BONUS, which

are the incremental effects of the change in salary and change in bonus on change in option

compensation for affected executives.

We conduct our analysis using the change between the last year pre-section 162(m), and the

first year post-section 162(m). For December fiscal year end companies, the last year prior to (first

year after) section 162(m) would be 1993 (1994), while for non-December fiscal year end

companies, the last year prior to (first year after) section 162(m) would be 1994 (1995).

The results of this analysis are presented in table 7. We first run the model without the

qualification variable to serve as a baseline. We find positive coefficients on ∆SAL and ∆BONUS,

18

indicating that the change in option compensation is positively associated with the change in salary

and bonus compensation. Interestingly while the coefficient on the change in bonus (0.9531) is

significantly greater than zero, it is insignificantly different from one. This indicates a one dollar

increase in bonus is associated with a one dollar increase in option compensation. In contrast the

coefficient on the change in salary (73.0343) is significantly greater than one, indicating a one

dollar increase in salary is associated with a 73 dollar increase in option compensation. We then

find that the coefficient on DUM2 is positive and significant, indicating an increase in option

compensation independent of any other changes in the compensation package for affected

executives. The coefficient on ∆SAL*DUM2 (12.1554) is significantly greater than zero, while that

on ∆BONUS*DUM2 (-0.883) is significantly less than zero. The former indicates the multiplier on

a dollar increase in salary increases from 73.0343 for unaffected executives to 85.1897 for affected

executives, and is consistent with firms substituting larger increases in stock options for increases in

salary for affected executives. The latter indicates the coefficient on bonus for affected executives,

the sum of 0.9531 and -0.8883, is insignificantly different from zero.

The results of the regression including the qualification variable (DUM3) are in the right

most columns of table 7. As with the first regression in table 7, we find positive coefficients on

∆SAL, ∆BONUS, DUM2, and ∆SAL* DUM2, and a negative coefficient on ∆BONUS *DUM2,

with the magnitudes of the coefficients almost identical to those in the earlier model. Of the

additional variables, the coefficient on DUM3 is positive, but insignificant, while the interaction,

∆BONUS* DUM3, is positive and significant. The latter, when summed with the coefficients on

the level variable, ∆BONUS, and the interaction, ∆BONUS*DUM2, is also positive and significant,

indicating that for affected executives at firms which qualified their annual bonus plans, there is a

positive and significant association between the change in bonus and change in option

compensation.

19

Focusing on the association between change in option compensation and change in bonus,

we observe that it is positive and significant, and the coefficient is insignificantly different from one

for unaffected executives and affected executives in firms with qualified annual bonus plans. This

is consistent with both bonuses and option grants varying with performance, i.e., assuming that

bonuses are based upon performance, which seems reasonable for at least the firms with qualified

bonus plans. In contrast, when the firm has not qualified its bonus plan, the association between the

change in option compensation and the change in bonus is insignificantly different from zero. That

is, for affected executives changes in options appear to be independent of changes in bonuses. We

do not see any evidence that firms substitute options for bonuses.

SUMMARY

This paper extends the prior research on the effect of Internal Revenue Code section 162(m)

on executive compensation by focusing on the use of stock options. Under the requirements of

section 162(m), firms must put the annual cash bonus compensation at risk for the bonus to qualify

as deductible. This is a significant change from most firms’ practices in previous years. In contrast,

section 162(m) required little or no change in compensatory stock option plans because such plans

generally met the definition of ‘performance-based’ under section 162(m). As a consequence,

section 162(m) increased the risk of annual cash bonuses relative to option compensation. In this

paper, we posit that this may provide an incentive for firms and their executives to shift

compensation to stock options. Our results provide evidence that section 162(m) has led to

increases in the use of stock options by affected firms, presumably to maximize their deductible

compensation. In addition, we find evidence of a substitution effect for salary increases for affected

executives, but no evidence for annual cash bonuses.

Our analysis controls for a variety of other factors that may affect executive stock option

grants, including the dividend yield, firm size, firm performance (both accounting and market), the

20

riskiness of the firm’s shares and volatility of its accounting income as well as the firm’s cash

constraints and its investment opportunities. We also include controls for existing executive equity

ownership, executive rank, year and industry. We interpret our results to mean that firms and their

executives are acting in a way consistent with the incentives provided by section 162(m).

References

Balsam, S., 2002. An Introduction to Executive Compensation, Academic Press, San Diego: California.

Balsam, S., and D. Ryan. 1996. Response to tax law changes involving the deductibility of executive compensation: A model explaining behavior. Journal of the American Taxation Association 18: 1-12.

Balsam, S., and D. Ryan. 2004. Social engineering and the Internal Revenue Code: The case of CEOs hired after the imposition of section 162(m), the million-dollar cap on executive compensation. Working paper, Temple University.

Balsam, S., and J. Yin. 2005. Explaining Firm Willingness to Forfeit Tax Deduction Under Internal Revenue Code Section 162(m): The Million-dollar Cap, forthcoming Journal of Accounting and Public Policy.

Brownstein, A., and M. Panner. 1992. Who should set CEO pay? The press? Congress? Shareholders? The Harvard Business Review (May-June): 28-38.

Carter, M.E., L.J. Lynch, and I. Tuna. 2004. The role of incentives and accounting in the design of executive compensation packages. Working Paper, The University of Pennsylvania.

Core, J and W. Guay. 1999. The use of equity grants to manage optimal equity incentive levels. Journal of Accounting and Economics 28: 151-184.

Crystal, G. 1992. In Search of Excess: The Overcompensation of the American Executive. New York, NY: W.W. Norton.

Dechow, P., A. Hutton, and R. Sloan. 1996. The economic consequences of accounting for stock-based compensation. Journal of Accounting Research 34: 1-20.:

Financial Economists Roundtable. 2003. Statement on the controversy over executive compensation. Website url: http://www.luc.edu/orgs/finroundtable.

Halperin, R., Y. Kwon, and S. Rhoades-Catanach. 2001. The impact of deductibility limits on compensation contracts: A theoretical examination. Journal of American Taxation Association 23 (supplement): 52-65.

21

Harris, D., and J. Livingstone. 2002. Federal tax legislation as a political cost benchmark. The Accounting Review 77 (October): 997-1018.

Hodges, F., S. Rajgopal, and T. Shevlin. 2005. How do managers value stock options and restricted stock. Working Paper, University of Washington.

Johnson, M., S. Porter. and M. Shackell. 2001. Stakeholder pressure and the structure of executive compensation. Working Paper, University of Michigan.

Lambert, R. A., W. N. Lanen, and D. F. Larcker, 1989, Executive stock option plans and corporate dividend policy, Journal of Financial and Quantitative Analysis 24: 409-425.

Liang, N. and S. J. Weisbenner. 2001. Who Benefits from a Bull Market? An Analysis of Employee Stock Option Grants and Stock Prices. FEDS Working Paper No. 2001-57.

Matsunaga, S. R. 1995. The effects of financial reporting costs on the use of employee stock options, The Accounting Review 70(1): 1-26.

McCarroll, T. 1993. Rolling back executive pay. Time (March 1): 49-50.

Meulbroek, Lisa K. 2001. The efficiency of equity-linked compensation: Understanding the full cost of awarding executive stock options, Financial Management 30(2): 5-44.

Murphy, K. J. 1985. Corporate Performance and Management Remuneration: An Empirical Analysis, Journal of Accounting and Economics 7: 11-42.

Murphy, K. J. 1998. Executive compensation, Working Paper, University of Southern California

Perry, T., and M. Zenner. 2001. Pay for performance? Government regulation and the structure of compensation contracts. Journal of Financial Economics 62(3): 453-488.

Reitenga, A., S. Buchheit, J. Yin, and T. Baker. 2002. CEO bonus pay, tax policy, and earnings management. Journal of American Accounting Association (supplement), 1-23.

Rose, N., and C. Wolfram. 2000. Has the “million-dollar cap” affected CEO pay? The American Economic Review 90(2): 197-202.

Rose, N., and C. Wolfram. 2002. Regulating executive pay: Using the tax code to influence chief executive compensation. Journal of Labor Economics 20(2): S138-175.

U.S. Congress, House. 1993. Fiscal year budget reconciliation: Recommendations of the Committee on Ways and Means. (May 18) Washington, DC: U.S. Government Printing Office.

Yermack, D. 1995. Do corporations award CEO stock options effectively? Journal of Financial Economics 39: 237-269.

22

23

TABLE 1Industry Distribution

Two-digit SIC Code Number of Observations Percentage of Observations

1 188 0.307 18 0.00

10 442 0.7012 15 0.0013 2,000 3.4014 140 0.2015 365 0.6016 215 0.4017 74 0.1020 1,609 2.7021 85 0.1022 516 0.9023 586 1.0024 470 0.8025 399 0.7026 1,174 2.0027 1,268 2.1028 4,633 7.8029 624 1.0030 613 1.0031 199 0.3032 396 0.7033 1,509 2.5034 959 1.6035 3,775 6.3036 4,289 7.2037 1,931 3.2038 2,707 4.5039 450 0.8040 283 0.5041 29 0.0042 425 0.7044 241 0.4045 579 1.0047 191 0.3048 1,397 2.3049 4,608 7.7050 1,241 2.1051 733 1.2052 289 0.50

24

53 856 1.4054 493 0.8055 256 0.4056 960 1.6057 472 0.8058 1,075 1.8059 1,171 2.0060 58 0.1061 557 0.9062 882 1.5063 2,501 4.2064 386 0.6067 433 0.7070 202 0.3072 308 0.5073 4,643 7.8075 119 0.2078 188 0.3079 447 0.7080 973 1.6082 155 0.3083 14 0.0087 612 1.0099 272 0.50

25

TABLE 2Year Distribution

Fiscal Year Ending Number of Observations Percentage of Observations

1993 4,526 7.601994 (Pre December) 2,280 3.82

1994 (December) 3,966 6.641995 6,253 10.501996 6,339 10.601997 6,562 11.001998 6,170 10.301999 6,301 10.602000 6,090 10.202001 5,763 9.702002 5,448 9.10

59,698

26

TABLE 3Descriptive Statistics

Variables Observations Mean Std Dev 1st

QuartileMedian 3rd

QuartilePERCENTOPT 59698 0.53 1.09 0.05 0.28 0.51PERCENTOPT2 59619 1.17 1.94 0.06 0.48 1.28BSVAL 59698 900.05 1,946.03 19.62 223.85 784.62NUMGRT 59698 74.87 135.52 5.00 25.00 75.00DUM1 59698 0.20 0.40 0.00 0.00 0.00DUM2 59698 0.19 0.39 0.00 0.00 0.00DIVYIELD 59698 1.36 2.21 0.00 0.54 2.09SIZE 59698 7.15 1.58 5.97 7.01 8.22TRS 59698 18.03 69.33 -15.83 8.44 35.48TRS3YR 59698 9.16 27.56 -5.72 9.39 24.56TRS5YR 59698 7.41 21.37 -5.42 9.21 20.46ROA 59698 0.04 0.09 0.02 0.05 0.08PCROA 59698 0.00 0.08 -0.01 0.01 0.03LOSS 59698 0.16 0.36 0.00 0.00 0.00LESS 59666 0.37 0.48 0.00 0.00 1.00VARROA 59698 0.01 0.05 0.00 0.00 0.00RISK 59698 0.40 0.18 0.27 0.36 0.50CONSTRAINT 59698 0.62 0.48 0.00 1.00 1.00FCF 59698 0.01 0.10 -0.05 0.00 0.06BKM 59698 0.51 0.61 0.26 0.43 0.66VALUE 59698 584.07 87,217.67 0.83 2.25 6.11

Where

PERCENTOPTit = the Black-Scholes value of option grants to executive i in year t divided by executive i's total compensation, where both the Black-Scholes value and total compensation are provided by ExecuComp;

PERCENTOPT2it = is the Black-Scholes value of option grants to executive i in year t divided by executive i’s total cash compensation, where both the Black-Scholes value and total cash compensation are provided by ExecuComp;

BSVALit = is the Black-Scholes value of the options granted to executive i in year t as provided by ExecuComp;

NUMGRTit =the total number of options granted to executive i in year t;DUM1it =is an indicator variable taking the value of 1 if cash compensation of

executive i is greater than $900,000 in year t, 0 otherwise;DUM2it =is an indicator variable taking the value of 1 if cash compensation of

executive i is greater than $900,000 in year t and year t is 1994 or later, 0 otherwise;

DIVYIELDit = the dividend yield of executive i's firm in year t;SIZEit = the log of assets of executive i's firm in year t;TRSit = the return to shareholders of executive i's firm in year t;

27

TRS3YRit = the return to shareholders of executive i's firm for three years ending with year t;

TRS5YRit = the return to shareholders of executive i's firm for three years ending with year t;

ROAit = net income before extraordinary items and discontinued operations deflated by total assets for executive i's firm for year t;

PCROAit = change in net income before extraordinary items and discontinued operations deflated by total assets for executive i's firm in year t;

LESSit = indicator variables taking the value of one if net income before extraordinary items and discontinued operations was less than prior year, and zero otherwise for executive i's firm in year t;

LOSSit = indicator variables taking the value of one if net income before extraordinary items and discontinued operations was less than zero, and zero otherwise for executive i's firm in year t;

VARROAit = variance of NIBEX using all available observations for company i. Minimum number of observations is 6.

RISKit =the volatility measure (60 month) used by ExecuComp to calculate the Black-Scholes values for executive i's firm in year t ;

CONSTRAINTit = indicator variable taking the value of 1 when retained earnings plus the value of cash dividends and stock repurchases in the current year divided by cash dividends and stock repurchases in prior year is less than two and 0 otherwise;

FCFit = ratio of free cash flow to total assets;BKMit = book to market value of equity; andVALUEit = value of shares owned, plus intrinsic value of options held, deflated by

total direct compensation – all measured at end of previous year.

28

TABLE 4Tobit Regression Results

PERCENTOPTit = 0 + 1DUM1it + 2DUM2it + 3DIVYIELDit + 4SIZEit + 5TRSit + 6ROAit + 7VARROAit + 8RISKit + 9CONSTRAINTit + 10FCFit + 11BKMit + 12VALUEit-1 + 13-16RANKit + ∑YEAR + ∑IND + it

Model w/VALUE Model w/o VALUE

Variable name COEFFICIENT(Chi-square)

COEFFICIENT(Chi-square)

INTERCEPT -2.3394*** (370.22)

-2.1014***(545.19)

DUM2 0.2805*** (24.66)

0.2698***(43.54)

Executive related control variables DUM1 -0.3774

*** (47.02)-0.2504

***(41.09)RANK1 0.4339

*** (576.95)0.5613

***(1410.55)RANK2 0.1800

*** (80.61)0.2154

***(181.93)RANK3 -0.0197

(0.82)0.0097(0.34)

RANK4 -0.0898*** (13.79)

-0.0867***( 24.56)

VALUE -0.0000(2.49)

Firm related control variablesDIVYIELD -0.0343

*** (142.80)-0.0342

***(226.32)SIZE 0.3335

*** (3665.69)0.2536

***( 3792.76)TRS -0.0004

*** (21.25)-0.0003

***(31.00)ROA 1.7415

*** (419.81)1.0604

***(293.55)RISK 3.6876

*** (3951.78)3.2913

***(5563.75)VARROA 1.4143

*** (115.85)1.0082

***(103.51)CONSTRAINT 0.2349

*** (224.03)0.1969

****(266.66)FCF 0.8592

*** (182.43)0.7376

***(242.77)BKM -0.3168

*** (624.22)-0.2570

***( 771.89)YEAR NR NRIND NR NR

*** denotes significance at p value < .01Variable definitions are provided at the bottom of table 3We omit the coefficients for the year and industry dummies for brevity.

29

TABLE 5Tobit Regression Results for Alternative Dependent Variables

DEPENDit = 0 + 1DUM1it + 2DUM2it + 3DIVYIELDit + 4SIZEit + 5TRSit + 6ROAit + 7VARROAit + 8RISKit +

9CONSTRAINTit + 10FCFit + 11BKMit + 12VALUEit-1 + 13-16RANKit + ∑YEAR + ∑IND + it Dependent

variablePERCENTOPT2 BLK_VALU SOPTGRNT

Variable name COEFFICIENT(Chi-square)

COEFFICIENT

Chi-square)

COEFFICIENT(Chi-square)

INTERCEPT -5.3058*** (729.65)

-7529.7000*** (1359.18)

-396.3115*** (810.10)

DUM2 0.4269*** (21.51)

1833.5000*** (363.12)

79.9039*** (135.21)

Executive related control variables DUM1 -0.7031

*** (61.64)317.3985

*** (11.52)71.0117

*** (125.33)RANK1 0.8263

*** (787.72)1184.0000

*** (1461.85)95.9944

*** (2093.52)RANK2 0.3385

*** (107.63)470.0726

*** (190.95)32.6146

*** (198.41)RANK3 -0.0428

(1.45)-122.5160

*** (10.95)-20.4406

*** (65.89)RANK4 -0.1504

*** (14.55)-116.3133*** (8.06)

-17.2007*** (37.88)

VALUE -0.0000(2.43)

-0.0000(0.06)

-0.0000(0.07)

Firm related control variablesDIVYIELD -0.0632

*** (189.73)-56.8137

*** (128.81)-1.2296

*** (13.95)SIZE 0.6313

*** (4969.29)824.8847

*** (7966.08)42.4815

*** (4656.33)TRS -0.0005

*** (11.10)1.0602

*** (46.73)-0.0346

*** (10.23)ROA 2.8155

*** (423.01)2953.6000

*** (416.50)-48.6752

*** (23.15)RISK 7.0420

*** (5388.19)5415.7000

*** (2976.40)338.5982

*** (2530.59)VARROA 2.1850

*** (104.63)2609.3000

*** (135.12)325.73

*** (437.10)CONSTRAINT 0.3581

*** (195.02)335.5600

*** (159.34)23.1464

*** (166.05)FCF 1.5787

*** (230.53)557.1492

*** (25.83)-29.7300

*** (15.75)BKM -0.5865

*** (832.23)-425.1669

*** (420.64)-19.1967

*** (197.86)

YEAR NR NR NRIND NR NR NR

Notes:*** denotes significance at p value < .01Variable definitions are provided at the bottom of table 3We omit the coefficients for the year and industry dummies for brevity.

30

TABLE 6Tobit Regression Results with Alternative Performance Measures

The dependent variable is PERCENTOPT Variable name COEFFICIENT

(Chi-square)

INTERCEPT -2.2663***(346.81

)

-2.2222***(322.90

)

-2.4100***(397.59

)

-2.3875***(390.39

)DUM2 0.2794

***(24.26)0.2831

***(24.94)0.2901

***(26.38)0.2856

***(25.61)

1 Both Matsunaga (1995, note 6) and Murphy (1998) find about 95 percent of corporations granting options with an exercise price equal to grant-date fair market value .

2 As noted in the sensitivity analysis, we alternatively define the dependent variable as Black-Scholes value of options granted divided by total cash compensation, as the un-deflated Black-Scholes value of options granted, and as the number of options granted, with no change in results.

3 We use cash compensation rather than total compensation to define affected executives following the previous literature, e.g., Perry and Zenner (2001), Balsam and Ryan (2004), Balsam and Yin (2005). We use a cutoff of $900,000 to avoid missing firms that reduced compensation because of section 162(m). Our results are not affected by the use of other cutoffs, i.e., $950,000 or $1,000,000. In addition, our results are qualitatively the same when we also use salary or total direct compensation to define affected executives. Consequently while our choice of affected executives could potentially bias our results, the fact that the results are robust to alternative cutoffs and ways of measuring affected executives provides reassurance that this is not the case.

4 Rank 5 is incorporated into the intercept. The results are the same if we use rank 1 as the intercept.

5 In place of ROA, we tried other performance measures, indicator variables indicating if net income was less than the prior year or the existence of a loss. As shown in the sensitivity analysis, our conclusion is unchanged.

6 The year 1993 is incorporated into the intercept. The results are the same if we use 2002 as the intercept.

7 While the bonus has to be based on objective performance measures, there is no requirement that these measures be accounting based.

8 We need information on each executive’s prior year stock and option holdings to compute the variable, VALUE. Consequently, we lose observations in those instances where prior year information on the executive’s holdings is not available because the executive was not a listed officer in the company in the prior year.

9 The difference between the 62 percent we report and the 44 percent reported in Core and Guay (1999) is driven by our decision to classify those firms that do not pay dividends or repurchase shares as constrained. If we reclassify those firms as unconstrained the percentage of firms classified as constrained drops to 47 percent. Most importantly, reclassifying those firms does not affect our results.

10 Recall that in our model, this period’s equity compensation is based in part, on the equity and option holdings at the end of the period, i.e., VALUE is lagged, causing us to lose the earliest year for which

31

Executive related control variables DUM1 -0.3440

***(38.74)-0.3580

***(42.00)-0.3990

***(52.55)-0.3962

***(51.90)RANK1 0.4276

***(556.75)0.4286

***(559.16)0.4320

***(573.01)0.4344

***(579.74)RANK2 0.1866

***(85.91)0.1832

***(82.81)0.1754

***(76.58)0.1809

*** (81.64)RANK3 -0.0207

(0.89)-0.0220

(1.01)-0.0271

(1.54)-0.0281

(1.66)RANK4 -0.0810

*** (11.13)-0.0837

*** (11.89)-0.0964

*** (15.91)-0.0967

*** (16.02)VALUE -0.0000

(1.91)-0.0000

(2.09)-0.0000

(2.65)-0.0000

(2.44)Firm related control variablesDIVYIELD -0.0333

*** (141.40)-0.0327

*** (133.24)

-0.0320***

(118.30)

-0.0311***

(111.69)SIZE 0.3144

*** (3261.42)

0.3182*** (3346.5)

0.3304***

(3595.5)

0.3254***

(3448.9)TRS -0.00

(0.10)-0.0002

(3.51)TRS 3 yr 0.0028

*** (134.21)

TRS 5 yr 0.0041***

(174.21)ROA 1.4487

*** (279.70)

1.4821***

(300.35)LESS 0.0889

*** (41.62)LOSS -0.0248

(1.58)RISK 3.3662

*** (3471.70)

3.4184***

(3378.6)

3.6366***

(3892.5)

3.6571***

(3956.5)VARROA 0.8644

*** (45.76)0.9039

*** (49.37)1.4714

*** (123.91)

1.4960***

(128.68)CONSTRAINT 0.2454

*** (243.14)0.2422

*** 0.2449

*** 0.2623

***

data is available.

11 One advantage of incorporating 1992 into the analysis is that the percentage of the observations in the pre section 162(m) period increases from 11.42 percent to 18.90 percent of the sample.

12 The coefficient on VALUE is insignificant and does not affect the significance of the coefficients on any of the other variables in the model. 13 We include the current level of executive rank as an independent variable as the rate of compensation change can differ across executive ranks, and we include the change in executive rank as an additional independent variable as a promotion (or demotion) will affect the rate of compensation change.

14 We also reran model one including an additional indicator variable for whether on not the firm qualified its annual bonus plan. The indicator variable was insignificant and our variable of interest, DUM2 remained positive and significant.

32

(236.82) (242.58) (274.15)FCF 0.4953

*** (64.28)0.5241

*** (71.79)0.8306

*** (170.64)

0.8568***

(182.48)BKM -0.3840

*** (987.80)-0.3729

*** (896.27)

-0.2712***

(441.05)

-0.2767***

(472.19)

YEAR NR NR NR NRIND NR NR NR NR

*** denotes significance at p < 0.01Variable definitions are provided at the bottom of table 3. We omit the coefficients for the year and industry dummies for brevity.

33

TABLE 7OLS Regression Results for Change Model

The dependent variable is the change in the Black Scholes value of options

∆BSVit = 0 + 1∆SALi + 2∆BONUSi + 3DUM2i + 4DUM3i + α5∆SAL*DUM2i + α6∆BONUS*DUM2i +

α7∆BONUS*DUM3i + 8-11RANKi + 12∆RANKi + 13∆DIVYIELDi + 14∆SIZEi + 15∆TRSi + 16∆ROAi + 17∆VARROAi + 18∆RISKi + 19∆CONSTRAINTi + 20∆FCFi + 21∆BKMi + 22∆VALUEit-1 + ∑IND + it (2)

Variable Coeff (t-stat) Coeff (t-stat)

INTERCEPT -12.1822 -0.24 -12.6011 -0.25∆SAL 73.0343 ***61.40 73.0450 ***61.41∆BONUS 0.9531 ***9.27 0.9524 ***9.27DUM2 23.2195 ***2.96 20.9733 **2.51DUM3 12.9285 0.74∆SAL*DUM2 12.1554 ***4.16 11.5066 ***3.92∆BONUS*DUM2 -0.8883 ***-4.20 -0.9394 ***-4.40∆BONUS*DUM3 0.7277 1.96RANK1 19.0852 **2.17 18.8834 **2.15RANK2 8.0037 0.79 7.8686 0.77RANK3 -2.1867 -0.20 -2.0851 -0.19RANK4 5.1479 0.44 5.1350 0.44∆RANK -1.3885 -0.41 -1.3927 -0.41∆DIVYIELD -11.1006 ***-5.15 -11.0634 ***-5.14∆SIZE 59.0416 ***6.88 58.8093 ***6.85∆TRS -18.2960 -1.01 -17.9035 -0.99∆ROA 1.6451 1.49 1.6486 1.49∆RISK 0.0000 ***4.12 0.0000 ***4.16∆VARROA -0.2094 -0.80 -0.2149 -0.82∆CONSTRAINT -57.1407 -1.11 -55.0935 -1.07∆FCF 0.0579 0.20 0.0491 0.17∆BKM 12.3386 1.55 12.0442 1.51IND NR NR

Notes:*** denotes significance at p < 0.01.Where DUM3 is an indicator variable that takes the value of 1 if the executive is defined as affected (i.e., DUM2=1) and the firm has qualified its short-term bonus plan and all other variables are defined at the bottom of table 3. The symbol ∆ in a variable name denotes a change in the value of the variable from the last year pre-section 162(m) to the first year post-section 162(m). For December fiscal year end companies, the last year prior to (first year after) section 162(m) would be 1993 (1994), while for non-December fiscal year end companies, the last year prior to (first year after) section 162(m) would be 1994 (1995). We omit the coefficients for the industry dummies for brevity.

34

Notes

35