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Behavioral Responses of CEOs to Stock Ownership and Stock Option Pay
Author(s): Gerard Sanders

Source: The Academy of Management Journal, Vol. 44, No. 3 (Jun., 2001), pp. 477-492
Published by: Academy of Management
Stable URL: http://www.jstor.org/stable/3069365
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o Academy of Management Journal
2001, Vol. 44, No. 3, 477-492.
BEHAVIORAL RESPONSES OF CEOs TO STOCK OWNERSHIP

AND STOCK OPTION PAY
WM. GERARD SANDERS

Brigham Young University
Executive stock ownership and stock option pay are often assumed to have congruent
incentive effects; however, these incentives have asymmetrical risk properties, and
executives may respond to them in different ways. This study, which examined the
effects of ownership and option pay, showed that they had diametrically opposite
effects on firms' acquisition and divestiture propensity. Moreover, situational charac-
teristics moderated the risk-seeking behavior associated with stock option pay but not
the risk aversion associated with ownership.
The past two decades have witnessed an increaseplistic assumptions about how executives make
decisions. Others have raised questions about
in the use and the levels of executive stock option
whether top executives really base changes in ho
pay and a call for greater levels of executive stock
ownership among large U.S. firms (Jarrell, they 1993;manage firms on the form of their incentive
Lublin, 1998; Westphal & Zajac, 1994; Yermack, (Andrews, 1987; Finkelstein & Hambrick, 1996).
1995). Stock option pay now averages close Finally,
to 40 although research on executive financial
percent of total CEO pay (Forbes, 1998), and in-
incentives has proliferated, most of that research
creasing numbers of firms are requiring theirhas topfocused on the association between firm per-
executives to own significant amounts of firm stock
formance and compensation levels (Barkema &
(Gogoi, 1999). Many agency theorists (Baker, Gomez-Mejia, 1998; Finkelstein & Hambrick, 1996).
Jensen, & Murphy, 1990; Eaton & Rosen, 1983; Thus, there is little direct empirical evidence re-
Mehran, 1995; Shleifer & Vishny, 1997), manage- garding the effects of stock-based financial incen-
ment scholars (Hrebiniak & Joyce, 1983), and pay tives (Finkelstein & Hambrick, 1996; Murphy,
consultants (O'Byrne, 1992) advocate stock-based 1999). Therefore, my first goal in this research was
incentives because they reward executives for cre- to examine behavioral effects of stock-based finan-
ating shareholder value. This incentive alignment cial incentives by studying the association between
hypothesis suggests that boards can use stock- such incentives and important corporate resource
based incentives to discourage managerial oppor- allocations.
tunism, promote shareholder-wealth-maximizing An important but untested assumption under-
behaviors, and achieve higher levels of firm perfor-
lying the use of stock option pay is that it substi-
mance (Jensen & Meckling, 1976; Jensen & Murphy,
tutes for executive stock ownership, rewarding ex-
1990; Marcus, 1981). The stock market appears to
ecutives achieving higher stock prices (Jensen &
anticipate and positively value the purported ben-
Murphy, 1990; Shleifer & Vishny, 1997; Yermack,
efits of stock-based incentives (Westphal, 1999).
1995). Thus, it is widely assumed that stock option
Nevertheless, some scholars have questioned
pay and executive stock ownership have congruent
whether incentives actually work as prescribed.
incentive effects. A common research practice in
For instance, Donaldson and Lorsch (1983) argued
this area has been to aggregate stock option pay and
that the incentive alignment logic is based on sim-
stock ownership into a single measure of stock-
based incentives, suggesting an implicit belief that
these two incentives have similar effects (Agrawal
I wish to thank Alison Davis-Blake and David B. Jemi- & Mandelker, 1987; Eaton & Rosen, 1983; Jensen &
son (my dissertation cochairs), Jim Fredrickson, Paul Murphy, 1990; Mehran, 1995). Consultants also use
Mang, and John Martin for their guidance and assistance
this logic of substitution when recommending that
during the early stages of this research. In addition, I
firms aggressively implement stock option schemes
thank Mason Carpenter, Catherine Daily, Hal Gregersen,
Rita Kosnik, Lee Perry, Mark Shanley, Jim Walsh, Jim
(Towers Perrin, 1997). When describing executive
Westphal, Robert Wiseman, and two anonymous review- pay in firm proxy statements, boards of directors
ers for their helpful comments. This research was par- often explicitly state that stock option pay is a
tially funded by a grant from the Eugene and Dora Bon- useful incentive that can be used when executive
ham Memorial Fund. stock ownership is lacking (cf. Zajac & Westphal,
477
478 Academy of Management Journal June
1995). Although the assumption of substitution ap- nancial incentives may have effects not generally
pears to be widely held, it has been for the most foreseen. Prior empirical research on the link be-
part untested. Research has shown that the use of tween incentives and acquisitions has focused on
option pay is greater when ownership levels are two distinct issues. First, research has examined
low (Zajac & Westphal, 1994), but no research has acquisitions as a means to achieve higher levels of
examined whether these two incentives have con- pay (Lambert & Larcker, 1987; Rose & Shepard,
gruent effects on firms. This gap is important, be- 1997; Schmidt & Fowler, 1990). Second, research
cause stock option pay has some risk attributes thathas used event studies to examine the correlation
differ from those of stock ownership. The riskbetween incentives and stock price returns afte
asymmetry between the two incentives may bearacquisitions (Agrawal & Mandelker, 1987; Lewe
significantly on how executives respond to them.len, Lorderer, & Rosenfeld, 1985). In contrast to
Therefore, my second purpose in this study was to these two streams of research, this study examines
examine whether stock option pay is an effectivehow stock ownership and stock option pay affect
substitute for executive stock ownership. Specifi-the propensity of firms to engage in acquisitions
cally, I examined whether stock option pay and and divestitures.
executive stock ownership have congruent effects Because the focus of this study was the behav-
on corporate resource allocation decisions. ioral effects of incentives, I used behavioral deci-
Acquisitions and divestitures are interesting cor- sion theory (Shapira, 1995; Sitkin & Pablo, 1992;
porate resource-allocation decisions that offer theWiseman & Gomez-Mejia, 1998) to supplement the
opportunity to study the effects of stock-based fi- traditional agency theory view of incentives.
nancial incentives. These corporate actions repre-Agency theory focuses on the role of incentives in
sent very common investment choices made by altering agents' risk aversion, but agency theorists
large firms. Worldwide, there were more than have sometimes ignored the organizational and sit-
16,000 acquisitions and divestitures in 1999, val-uational contexts associated with decision making
ued at over $3.4 trillion, more than one-half of (Amburgey & Miner, 1992). On the other hand,
which were made in the United States. Moreover, behavioral decision theory has focused more on
by their very nature, acquisitions and divestitures situational characteristics as determinants of risky
are risky (Haspeslagh & Jemison, 1991; Pablo, Sit- decision making, but its theorists have given little
kin, & Jemison, 1996; Shapira, 1995). Research in- direct attention to the role of top executive incen-
dicates significant variance in returns from acqui- tive systems. I argue that both incentives and situ-
sitions (Jensen & Ruback, 1983; Mueller, 1987; ational characteristics are likely to influence deci-
Ravenscraft & Scherer, 1987). Furthermore, because sions to acquire and divest businesses. Moreover,
acquisitions often fail, they tend to result in subse- research on risky decision making suggests that
quent divestitures (Porter, 1987; Ravenscraft & executives may respond to the asymmetric risk
Scherer, 1987). In general, the market values dives- properties of ownership and option pay in ways not
titures positively (John & Ofek, 1995; Linn & Rozeff, generally anticipated by scholars, consultants, and
1984; Markides, 1995; Weston & Chung, 1990). boards. In the next section, I detail the dimensions
However, empirical evidence suggests that returns on which stock ownership and stock option pay are
are not always positive and that many divestitures similar and incongruent and then develop specific
result in negative market reactions (Markides, hypotheses.
1992; Markides & Berg, 1992). Thus, divestitures
are also somewhat risky.
Scholars have suggested that acquisitions and CONCEPT''UAL DEVELOPMENT
divestitures are largely functions of executive fi-
The Effect of Asymmetric Risk
nancial incentives (Dial & Murphy, 1995; Jensen,
1986; Jensen & Murphy, 1990; Mueller, 1987). For Although commonly viewed as congruent incen
example, scholars have contended that without a tives, stock ownership and stock options tie ex
stock-based incentive structure, executives (1) utive wealth to that of shareholders in different
"cause their firms to grow beyond the optimal size" ways. For executives who own stock, the value of
(Jensen, 1986: 323), (2) "are invariably tempted to their shares changes in direct proportion to share-
acquire other companies and expand the diversity holder returns, both positively and negatively.
of their empire" (Jensen & Murphy, 1990: 149), and Moreover, at any given time an executive's stock
(3) "resist downsizing and restructuring" (Dial & portfolio has currency: real and immediate value
Murphy, 1995: 266). However, empirical evidence that can be exchanged for goods and services.
of such relationships is lacking. In addition, due to These attributes contrast with features of stock op-
asymmetrical risk properties, some stock-based fi- tions. Like executives who own stock, those paid
2001 Sanders 479
with options benefit along with shareholders when Acquisitions. The incentive alignment perspec-
stock prices rise. However, in the event that the tive suggests that executives who own large
firm's stock price declines after the date of the stock amounts of stock should be reluctant to engage in
option grant, executives experience no reduction in acquisitions (Amihud & Lev, 1981; Jensen & Mur-
real wealth. Whenever the stock price is at or below phy, 1990). This idea is based on the assumption
the option price, no executive would exercise his or that share-holding executives will avoid invest-
her options; the options' positive payoff is zero as ments that do not increase the wealth of sharehold-
long as the stock price remains below the option ers. The behavioral perspective gives a similar
price (Wu, 1998). In addition, when granted, option prediction, but for a slightly different reason: share-
pay has no marketable value. Thus, both ownership holding executives have something to lose (the
and stock option pay result in executives benefiting value of their stock) and will be somewhat risk
from rising stock prices; however, only stock own- averse. It is very difficult to predict a priori which
ership can result in executives suffering real and acquisitions will add value and which will reduce
immediate reductions in their current wealth. value. Therefore, stock ownership is likely to cause
The familiar agency theory view suggests that executives to be conservative when considering ac-
stock-based incentives motivate executives to be quisitions and generally to avoid them. So, with
respect to executive stock ownership, the behav-
less risk averse and to invest in projects that should
increase shareholders' wealth because doing ioral
so view of decision making results in a predic-
will also increase executive wealth; however, such tion consistent with that of the traditional incentive
a view places little emphasis on downside risk. alignment hypothesis. Specifically:
Although some agency theorists have noted that
Hypothesis 1. There will be a negative associ-
stock ownership and stock option pay have differ-
ation between CEO stock ownership and firm
ent risk characteristics (Marcus, 1981; Tufano,
acquisition activity.
1996), the conclusion from such an observation is
typically that the intensity of incentive effects will As reviewed earlier, the incentive alignment
differ. Research in behavioral decision theory sug- logic has been routinely applied to stock option pay
gests that downside risk is as important as upside as if its effects were congruent with those of stock
potential when determining a decision maker's risk ownership (Eaton & Rosen, 1983; Jensen & Murphy,
aversion. When decision makers have something to 1990; Mehran, 1990). However, as noted, there is a
lose, they exhibit strong preferences for risk aver- great deal of variance in acquisition outcomes
sion (Kahneman & Tversky, 1979). Alternatively, (Haspeslagh & Jemison, 1991; Jensen & Ruback,
those who have nothing to lose but something to 1983; Pablo et al., 1996). Some acquisitions pro-
gain exhibit preferences for riskier alternatives duce very large gains when they are announced.
(Kahneman & Tversky, 1979; Sitkin & Weingart, Some acquisitions add value after the transactions
1995). This view of decision making has generally have occurred, and the market may not be able to
been applied when gains and losses are defined in fully value such gains at the time of the transac-
terms of the firm or decision situation. I suggest tions (Haspeslagh & Jemison, 1991). Thus, there is
that it also has important application in the realm an opportunity for executives to benefit signifi-
of the decision maker's personal financial incen- cantly from gains in stock price associated with
tives. some acquisitions. And, given that executives may
Because the risk-reward characteristics of stock have healthy doses of managerial hubris, many are
ownership and stock option pay are fundamentally likely to perceive that their acquisitions will have
different, they likely have distinct effects on deci- positive outcomes (Hayward & Hambrick, 1997;
sion making. Since both incentives reward execu-Roll, 1986). Hence, those paid with options are
tives for increasing firm share prices, both may motivated to chase potentially large gains from ac-
encourage decisions that can increase shareholder quisitions even if such gains are not assured. Be-
wealth. However, the downside risk associated cause option pay does not penalize executives for
with stock ownership may lead executives to be acquisition failures, it provides little disincentive
more risk averse. Alternatively, given the fact that to engage in acquisitions. This leads to the follow-
options reward only upside movements and do not ing hypothesis:
penalize downside movements in stock price, op-
Hypothesis 2. There will be a positive associa-
tion pay should result in risk-seeking behaviors.
tion between CEO stock option pay and firm
Consequently, I expected the risk asymmetry be-
acquisition activity.
tween stock ownership and stock option pay to
affect executives' risk propensity in terms of engag- Divestitures. Divestitures have become an in-
ing in acquisitions and divestitures. creasingly popular corporate restructuring tool
(Markides, 1995), and they generally lead to an in- large and growing firms (Donaldson & Lorsch, 198
crease in shareholder value. For example, Markides Mueller, 1987). For example, Jensen observed that fe
(1992) reported that the cumulative abnormal re- CEOs want "to be remembered as presiding over an
turn to shareholders over the two days following an enterprise that makes fewer products in fewer plants
announced divestiture was 1.73 percent. Markides fewer countries than when he or she took office-even
and Berg (1992) reported that such abnormal stock when such a course increases productivity and adds
price gains persist for approximately two months hundreds of millions of dollars of shareholder value"
surrounding the initial announcement of a divesti- (1989: 66). Moreover, the level of executive compensa-
ture. A review of many studies of divestitures (John tion is strongly tied to firm size (Hambrick & Finkel-
& Ofek, 1995; Klein, 1986; Linn & Rozeff, 1984; stein, 1995). Strong financial incentives, such as stock
Markides, 1992, 1995; Montgomery & Thomas, option pay, may be needed to motivate executives to
1988; Tehranian, Travlos, & Waegelein, 1987; willingly divest (Dial & Murphy, 1995).
Weston & Chung, 1990) makes it clear that the As noted above, divestitures do often lead to
average return from divestitures is positive and sig- higher stock prices. Consequently, for executives
nificant. Given that divestitures generally result in who are granted stock options, divestitures present
increases in firm share prices, some have suggested an opportunity to create possible value in those
that higher levels of executive stock ownership will options. In addition, option pay offers no disincen-
result in an increased willingness to downsize a tive to engage in divestitures because there is no
firm through divestitures (Dial & Murphy, 1995). direct financial penalty for option holders when
The incentive alignment logic may not capture divestitures result in reductions in shareholder
the whole process; there is also evidence that di- value. Therefore, stock option pay is likely to resu
vestitures sometimes decrease shareholder value as
in executives framing possible divestiture deci
well (Markides, 1992; 1995; Markides & Berg, sions as opportunities to gain. This logic support
1992). For example, Markides (1992) reported thatHypothesis 4:
one-third of divestitures in his study destroyed Hypothesis 4. There will be a positive associa-
shareholder value. Similar results have been re-
tion between CEO stock option pay and firm
ported in other studies (Klein, 1986; Tehranian et divestiture activity.
al., 1987). In addition, some scholars have argued
that divestitures and downsizing can have delete-The Context of Incentives
rious effects on firms; they may result in lower
employee morale, loss of key corporate resources The specific situational characteristics in which
necessary to other divisions, and the realization of
stock-based incentives are present likely play a sig-
large accounting losses in the near term (Freeman nificant
& role in how those incentives affect decision
Cameron, 1993; Markides, 1995). Thus, divestituresmaking (Amburgey & Miner, 1992). This is impor-
tant, because boards often implement incentives
offer an opportunity to create value for sharehold-
such as stock option pay with the expressed inten-
ers, but they also bring with them the prospect for
significant value erosion. tion of achieving incentive alignment and altering
Given that divestitures generally lead to higher firm outcomes (Westphal & Zajac, 1994). Situa-
stock prices, the upside of stock ownership may tional characteristics could conceivably obscure
the incentive effects desired by a board (Kosnik,
motivate greater propensity to engage in divesti-
tures. Alternatively, given the potential risk that
1987). Consequently, understanding the contingen-
divestitures could reduce shareholder value, share-cies that affect the ability of financial incentives to
alter firm outcomes is important for testing the
holding executives may give more weight to the
robustness of the theory. It could be valuable infor-
possibility of losses than to the possibility of gains.
The evidence is equivocal. Therefore, I present two mation for shareholders, for boards, and for execu-
competing hypotheses: tives as well.
I examine the role of two specific moderating
Hypothesis 3a. There will be a positive associ-variables: executive tenure and organizational per-
ation between CEO stock ownership and firmformance, both very prominent in theories about
divestiture activity. upper echelons (Hambrick & Mason, 1984), invest-
Hypothesis 3b. There will be a negative associ- ment decisions, and risk taking. Research suggests
that tenure affects how executives make decisions
ation between CEO stock ownership and firm
(Finkelstein & Hambrick, 1990; Hambrick & Fukutomi
divestiture activity.
1991; Hambrick, Geletkanycz, & Fredrickson, 1993),
Reducing the size of a firm through divestitures is and
at firm performance is clearly salient to top execu
tives (Hambrick et al., 1993).
odds with the view that executives aspire to manage
2001 Sanders 481
Position tenure. Executives with short tenures firm performance leads to investment decisions be-
are generally willing to take more risks and to de-ing framed negatively (the perception is that there
part from historical conventions than are long-ten-is little to lose), resulting in decision makers em-
ured executives (Finkelstein & Hambrick, 1990; phasizing the positive opportunities associated
Hambrick & Fukutomi, 1991; MacCrimmon & with such choices (Kahneman & Tversky, 1979;
Wehrung, 1990; Wiersema & Bantel, 1992). Given Sitkin & Pablo, 1992; Sitkin & Weingart, 1995). In
that position tenure is positively associated with addition, shareholders and other stakeholders rou-
CEO age (Wiersema & Bantel, 1992), short-tenuredtinely attribute an organization's poor performance
CEOs will often have more time to make such strat- to its top executives (Meindl, Ehrlich, & Dukerich,
egies work out. Alternatively, as CEOs advance in 1985), as do the executives themselves (Salancik &
tenure and approach the end of their careers, they Meindl, 1984; Staw, McKechnie, & Puffer, 1983).
tend to become more conservative (Finkelstein & Thus, poor performance not only results in nega-
Hambrick, 1990; Hambrick & Fukutomi, 1991; tively framed decisions, but also increases share-
MacCrimmon & Wehrung, 1990) and are therefore holder scrutiny of a firm and the CEO's role in such
less likely to engage in risky strategies. Longer- negative outcomes.
tenured executives have much to lose and little to In such situations, executives have an incentive
gain by engaging in risky strategies (Coffee, 1988; to search for new solutions to performance prob-
Finkelstein & Hambrick, 1990). In summary, re-lems, and the risk associated with doing acquisi-
search suggests that position tenure is negativelytions and divestitures will likely be minimized by
associated with an executive's risk preferences. decision makers. Moreover, acquisitions and dives-
Given that tenure will likely affect an executive's titures represent changes from the status quo that
risk propensity, I argue that tenure should moder- may provide needed solutions to such performance
ate the incentive effects outlined earlier. With re- problems.
spect to stock ownership, I would expect tenure to Alternatively, when performance is particularly
compound the risk aversion manifested by execu- good, executives will more likely frame investment
tives with large ownership positions. Therefore, decisions positively and perceive that they have
CEOs with large ownership positions who are long- something to lose by changing their firm's portfolio
tenured should be even less likely to engage in through acquisitions and divestitures (cf. Kahne-
acquisitions and divestitures than those who are man & Tversky, 1979; Sitkin & Weingart, 1995;
short-tenured. Likewise, the motivation provided Wiseman & Gomez-Mejia, 1998). In addition, they
by option pay to engage in acquisitions and dives-will more likely believe that the way to maximize
titures should be somewhat conditional on tenure. future returns (and thus create value in their op-
Tenure, and the risk aversion that it brings, willtions) is to maintain the strategic status quo (Ham-
likely reduce the effect of stock option pay on ex- brick et al., 1993). This logic leads to the following
ecutives' risk propensity. Therefore, I expect thathypotheses:
CEO tenure will moderate the effects of stock own-
ership and stock option pay on acquisition and Hypothesis 7. Firm performance will nega-
divestiture activity. Stated formally: tively moderate the relationship between CEO
stock ownership and firm acquisition and di-
Hypothesis 5. CEO tenure will negatively mod- vestiture activity.
erate the relationship between CEO stock own-
Hypothesis 8. Firm performance will nega-
ership and firm acquisition and divestiture ac-
tively moderate the relationship between CEO
tivity.
stock option pay and firm acquisition and di-
Hypothesis 6. CEO tenure will negatively mod- vestiture activity.
erate the relationship between CEO stock op-
tion pay and firm acquisition and divestiture
METHODS
activity.
Sample and Data
Firm performance. Firm performance is a pow-
erful factor that may affect executives' calculation I randomly selected a total of 250 firms from
of potential gains and losses from risky decisions. Standard & Poor's 500 (S&P 500). To be included in
Thus, I expect that firm performance will influence the sample, firms had to be listed in the S&P 500 in
how CEOs frame potential acquisitions and dives- either the beginning or the ending year of a five-
titures. Moreover, this decision framing should af- year study period (1991-95), or in both years. I
fect how executives respond to their stock-based used the beginning and ending years of the study
financial incentives. Evidence suggests that poor (1991 and 1995) to define the sample frame to in-
clude firms that either (1) demonstrated significant which a firm acquired a controlling interest in an-
growth during the period (and thus were not on the other firm. Divestiture activity was measured as the
list in 1991) or (2) fell off the list during the study number of divestitures in each year. Divestitures
period owing to merger, buyout, bankruptcy, or were identified in the same manner as acquisitions.
sales decline. Life insurance companies (unless Other researchers have used both of these measures
highly diversified), depository institutions, and (Davis et al., 1994; Haunschild, 1993; Hitt, Hoskis-
utilities were not sampled, because acquisitions in son, Johnson, & Moesel, 1996).
these industries are highly regulated and may stem It should be noted that I used the number of
from different processes than those in other indus- acquisition and divestiture transactions completed,
tries. Because acquisitions and divestitures are rel- rather than the value of transactions, for four re
atively infrequent in many firms, I used a pooled sons. First, most transactions in Mergers & Acqui-
cross-sectional time series design in order to have a sitions are reported without a value disclosed b
time window long enough to capture the activities the companies involved; thus, using transactio
of interest. Therefore, I collected five consecutive value as the dependent variable requires that mo
years of data for each firm. Missing data in 32 acquisitions and divestitures be ignored. Second,
firm-years resulted in a final sample of 1,218 firm- was interested in the frequency with which acqui-
years of data. sitions and divestitures are completed, and using a
Mergers & Acquisitions, which contains informa- count measure matches the theory tested. Thir
tion on acquisitions and divestitures made during using only transactions for which values are re
this period, was used to code acquisition and di- ported would bias the results toward large deals
vestiture activity. This publication is the source of Focusing exclusively on large transactions deviates
the data used in previously published research on from my purpose and ignores a significant amoun
acquisitions (Davis, Diekmann, & Tinsley, 1994; of data. Fourth, using the count measure of acqui-
Haunschild, 1993; Markides, 1995), aiding subse- sitions and divestitures aids in comparing the r
quent cross-study tests and comparisons. Executive sults with those of others who also used such a
compensation and ownership data were collected measure (Davis et al., 1994; Haunschild, 1993; Hitt
from Standard & Poor's Execucomp, which collects et al., 1996).
company proxy statements and summarizes execu- Independent variables. CEO stock ownership
tive compensation information. The Securities and was measured as the value of stock owned by a
Exchange Commission (SEC) requires that proxy firm's CEO. Because I was interested in the inten-
statements contain detailed information on the sity of the wealth effects provided by stock owner-
ship, I chose to measure stock ownership as the
compensation of the five highest-paid officers of all
dollar value of shares owned by the CEO rather
publicly held corporations. Moreover, firms are re-
quired to report compensation awards by categorythan as the percentage of shares she or he owned.
(for instance, salary, bonus, stock options). I en-
CEO stock option pay was measured as the value of
sured the reliability of the data by checking the
stock options granted during a given year. Stock
information on compensation against the informa- options were valued using the SEC present-value
tion in other secondary sources, such as Business-method, in which one computes the present value
Week and the Wall Street Journal. Any cases of of stock options by assuming that stock price ap-
significant difference were resolved by referring preciates
to 5 percent per year over ten years, sub-
the company's proxy statement. Firm financial datatracting the option price, and then discounting the
were collected from COMPUSTAT. Blockholder potential gain at 5 percent per year. The great ma-
ownership and board composition data informa-
jority (71%) of the S&P 500 firms reported stock
tion were collected from firm proxy statements.option
All values using this method (versus the more
independent and control variables were measured
sophisticated Black-Scholes method, the only other
SEC-approved alternative). Values derived using
in the year preceding the acquisition and divesti-
ture activity being estimated. In addition, because
the SEC method have also been shown to be highly
it is difficult to know a priori the appropriate correlated
lag, (r = .90) with those derived using
options and ownership were also measured asthe theBlack-Scholes method (Lambert, Larcker, &
average of the amount owned or granted during Weigelt,
the 1993; Sanders, Davis-Blake, & Fredrick-
previous three years. That specification yielded son,
re- 1995). More important, subsequent analyses
sults consistent with those presented below. on a subset of the sample for which I had both
Dependent variables. Acquisition activity, mea-measures revealed that the results were not sensi-
tive to the option valuation method used. CEO
sured as the number of acquisitions completed dur-
ing a year, was determined by examining Mergers position
& tenure was measured as the number of
Acquisitions for the number of transactions in years an executive had held the CEO title at the
2001 Sanders 483
sampled firm. Firm performance was measured as There is evidence that external blockholders
return on assets (ROA), because its frequent use in (large shareholders) can control and monitor ex
other studies of acquisitions and divestitures utives and affect acquisition and divestiture activ
(Haunschild, 1993; Hitt et al., 1996) facilitated ity (Amihud & Lev, 1981). Therefore, blockhol
comparing results across studies. ownership was measured as the total percentage o
Control variables. Other executive wealth ef- a company's shares owned by all external (non
fects and firm attributes that may affect firm acqui- officer) shareholders that owned more than 5 per
sition and divestiture activity were included ascent of its outstanding shares. Because board go
controls. Each of these variables is detailed below. ernance may be associated with acquisitions an
I included controls for all other forms of CEO pay divestitures (Hoskisson & Hitt, 1990), I also in-
for two reasons. First, the level of executive pay cluded board outsiders, a measure of the propor-
theoretically affects motives for diversification tion of its board's members who were not otherwise
(Mueller, 1987). If executives diversify their firms employed by or affiliated with a firm. Diversifica-
in order to achieve greater levels of compensation, tion level was included as a control because it may
then those executives that are already highly paid increase the opportunities for incremental acquisi-
should be less likely to engage in acquisition activ- tion and divestiture activity. Diversification level
ity than are those who are paid significantly less. was measured using the entropy measure for total
Second, the power of options and stock ownership diversification (Palepu, 1985): diversificationa = E
to affect resource allocation decisions is likely to Pia ln(l/Pia), where Pia is the proportion of a firm
depend not only on their absolute level, but also on a's sales in business segment i.
their level relative to that of the other compensa- R&D intensity has been shown to affect diversi-
tion executives receive. The three other forms of fication activity (Chatterjee & Wernerfelt, 1991;
compensation include CEO cash compensation,Montgomery & Hariharan, 1991). Therefore, R&D
restricted stock, and long-term accounting-basedintensity, measured as R&D spending divided by
performance plans. CEO cash compensation was sales, was included as a control variable. Recent
measured as the sum of salary, bonus, and miscel-acquisition activity was included as a control vari-
laneous cash compensation. Restricted stock isable because acquisition activity has been shown to
common stock granted as compensation. The be a highly inertial practice (Amburgey & Miner,
granted shares have restricted ownership rights and1992; Haunschild, 1993) that leads to future dives-
forfeiture penalties in the event of employment ter- titure activity (Porter, 1987; Ravenscraft & Scherer,
mination prior to the expiration of the restriction 1987). Recent acquisition activity was measured as
period (usually three to five years). As in othera count of the number of acquisitions completed by
research, restricted stock was valued at the currentan acquiring firm during the previous three years, a
market value of a firm's common stock (Lambert et measure used by others studying acquisition activ-
al., 1993). Long-term incentive plans are compen- ity (Amburgey & Miner, 1992; Haunschild, 1993).
sation plans that have a future payout contingent
on future accounting returns of the firm (such as Estimation Methods
ROA and ROE). I valued these at the expected fu-
ture payout reported by the firm, discounting them As previously discussed, acquisition and dives-
at 5 percent per year to obtain a present value titure activity were measured as the number o
(Lambert et al., 1993). times the relevant activity occurred during a year.
Firm size, measured as the logarithm of firm Consequently, the dependent variables take on
sales, was included because it likely affects acqui- limited range of positive integer values, and ordi
sition (Amburgey & Miner, 1992; Haveman, 1993) nary least squares (OLS) regression techniques ar
and divestiture (John & Ofek, 1995) activity. A inappropriate. Negative binomial regression was
firm's financial capacity may also affect the pro- used in this study because it is particularly wel
pensity to engage in acquisitions, as resources are suited to handling the problems of overdispersio
needed to acquire other firms (Hoskisson & Hitt, often associated with this type of dependent vari-
1990; Jensen, 1986), and divestitures represent a able (Hausman, Hall, & Griliches, 1984; Kogut &
logical way to generate needed resources for other Chang, 1991; Ramaswamy, Anderson, & DeSarbo
purposes (Weston Chung, 1990). The debt-to-equity 1994; Ranger-Moore, Banasazak-Holl, & Hannan,
ratio was included as a control for firm financial 1991). Negative binomial regression is derived from
structure (Chatterjee & Wernerfelt, 1991; Jensen, Poisson regression but has a stochastic compo
1986). In addition to being hypothesized as a mod- nent that accounts for and accommodates the
erating variable, firm performance (ROA) was overdispersion
in- problem (Greene, 1995; Hausm
cluded as a control in all models. et al., 1984).
Because of the pooled cross-sectional time- those reported in prior studies of acquisitions
series design, nonindependence of observations divestitures. On the average, firms engaged
was also a potential problem. To mitigate this, I slightly less than one acquisition per year and
estimated both random- and fixed-effects models.
proximately one divestiture every other year. T
Fixed-effects models are essentially within-firm activities varied significantly across firms, rang
regression analyses and therefore provide conser-
from 0 to 14 acquisitions and 0 to 8 divestitures
vative tests of hypotheses (Haveman, 1993; Judge,
year. Stock option pay averaged $924,000 per ye
Hill, Griffiths, Liitkepohl, & Lee, 1988). Although
the results were substantially similar for the in- and stock ownership averaged $4,840,000. Bo
dependent variables of interest with both random- stock option pay and stock ownership also va
and fixed-effects models, I report the latter because significantly across firms.
this specification is a more theoretically justifiable Table 2 reports the results of the tests of
and empirically conservative approach (Greene, hypotheses regarding acquisition activity. Mod
1995; Haveman, 1993). It should be noted that the reports the results for control variables. Diversi
fixed-effects specification requires that there be cation level, ROA, and recent acquisition activ
within-group variance in all variables for at least were positively associated with acquisition act
some of the groups (Greene, 1995). Therefore, I ity, but firm size and blockholder ownership w
could not include controls for industry, because negatively associated with such activity. As
industry membership is invariant over time for
CEO stock ownership and stock options, I hyp
each firm. However, comparisons of the results of
the fixed-effects models (without controls for in- esized that CEO stock ownership would ha
dustry) with those of the random-effects models negative effect and CEO stock option pay w
(with and without industry controls) suggest that have a positive effect on acquisition activity
the results reviewed below were not sensitive to the reported in model 2, the "main effect" for s
exclusion of industry as a control. ownership was indeed negative and significa
supporting Hypothesis 1, and the effect for
RESULTS stock option pay was positive and significant, su
porting Hypothesis 2.
I also argued that important situational char
Table 1 reports descriptive statistics and correla-
teristics would moderate the effects of stock own-
tions for the variables used in this study. The
ership
means for the dependent variables are similar to and stock option pay on acquisition activity.
TABLE 1
Descriptive Statistics and Correlationsa

Mean s.d. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
0.95 1.72
1. Acquisition activityb
0.50 activityb
2. Divestiture 1.14 .23
3. CEO stock ownershipc

4,840 18,540 -.04 -.07
4. CEO stock option
924 2,566 .13 .17 -.04
payc
5. CEO position .07 -.06 -.05 .29
8.62 5.91 tenure
6. ROAd 5.09 6.10 -.00 -.12 .04 .24 .04
1,335 1,386 .10 .06 .13 .10 .14 .05

7. Cash compensationc
8. Restricted stockc 276 1,847 .02 .02 .07 .24 .05 .05 .10
9. Long-term incentive plansc 135 399 .05 .09 -.01 -.03 -.10 -.02 -.04 -.02
10. Firm salese 8.50 1.08 .28 .26 .16 -.02 .01 -.12 .19 .08 .12
11. Debt to equity ratio 1.15 2.28 .14 .07 .04 -.05 -.01 -.21 .09 .01 .01 .23
12. Blockholder ownership 0.12 0.14 -.12 -.14 -.11 .16 .04 -.07 -.10 -.02 .03 -.19 -.01
13. Board outsidersf 76 11 .08 -.05 .02 -.14 -.03 -.09 .02 .04 -.01 .05 .02 -.08
14. Diversification levelf 0.62 0.56 .28 .12 .04 -.13 -.01 -.21 .07 .04 .04 .29 .15 -.15 .16
15. R&D intensity 0.02 0.04 -.01 .01 -.00 -.05 -.06 .16 -.06 -.02 -.03 -.11 -.10 -.04 -.12 -.09
16. Recent acquisition activity2.60 3.92 .61 .21 .05 -.05 .05 -.07 .09 .03 .05 .42 .23 -.11 .13 .37 -.07
a Correlations greater than .06 are significant at p < .05, and those greater than
b Number per year.
c In thousands of dollars.
d Percentage.
e Logarithm.
f Entropy measure.
2001 Sanders 485
TABLE 2
Results of Negative Binomial Regression Analysis for Amount of Acquisition Activity'
Variable Model 1 Model 2 Model 3 Model 4 Model 5 Model 6
CEO stock ownership -0.09** -0.04 -0.14*

(0.03) (0.07) (0.03) (0.07) (0.03)
X CEO position tenure -0.01
(0.10)
x ROA 0.48
(0.62)
CEO stock option pay 0.58*** 0.58*** 0.55*** 0.59*** 0.55***
(0. 11) (0. 11) (0. 11) (0. 11) (0. 11)
X CEO position tenure -0.89*
(0.44)
x ROA -0.15**
(0.08)
CEO position tenure 0.08 0.83 0.63 0.94
(0.65) (0.67) (0.76) (0.39) (0.67) (0.07)
ROA 0.18* 0.23* 0.22* 0.26** 0.23** -0.llt
(0.08) (0.09) (0.09) (0.09) (0.04) (0.07)
CEO cash compensation level 0.09 -0.65 0.67 -0.05 -0.04 -0.52
(0.41) (0.48) (0.49) (0.49) (0.48) (0.49)
CEO restricted stock pay -0.20 -0.24 -0.25 -0.23 -0.24 -0.23
(0.52) (0.64) (0.63) (0.65) (0.63) (0.65)
CEO long-term incentive pians 0.16 0.17 0.17 0.16 0.17 0.16
(0.13) (0.13) (0.12) (0.13) (0.13) (0.12)
Firm sizeb
(0.15) (0.15) (0.15) (0.15) (0.15) (0.15)
Debt-to-equity ratio -0.16 -0.06 -0.06 -0.09 -0.07 -0.08
(0.28) (0.26) (0.26) (0.27) (0.26) (0.27)
Blockholder ownership -0.84* * -0.64* -0.63* -0.47 -0.63* -0.48
(0.32) (0.33) (0.33) (0.35) (0.33) (0.35)
Board outsiders 0.55 0.79 0.79 0.76 0.79 0.76
(0.85) (0.94) (0.94) (0.87) (0.95) (0.87)
Diversification level 0.87*** 0.93*** 0.91 ** * 0.94** * 0.95*** 0.94***
(0.15) (0.15) (0.15) (0.15) (0.15) (0.15)
R&D intensity -2.60 - 2.3 7k -2.23 -2.24
(1.44) (1.46) (1.45) (1.46) (1.45) (1.45)
Recent acquisition activity 0.14*** 0.14*** 0.14*** 0.14*** 0.14*** 0.14***
(0.01) (0.01) (0.01) (0.01) (0.01) (0.01)
Alpha 0.80** * 0.77*** 0.77*** 0.76*** 0.78*** 0.76***
(0.09) (0.09) (0.09) (0.09) (0.09) (0.08)
Chi-square 196.5 190.3 190.4 187.2 190.4 187.2

Log likelihood -1,493 -1,485 -1,485 -1,482 -1,482 -1,482
a n = 1,218. Numbers in parentheses are standard errors.
b Log of sales.
tp < .10
* p < .05
** p < .01
** p < .001
Specifically, I reasoned that CEO tenure would neg- would negatively moderate the relationships be-
atively moderate the effects of stock ownership and tween stock ownership and stock option pay and
stock option pay because, as CEOs approach the acquisition activity (Hypotheses 7 and 8), because
ends of their tenures, they generally become more firm performance should affect how acquisition de-
risk averse. As noted in model 3, the interaction of cisions are framed. The interaction of performance
CEO tenure and stock ownership was not signifi- with stock ownership was not significant (model
cant, failing to support Hypothesis 5. However, for 5), but the interaction with stock option pay was
stock option pay, the interaction was negative and negative and significant, as predicted (model 6).
significant, in support of Hypothesis 6 (model 4). Table 3 reports the results of the tests for dives-
Furthermore, I predicted that firm performance titure activity. Model 7 reports the effects for con-
486 486 ~~~~~~~~~Academy of Management Joumnal Jn June
TABLE 3
Results of Negative Binomial Regression Analysis for Amount of Divestiture Activity a
Variable Model 7 Model 8 Model 9 Model 10 Model 11 Model 12
CEO stock ownership -0.08k' -0.41 -0.12* -0.10 -0.12**

(0.05) (0.15) (0.07) (0.15) (0.07)
X CEO position tenure 0.00
(0.02)
x ROA 0.02
(0.14)
CEO stock option pay 0.75** 0.76** 0.71* 0.76** 0.71*
(0.32) (0.32) (0.32) (0.32) (0.32)
X CEO position tenure
(0.07)
x ROA
(0. 11)
CEO position tenure -0.29** -0.28* -0.28** -0.18
(0. 10) (0. 11) (0.13) (0.06) (0.12) (0. 11)
ROA -0Q47** -0.47* *
(0.17) (0.14) (0.14) (0.12) (0.15) (0. 11)
CEO cash compensation level 0.90 0.45 0.45 0.53 0.45 0.53
(0.59) (0.62) (0.62) (0.58) (0.62) (0.59)
CEO restricted stock pay 0.09 0.17 0.18 0.22 0.16 0.22
(0.54) (0.74) (0.75) (0.74) (0.74) (0.74)
CEO long-term incentive plans 0.40* 0.46** 0.46** 0.41* * 0.46** 0.41*
(0.19) (0.17) (0.18) (0.17) (0.18) (0.17)
Firm sizeb -0.46* -0.42* -0.43* -0.43* -0.43* -0.42*
(0.22) (0.21) (0.22) (0.21) (0.21) (0.21)
Debt-to-equity ratio -0.24 -0.20 -0.20 -0.31 -0.20 -0.31
(0.27) (0.29) (0.29) (0.30) (0.28) (0.30)
Blockliolder ownership
(0.61) (0.62) (0.62) (0.65) (0.63) (0.65)
Board outsiders -0.08 -0.05 -0.04 -0.06 -0.04 -0.06
(0. 10) (0. 11) (0.12) (0.09) (0.12) (0.09)
Diversification level 0.45* 0.41 * 0.41 * 0.41* 0.39*
(0.23) (0.21) (0.23) (0.21) (0.22) (0.21)
R&D intensity 0.81 1.35 1.35 2.05 1.34 2.06
(2.36) (2.33) (2.35) (2.35) (2.36) (2.35)
Recent acquisition activity 0.60** * 0.61*** 0.61*** 0.52*** 0.61*** 0.52**
(0.18) (0.18) (0.18) (0.17) (0.18) (0.17)
Alpha 2.28*** 2.21*** 2.21 ** * 2.07*** 2.21 * ** 2.07***
(0.29) (0.27) (0.27) (0.26) (0.27) (0.26)
Chi-square 319.4 310.8 310.6 286.9 310.8 286.0

Log likelihood -1,078 -1,074 -1,074 -1,066 -1,074 -1,066
a n = 1,218. Numbers in parentheses are standard errors.
b Log of sales.
14p < .10
* p < .05
** p < .01
** p < .001
trol variables. CEO position tenure, ROA, firm size, ership supports Hypothesis 3b but contradicts Hy-
and blockholder ownership all had negative rela- pothesis 3a. Consistent with Hypothesis 4, the ef-
tionships with divestiture activity. Long-term ac- fect of stock option pay on divestiture activity was
counting-based performance plans, diversification positive and significant. I also hypothesized that
level, and recent acquisition activity had positive CEO tenure and firm performance would nega-
associations with divestiture activity. tively moderate the effects of CEO stock ownership
Competing hypotheses (3a and 3b) were devel- and stock option pay on divestiture activity. As
oped regarding the effect of executive stock owner- reported in models 9 and 11, the interactions of
ship on divestiture activity. In the model 8 results, CEO position tenure and firm performance with
the significant, negative main effect for stock own- CEO stock ownership were not significant, failing
2001 Sanders 487
to support Hypotheses 5 and 7. However, the ef- different outcomes here. Firms were more likely t
fects for the interactions of position tenure and firm engage in acquisitions and divestitures when the
performance with CEO stock option pay were in- CEOs were compensated with stock option pay, but
deed negative and significant (models 10 and 12), they were much less likely to engage in such activ
supporting Hypotheses 6 and 8. ities when their CEOs owned stock. These effects
were consistent with the theory developed here,
DISCUSSION
according to which the risk characteristics of op-
tions are not symmetric with those of stock owner-
This study had two primary purposes. First, ship andI the lack of downside risk in options will
aimed to examine the behavioral effects of stock- likely make CEOs more willing to engage in risky
based financial incentives and their role in im- strategies. Although most research on executive fi-
portant corporate resource allocation decisions. nancial incentives rests on an assumption that op-
Second, I set out to examine whether stock own- tion pay and stock ownership should have similar
ership and stock option pay had congruent ef- effects (Beatty & Zajac, 1994; Eaton & Rosen, 1983
fects, as prescribed in the extensive governance Jensen & Murphy, 1990; Mehran, 1995), the find-
literature, or whether the asymmetric risk prop- ings of this study refute that view.
erties possessed by these two incentives would Drawing on behavioral decision theory, I devel-
lead to different resource allocation decisions. I oped theoretical arguments to suggest that situa-
theorized that stock ownership would lead to tional characteristics would moderate incentive
greater risk aversion and stock option pay, effects to because such factors can affect risk p
greater risk seeking. However, I also expected erences and problem framing. The findings s
situational characteristics to strongly affect how gest that such moderating effects occurred o
these stock-based incentives motivated execu- with respect to risk-seeking behaviors and n
tives to pursue or avoid acquisitions and dives- with respect to risk-aversion behaviors. I
titures. The findings provide strong supportsoned for that CEOs who are relatively new on t
the argument that asymmetric risk properties job should be much more willing than long-
lead to very different outcomes for stock owner- ured CEOs to chase the potential "lottery" retur
ship and stock option pay. However, situational that option pay can afford. With respect to s
factors only moderated the risk-seeking behavior option pay, the results of the study support
associated with stock option pay; they left that the view. However, even among long-tenu
incentive effects of stock ownership relatively executives, option pay still positively affe
unchanged. acquisitions and divestiture activity, just l
strongly than it did among short-tenured CE
The findings of this study help resolve conflict-
ing theoretical opinions regarding how incentives Consequently, option pay may serve as a use
affect top managers. Although a belief in the effi-tool for persuading long-tenured executives
cacy of incentives is pervasive among agencyengage the- in more risk-taking behavior than th
would otherwise be willing to engage in. R
orists, some scholars have expressed doubt regard-
ing the power of incentives to alter the decisions
seeking induced by option pay was also temp
and behaviors of top executives (Andrews, 1987;
by firm performance. The higher the firm per
Donaldson & Lorsch, 1983; Finkelstein & Ham- mance, the less likely executives were to t
brick, 1996). For example, Donaldson and Lorsch new risks with acquisitions and divestitures,
argued that executives are interested primarily inthe more willing they were to stay the strat
the financial health and survival of their firms and course. It is noteworthy that the effects of s
therefore "do not give primary weight to the impact ownership on risk aversion were not moder
of their decisions on their personal finances" (1993: by situational characteristics. Ownership effe
22). However, the findings of this study refute the appear to dominate differences in problem fr
view that top executives are immune to incentives. ing across distinct situations and conditions
Both stock ownership and stock option pay showed
strong effects on important corporate resource allo-
Implications and Future Research
cation decisions. Other scholars have expressed
confidence that stock-based incentives will have The findings of this study have a number of
strong effects and that the effects of two incentives,
plications for both theory and practice. The pat
ownership and option pay, will be congruent of results of this study has important implicati
(Agrawal & Mandelker, 1987; Eaton & Rosen, 1983; for research in several areas, including the inte
Jensen & Murphy, 1990; Mehran, 1995). However, tion of behavioral decision theory and agency th
these two stock-based financial incentives had veryory, corporate governance, and mergers and acqui-
sitions. I discuss below some of these implications stock option pay and thereby encourage risk-
and the research questions they generate. seeking behaviors. Consequently, an integration of
An integrated behavioral agency model. Wise- agency theory and behavioral decision theory pro-
man and Gomez-Mejia (1998) argued that integrat- vides a more complete picture of top executive
ing agency theory and behavioral decision theory incentives and risk taking than does either perspec-
can better explain risk taking than either perspective alone.
tive alone. The findings of this study provide em- I focused on only two situational factors, but
pirical evidence for that claim. According to agency others may also moderate the effects of stock option
theory's compelling logic, financial incentives can pay (and perhaps of stock ownership). One such
alter agents' risk propensity. However, behavioral factor is prior outcome history (Sitkin & Pablo,
decision theory suggests that downside risk is an 1992; Wiseman & Gomez-Mejia, 1997). Theory sug-
important consideration for decision makers and gests that decision makers persist in a pattern of
perhaps even dominates upside incentives. Conse- risk taking when they have had success with that
quently, behavioral decision theory led me to the- type of risk taking (Osborn & Jackson, 1988; Sitkin
orize that stock ownership would foster risk aver- & Pablo, 1992). Prior success with acquisitions or
sion rather than risk seeking. In addition, because divestitures may result in executives being more
option pay has significant upside potential but no willing to engage repeatedly in such actions. Con-
downside risk, behavioral decision theory suggests versely, failure with either activity may result in a
that decision makers paid with options will mini- shift away from such forms of risk taking. However,
mize consideration of the downside risk associated stock option pay may persuade executives to
with resource allocation decisions. Consequently, deviate from the tendency to persist with risk-
option pay is likely to motivate executives to allo- minimizing strategies, even when such strategies
cate resources to projects (such as acquisitions) that have been successful. Further research is needed to
a pure incentive alignment perspective would sug- determine whether prior experience or incentives
gest they should avoid. Thus, stock option pay may dominate in such situations.
motivate executives to take some risks that are not The timing of potential investment returns may
fully offset with appropriately higher returns. On affect the relationship between incentives and risk
this point, behavioral decision theory complements taking. For example, one would expect that option
agency theory by highlighting the importance of pay and ownership might affect the willingness to
both upside rewards and exposure. Minimizing the take risks on new internal ventures. However,
importance of downside risk may lead theorists whereas acquisitions and divestitures are relatively
and practitioners to make inappropriate prescrip- "quick-hitting" strategic moves, internal invest-
tions for perceived agency problems. ments (such as R&D) usually have much longer
Agency theory also complements behavioral de- projected cycle times. The results of this study do
cision theory on the issue of the stability of risk not directly address whether option pay will also
propensity in two ways. First, although much of the motivate executives to pursue risky strategies that
behavioral literature has focused on situational have longer development times. Additional re-
search is needed to explore how the asymmetric
characteristics as determinants of risk taking, Sit-
kin and Pablo (1992) made the case that risk pro- properties of option pay and stock ownership affect
investments when "gratification" must be delayed.
pensity will dominate situational characteristics in
determining risk-taking behavior. The findings ofCorporate governance. As Westphal recently
the present study provide some empirical support noted, "Empirical evidence suggests that relatively
for that argument. Risk aversion brought on large by reductions in agency costs are derived from
stock ownership was unaffected by situational the mere introduction of financial incentives or
characteristics. Risk-seeking behavior broughtfrom
on relatively small levels of incentive alignment"
by stock option pay, however, was somewhat tem- (1999: 10). That conclusion was based on evidence
that the stock market reacts positively to the adop-
pered by situational characteristics, but still re-
tion of incentive-alignment mechanisms such as
sulted in more risk taking. Second, the agency the-
ory assumption that risk propensity can be easilystock option pay, even when the magnitude of the
incentive adopted is rather trivial. The findings of
altered through incentives is at odds with the tra-
ditional behavioral view that risk propensity is this
a study suggest that some financial incentives,
rather stable trait (Wolman, 1989). Sitkin and Pablo
even those thought to be best at aligning the inter-
ests of executives and shareholders (cf. Murphy,
(1992) proposed that risk propensity is changeable
1999), can result in increased agency costs. For
but persistent. The findings suggest that financial
example,
incentives may result in risk propensity being even acquisitions are often cited as key mani-
more malleable, as boards can easily manipulate festations of agency costs (Jensen, 1986; Jensen &
2001 Sanders 489
Murphy, 1990; Mueller, 1987; Ravenscraft & Roll, 1986). Importantly, my findings differ from
Scherer, 1987). In situations in which acquisitions Hayward and Hambrick's, demonstrating that the
are manifestations of agency costs, option pay form of pay has a significant effect on the invest-
would appear to exacerbate the problem, not re- ments firms make. Specifically, in this study,
duce or eliminate it. In addition, when significant higher levels of pay promoted more acquisition
risk taking is warranted, stock ownership could activity, but only higher levels of stock option
result in agency costs, as it may cause executives to pay did so.
positively frame decision contexts and avoid nec-
essary risks.
Limitations and Concluding Remarks
The results should not be generalized to suggest
that options are never appropriate governance mech- Like most research of this type, this study has
anisms. On the contrary, in some firm and industry limitations. Notably, I did not measure the per-
contexts, options may be more appropriate than stock ceived risk that executives associated with their
ownership. For example, Dial and Murphy (1995) incentives, tenure, or firm performance. Rather, I
argued that in declining industries, options are an relied on accepted theory regarding these con-
ideal incentive because they provide motivation to structs. Moreover, although behavioral decision
consolidate or downsize (that is, to divest). Moreover, theory (Sitkin & Pablo, 1992) clearly supplement
it is possible that the risk-seeking behavior promoted the agency view of potential incentive effects, I di
by options may be appropriate at some levels (or in not test a full integration of those theories (Wise-
some positions) in an organization and that the man & Gomez-Mejia, 1998). By design, I studied the
behavior motivated by ownership may be more effect of incentives on specific investment choices
appropriate at other levels. In addition, options may (acquisitions and divestitures), but I did not study
be effective tools for increasing the level of risk taking the effects of either acquisitions or divestitures on
when other contextual factors and individual charac- shareholder wealth. Despite these limitations, three
teristics would otherwise reduce it below the levels features of this research support an inference that
desired by the board and shareholders. Thus, within the processes I describe do occur. First, the overall
the context of corporate governance, a more holistic pattern of results, including those for the contin-
view of incentives- one that includes behavioral as gency hypotheses, is consistent with the theoretica
well as agency factors-should result in a superiorframework. Second, the research design controlled
ability to prescribe appropriate alignments between for other known causes of acquisitions and dives
governance mechanisms and corporate context. titures. Third, the pattern of findings seems to sup-
Mergers and acquisitions. The findings also port no alternative explanation.
raise a question about a long-held view regarding The results of this study suggest that financia
the motivation for acquisitions. Some scholarsincentives affect CEOs in that incentives play a
have argued that executives are prone to engagelarge role in determining how CEOs allocate firm
in acquisitions so that they can attain the higherresources. This study examined the two most com-
levels of compensation associated with large mon types of executives' stock-based incentives
firms (Mueller, 1987). Others have claimed that The findings demonstrate that incentives have
stock-based incentive pay should reduce acquisi- strong effects on whether firms engage in acquisi-
tion activity among U.S. firms (Jensen & Murphy, tions and divestitures, two strategic choices that
1990). The results contradict both of these ideas. can have significant, long-lasting effects (Ravens
In fact, inasmuch as the highest-paid executives craft & Scherer, 1987). Consequently, the results
tend to receive more stock options than those suggest that executives are very likely to cause their
with lower pay (Yermack, 1995), the results sug- firms to enact strategies that conform to their per-
gest that acquisition activity is more common ceived personal self-interests. However, the inte
among firms with highly paid executives than grated behavioral agency model helps show that
among those that lag behind their peers in pay. perceived self-interest is not always in harmony
That interpretation is consistent with the find- with widely believed prescriptions and assump-
ings of Hayward and Hambrick (1997), who tions of a simple agency model.
found executive pay level to be positively asso- Stock ownership and stock option pay have
ciated with acquisition premiums paid. They asymmetric incentive properties and very differen
maintained that highly paid executives are likely effects on corporate resource allocation decisions
to have exaggerated pride and self-confidence Options offer tremendous upside potential, yet
and thus perceive that they can make money with they impose no real downside risk on those wh
acquisitions, even when the latter require paying receive them in their compensation plans. Thus
large premiums (Hayward & Hambrick, 1997; options may be motivational "carrots" that lack the
complementary disciplinary "stick." Options ap- Donaldson, G., & Lorsch, J. W. 1983. Decision making at
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Behavioral Responses of CEOs to Stock Ownership and Stock Option Pay

Author(s): Gerard Sanders

BEHAVIORAL RESPONSES OF CEOs TO STOCK OWNERSHIP

WM. GERARD SANDERS

Descriptive Statistics and Correlationsa

3. CEO stock ownershipc

1,335 1,386 .10 .06 .13 .10 .14 .05

Results of Negative Binomial Regression Analysis for Amount of Acquisition Activity'

Variable Model 1 Model 2 Model 3 Model 4 Model 5 Model 6

CEO stock ownership -0.09** -0.04 -0.14*

Chi-square 196.5 190.3 190.4 187.2 190.4 187.2

a n = 1,218. Numbers in parentheses are standard errors.

Results of Negative Binomial Regression Analysis for Amount of Divestiture Activity a

Variable Model 7 Model 8 Model 9 Model 10 Model 11 Model 12

CEO stock ownership -0.08k' -0.41 -0.12* -0.10 -0.12**

Chi-square 319.4 310.8 310.6 286.9 310.8 286.0

a n = 1,218. Numbers in parentheses are standard errors.

Lambert, R. A., & Larcker, D. F. 1987. Executive compen-

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