warner stock market reaction to management incentives plan adoption an overview

8/9/2019 Warner Stock Market Reaction to Management Incentives Plan Adoption an Overview

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Journal of Accounting and Economics 7 (1985) 145-149. North-Holland

S T O C K M A R K E T R E A C T I O N T O M A N A G E M E N T I N C E N T IV E

P L A N A D O P T I O N

A n

O v e r v i e w

J er o l d B . W A R N E R

University of Rochester Rochester N Y 14627 USA

Received August 1984, final version received September 1984

1 . I n t r o d u c t i o n a n d su m m a r y

T h e p a p e r s b y B r i c k l e y , B h a g a t a n d L e a s e ( ' T h e I m p a c t o f L o n g - R a n g e

M a n a g e r i a l C o m p e n s a t i o n P l a n s o n S h a r e h o l d e r W e a l t h ' ) a n d b y T e h r a n i a n

a n d W a e g e l e i n ( ' M a r k e t R e a c t i o n t o S h o r t - T e r m E x e c u t i v e C o m p e n s a t i o n

P l a n A d o p t i o n ' ) e x a m i n e s to c k p ri c e p e r f o r m a n c e a r o u n d t h e ti m e f ir m s a d o p t

managemen t incen t ive p l ans . Each pape r f inds pos i t ive s tock p r i ce pe r fo r -

mance . In th i s ove rv iew , I i n t eg ra t e the ev idence p re sen ted in the se two

s t i m u l a t i n g p a p e r s , a n d s u g g e s t a d d i t i o n a l t e s t s o f i m p o r t a n t e c o n o m i c h y -

potheses .

B e fo re d i scuss ing the de ta i l s o f t he two pape rs , I have some obse rva t ions on

the ove ra l l p i c tu re tha t emerges f rom the s tud ie s . F i r s t , t he gene ra l conc lus ion

o f p o s it iv e s t o c k p r ic e p e r f o r m a n c e a r o u n d t h e t i m e o f i n ce n t iv e p l a n a d o p t i o n

i s s t rong ly suppor t ed by the ev idence in the two pape rs , and i s no t due to some

methodo log ica l qu i rk . In l i gh t o f t he se two pape rs (w i th d i f fe ren t sample s ye t

s imi l a r r e su l t s ) and o f La rcke r ' s (1983) f ind ings a long the same l ine s , i t i s

d i ff i cu l t t o a rgu e tha t i ncen t ive p l ans a re m ere ly an ' excess ive pe rk ' w hose

adop t ion hu r t s sha reho lde rs .

Second , the re i s ev idence on rea sons fo r the pos i t ive s tock p r i ce pe r fo r -

mance . The ev idence suppor t s two v iews . One i s t ha t p l an adop t ion l e ads to

higher s tock pr ices , v ia , for example , incent ive e ffec ts . An a l te rna t ive v iew is

tha t h ighe r s tock p r i ce s l e ad to p l an adop t ion : some o f the da ta sugges t t he

poss ib i l i t y tha t f i rms adop t p l ans a f t e r a pe r iod o f f avo rab le pe r fo rmance , and

t h e d a t a a r e c o n s i s t e n t w i t h t h e n o t i o n t h a t p l a n a d o p t i o n t a k e s p l a c e i n

expec ta t ion o f fu tu re s tock p r i ce inc rea se s , t ha t i s , when managemen t ha s

favorab le in s ide in fo rma t ion abou t the f i rm ' s fu tu re p rospec t s . As I sha l l

* I thank Michael Jensen and Jerold Zimme rman f or commen ts on an earlier draft.

0165 -41 01/ 85/ 3.3 0019 85, Elsevier Science Publishers B.V. (North-Ho lland)


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146 J.B. Warner Discussion

d i s c u s s , f u t u r e wo r k c a n e n h a n c e t h e c o n t r i b u t i o n o f t h e c u r r e n t p a p e r s b y

p r o v i d i n g m o r e i n f o r m a t i o n o n t h e r e l a ti v e i mp o r t a n c e o f t h e s e two a l t e r n a t iv e

v i e w s .

2 . T h e s a m p l e s a n d b a s e l in e r e s u l ts

B o t h p a p e r s e x a m i n e in c e n t i v e p l a n s p r o p o s e d b y t h e fi rm s b o a r d o f

d i r e c t o r s . T h e p r o p o s a l s a r e c o n t a i n e d i n p r o x y s t a te me n t s s e n t t o t h e f ir m s

s h a r e h o l d e r s a n d f i l e d wi t h t h e S e c u r i t i e s a n d E x c h a n g e Co mmi s s i o n ( S E C) .

B r i c k l e y , B h a g a t a n d L e a s e i n d i c a t e t h a t a l l p l a n s p r o p o s e d a r e s u b s e q u e n t l y

a d o p t e d . T h e s e a u t h o r s e x a m i n e 1 7 5 p l a n s a d o p t e d i n t h e 1 9 7 9 - 1 9 8 2 p e r i o d ,

w h i l e T e h r a n i a n a n d W a e g e le i n e x a m i n e 4 2 p la n s f ro m t h e 1 9 7 1 - 1 9 8 0 p e r i o d .

A l l p l a n s e x a m i n e d i n t h e tw o p a p e r s m a k e m a n a g e ri al c o m p e n s a t i o n a

f u n c t i o n o f f i r m p e r f o r ma n c e , me a s u r e d b y v a r i a b l e s s u c h a s s t o c k p r i c e

c h a n g e o r g r o wt h i n e a r n i n g s p e r s h a r e . B r i c k l e y , B h a g a t a n d L e a s e e x a mi n e

l o n g - t e r m p l a n s , w h e r e t h e in t e r v a l f o r me a s u ri n g p e r f o r ma n c e i s t y p i c a l l y

s e v e r a l y ea r s . T e h r a n i a n a n d Wa e g e l e i n fo c u s o n s h o r t- t er m p l a n s , wh e r e fi r m

p e r f o r m a n c e i s m e a s u r e d o v e r a o n e - y e a r i n te rv a l.

T a b l e 1

S u m m a r y o f s to c k p r ic e p e r f o r m a n c e a r o u n d t h e t im e o f m a n a g e m e n t i n ce n t i ve p la n a d o p t i o n .

C u m u l a t i v e m e a n

S ample abnorm a l s tock

P a p e r s iz e O b s e r v a t i o n p e r i o d p r i c e p e r f o r m a n c e Z - v a l u e

Br ick ley , Bhaga t 83

a n d L e a s e a

T e h r a n i a n a n d 4 2

W a e g e l e i n b

Board mee t ing da te 2 .4 2 . 18

t h r o u g h d a y a f t e r

r e c e i p t o f p r o x y

s t a t e m e n t b y t h e

S ecur i t i es and E x-

c h a n g e C o m m i s s i o n

( m e a n l e n g t h =

58 , 4 t rad ing days )

Mo nths - 3 th rough 11 .3 3 . 03

0 re la t ive to

p r o x y

s t a t e m e n t d a t e

Mo nths - 7 th rough 11 .0 4 . 32

- 4 r e l a ti v e t o p r o x y

s t a t e m e n t d a t e

a F r o m t a b l e 5 , B r ic k l ey , B h ag a t a n d L e a s e , ' T h e i m p a c t o f l o n g -r a n g e m a n a g e r ia l c o m p e n s a t i o n

p l a n s o n s h a r e h o l d e r wea l th ' , Journal of Accounting and Economics this issue

b F r o m t a b le 1 , T e h r a n i a n a n d W a e g e l ei n , ' M a r k e t r e a c ti o n t o sh o r t - te r m e x e c u t i v e c o m p e n s a t i o n

p l a n a d o p t i o n ',

Journal of Accounting and Economics

t h i s i ss ue . Z-va lues fo r the cum ula t ive av e rage

a b n o r m a l p e r f o r m a n c e m e a s u r e s a r e n o t r e p o r t e d i n tha t pape r . T he va lues s hown h e r e a r e d e r i v e d

unde r the a s s umpt ion tha t the ind iv idua l month ly t e s t s t a t i s t i c s reported there are i n d e p e n d e n t a n d

un i t norma l unde r the nu l l hypo thes i s .


3/5

J.B. Warner Discuss ion 147

Tab le 1 s um m ar ize s the cen t r a l r e s u l t s o f the two pape r s on pos i t ive s tock

p r i c e p e r f o r m a n c e a r o u n d t h e ti m e o f p l a n a d o p t i o n . F o r 8 3 f ir m s w i t h

ava i l ab le da ta , Br ick ley , Bhaga t and Leas e f ind e s t im a ted ave r age abnor m a l

p e r f o r m a n c e o f 2 . 4 i n t h e p e r i o d b e t w e e n B o a r d o f D i r e c t o r s m e e t in g a n d

pr oxy s ta tem en t r ece ip t by the SEC. Bas ed on the i r t e s t s , the e s t im a te o f

ave r age abnor m a l pe r f o r m ance i s s t a t i s t i c a l ly s ign i f i c an t , and i s no t d r iven by a

f e w o u t l i e r s . T e h r a n i a n a n d W a e g e l e i n f i n d s t r o n g e r i n d i c a t i o n s o f a b n o r m a l

p e r f o r m a n c e . F o r m o n t h s - 3 t h r o u g h 0 r e l a ti v e t o p r o x y s t a t e m e n t d a te , t h e re

i s 1 1.3 e s t im a t e d a b n o r m a l p e r fo r m a n c e ; i f i n s t e a d m o n t h s - 7 t h r o u g h 0 a r e

exam ined , the e s t im a ted cum ula t ive abno r m a l s tock p r ice r un - u p i s 2 2 .3 .

3 I n t e r p r e t a t i o n o f t h e r e s u l t s

3 1 H ypotheses about why p lan adopt ion resu l ts in a pos i t ive m ark e t react ion

Th e r e s u l t s in t ab le 1 l end s u ppo r t to the v iew tha t p lan ado p t ion l e ads to a

pos i t ive m ar ke t r e ac t ion . Fu r the r m or e , in th i s v iew, the h ighe r po in t e s t im a te s

o f T e h r a n i a n a n d W a e g e l e i n w o u l d n o t b e s u r p r i s i n g ( t o t h e e x t e n t t h e

d i f f e r ences a r e s t a ti s t i c a lly sign i fi c an t) . Thes e au th o r s f ocus on ly o n new p lans ,

wh e r ea s B r icldey , Bhaga t and Leas e inc lude ch ange s in ex i s ting p lans , and s u ch

cha ng es w il l l ike ly have a sm al le r s tock pr ice e f fec t .

B e t w e e n t h e t w o p a p e r s , t h e r e a r e a t l e a s t t h r e e h y p o t h e s e s a b o u t w h y p l a n

adop t ion wou ld b r ing abou t a pos i t ive r eac t ion . The f i r s t hypo thes i s i s tha t the

p lans have incen t ive e f f ec t s . The s econd i s tha t p lan adop t ion r evea l s in s ide

i n f o r m a t i o n t h a t m a n a g e m e n t t h i n k s t h e s t o c k i s u n d e r v a l u e d . T h e t h i r d i s t h a t

the p lans have tax e f fec ts .

W h i l e a l l t h r e e h y p o t h e s e s a r e w o r t h y o f c o n s i d e r a t i o n , f u r t h e r w o r k i s

neces s a r y to d i s t ingu i s h be tween them . None o f the t e s t s in the two pape r s do

s o , o r a ccoun t f o r the c r os s - s ec t iona l va r ia t ion in s ha r e r e tu r ns . I am uneas y

abou t a t t r ibu t ing a l a r ge pos i t ive s tock p r ice e f f ec t s o le ly to t ax e f f ec t s . I n

gene r a l , no t a l l p lans a r e t ax advan tageous [ s ee M i l l e r and Scho le s ( 1982 ) ] ;

p e r h a p s b e t t e r d a t a w o u l d a l l o w u s t o p a r t i t i o n t h e s a m p l e s a c c o r d i n g t o t h e

expec ted s ign o f t ax e f f ec t s , and to e s t im a te

a pr ior i

t h e m a g n i t u d e s o f t h e

im p l ied s tock p r ice r eac t ion . Fu r the r m or e , La r cke r ( 1983 , p . 12 ) a r gues tha t t ax

e f f ec ts a r e l ike ly to be r e la t ive ly s m a l l . H e f inds ev idence o f inc r ea se s in

c o r p o r a t e c a p i ta l i n v e s tm e n t f o l l ow i n g p l a n a d o p t i o n ; s u c h c h a n g es a r e co n -

s i s t en t wi th an incen t ive exp lana t ion , bu t ha r de r to r econc i l e wi th a t ax s to r y .

3 2 O th e r e x p la n a t ion s fo r th e p o s i t i v e s to c k p r i c e p e rfo r ma n c e : Co u ld a b n o r m a l

p e r fo r ma n c e t rig g er p la n a d o p t io n ?

T a b l e 1 i n d i c a t e s t h a t s o m e o f t h e a b n o r m a l r e t u r n s o c c u r r e d w e l l i n

adv ance o f p lan p r opos a l . Spec i fi c a lly , Te h r a n ia n and W aege le in f ind 11 .0

e s t im a t e d av e ra g e a b n o r m a l p e r f o rm a n c e f r o m m o n t h s - 7 t h r ou g h - 4 r el a-


4/5

148

J.B. Warner Discussion

t i ve to the p r ox y s t a t eme n t da te . In th i s pe r iod the samp le f irms typ ica l ly have

no t ye t had a boa rd mee t ing to f ina l i ze the incen t ive p l an p roposa l . A l though

t h e s to c k p r i c e b e h a v io r i n m o n t h s - 7 t h r o u g h - 4 c o u ld b e a t t r ib u t a b l e t o

t h e e x p e c t a t i o n o f p l a n p r o p o s a l o r t o a s u b s a m p l e o f f i r m s w i t h b o a r d

mee t ings in th i s pe r iod , t he re su l t s a t l e a s t sugges t t he poss ib i l i t y tha t f i rms

a d o p t p l a n s a f t e r a p e r i o d o f g o o d p e r f o r m a n c e .

T h i s p o s s i b l e l i n k b e tw e e n g o o d p e r f o r m a n c e a n d s u b s e q u en t p l a n a d o p t i o n

i s m e n t i o n e d b y T e h r a n i a n a n d W a e g e l e i n . H o w e v e r , I a m u n s u r e a b o u t t h e

mode l o f f i rm behav io r tha t wou ld l e ad to the re l a t ionsh ip . In pa r t i cu la r , wha t

recen t changes w i th in the f i rms wou ld have caused p lan adop t ion , and why a re

t h e s e c h a n g e s a c c o m p a n i e d b y p o s i t iv e s h ar e v a lu e c ha n g es ? H o w i m p o r t a n t i s

t h e o c c u r r e n c e o f p o s i t i v e a b n o r m a l p e r f o r m a n c e i n d e t e r m i n i n g w h i c h f i r m s

adop t p l ans? Answer ing such ques t ions rema ins fo r fu tu re work .

3 3 The c onfound ing e f fect o f earnings announcements

C o n t r o l l i n g f o r t h e e f f e c t s o f c o n t e m p o r a n e o u s e a r n i n g s a n n o u n c e m e n t s i s

impor tan t t o ou r unde rs t and ing o f the ex ten t t o wh ich h ighe r s tock p r i ce s l e ad

t o p l a n a d o p t i o n o r v ic e -v e rs a . T h e t i m i n g o f e a rn i n g s a n n o u n c e m e n t s a r o u n d

p l a n a d o p t i o n i s n o t a d d r e s se d i n d e ta i l i n t h e tw o p a p e r s. H o w e v e r, T e h r a n i a n

and W aege le in ind ica te tha t a l l o f t he i r sample f irms had annua l e a rn ings

a n n o u n c e m e n t s i n m o n t h s + 1 0 a n d + 1 1 r e la t iv e t o p r o x y s t a t e m e n t d a te .

Thus , i f I a ssume tha t r epo r t ing da te s fo r e ach sample f i rm a re fa i r ly r egu la r ,

a n n u a l e a r n i n g s m u s t a l so h a v e b e e n re l ea s e d i n a b o u t m o n t h - 2 o r - 1

re l a t ive to p roxy s t a t emen t da te . I f s imi l a r e a rn ings repo r t ing behav io r a l so

app l i e s to the B r i ck ley , B haga t and Lease sample , many o f the i r f i rms wou ld

h a v e h a d a n n u a l e a r n in g s a n n o u n c e m e n t s in t h e p e r io d b e tw e e n b o a r d m e e t i n g

da te and SEC p roxy s t a t emen t r ece ip t da te , t he pe r iod in wh ich B r ick ley ,

B h a g a t a n d L e a s e f o u n d p o s it iv e a b n o r m a l p e r fo r m a n c e .

H o w m u c h o f t h e p o s i ti v e s t oc k p r ic e p e r f o r m a n c e i s d r iv e n b y c o n t e m p o r a -

n e o u s e a r n i n g s a n n o u n c e m e n t s i s n o t e n t i r e l y c l e a r . I n t h e T e h r a n i a n a n d

W a e g e l e i n p a p e r , t h e e ar n in g s n u m b e r s r e le a s ed p r i o r to p l a n a d o p t i o n d o n o t

s e e m u n u s u a l . A ' n o r m a l ' p r o p o r t i o n o f t h e i r s a m p l e f i r m s r e p o r t e a r n i n g s

inc rea se s . T h i s r educes any conce rn tha t t he pos i tive s tock p r ice pe r fo rm ance i s

d u e t o e a r n i n g s a n n o u n c e m e n t s , o r d u e t o f a v o r a b l e p e r f o r m a n c e p r i o r t o t h e

f i rm ' s dec i s ion to adop t a p l an .

O ne pos s ib le d i f fi cu lty w i th the use o f ea rn ings num bers to in fe r e conom ic

p e r f o r m a n c e o f t h e s a m p l e f ir m s i s th a t i f m a n a g e r s k n o w t h a t t h e ir c o m p e n s a -

t ion w i l l become l inked to g rowth in repo r t ed ea rn ings pe r sha re , t hey have

incen t ive s to unde rs t a t e cu r ren t e a rn ings be fo re the new compensa t ion p lan i s

adop ted . Tes t s fo r unusua l e a rn ings behav io r cou ld con t ro l fo r th i s poss ib i l i t y

by focus ing on those sample f i rms whe re compensa t ion i s no t a func t ion o f

a c c o u n t i n g e a r n i n g s . E x a m i n a t io n o f t h e f r e q u e n c y o f ch a n g es i n a c c o u n t i n g


5/5

J.B. Warner Discussion 149

p r o c e d u r e s a r o u n d t h e ti m e o f p l a n a d o p t i o n [ se e H e a l y ( 1 98 5 )] w o u l d a l s o b e

use fu l . Fu r the rmore , a l though i t i s p robab ly a minor qu ibb le he re , even i f t he re

i s n o t h i n g u n u s u a l a b o u t e a r n i n g s o f t h e s a m p l e f i r m s , c o n t e m p o r a n e o u s

e a r n i n g s a n n o u n c e m e n t s i n c re a s e t he v a r ia n c e o f s t o c k r e t u r n s . U n d e r c e r ta i n

cond i t ions , even t s tudy t e s t s w i l l mi ss t a t e the s t a t i s t i c a l s ign i f i c ance o f the

r e s u l t s a n d f o r s o m e m e t h o d o l o g i e s a b n o r m a l p e r f o r m a n c e w i l l b e ' f o u n d '

when none i s p re sen t [ see B rown and Warne r (1984) ] .

4 F i r m p e r f o r m a n c e f o l lo w i n g p la n ad o p t io n : F u r t h e r e v i d e n c e a n d

a f i n a l p u z z l e

Tehran ian and Waege le in repo r t s ign i f i c an t i nc rea se s in annua l e a rn ings in

t h e y e a r i m m e d i a t e l y f o ll o w in g p la n a d o p t i o n . U n d e r t h e h y p o t h e s i s t h a t t h e

p lan s have incen t ive e ffec ts , t h is i s expec ted . The same re su l t i s expec ted un de r

t h e h y p o t h e s i s t h a t m a n a g e rs o f t h e s a m p l e f ir m s b r o u g h t a b o u t p l a n a d o p t i o n

w h e n t h e y h a d i n si d e i n f o r m a t i o n t h a t e a r n i n g s w o u l d i n c re a s e .

A su rp r i s ing re su l t , howeve r , i s t ha t a s t rong pos i t ive ave rage sha re p r i ce

r e a c t i o n o c c u r s a t th e t im e o f a n n u a l e a r n in g s a n n o u n c e m e n t , t y p i c a l ly m o n t h

+ 10 . Th i s r e su l t i n t r igues me . Assuming tha t i t does no t mere ly re f l ec t some

x post

sam ple se lec tion b ia s, i t seems incons i s t en t w i th m ark e t e f fi ci ency , and

sugges t s a p ro f i t ab le t r ad ing ru le : buy on news o f p l an p roposa l and ho ld

t h r o u g h e a r n i n g s a n n o u n c e m e n t . T e h r a n i a n a n d W a e g e l e i n i n d i c a t e t h a t s u c h

a s t r a t egy p roduces abno rma l p ro f it s on the o rde r o f 13 . W hi l e fu r the r work

on the s ens i t iv i ty o f the i r r e su l ts t o a l te rna t ive meas u re m en t p ro cedure s and to

d i f fe ren t f ea s ib l e t r ad ing ru le s wou ld be he lp fu l i n a sse ss ing the s t r eng th o f

the se f ind ings , t he re su l t s seem wor thy o f c lo se r sc ru t iny . No t on ly cou ld th i s

y ie ld add i t iona l i n s igh t s in to the behav io r o f secu r i ty p r i ce s a round incen t ive

p lan adop t ion , bu t i f t he re i s a p ro f i t oppor tun i ty he re , I wou ld l ike to f ind ou t

in t ime to ca l l my b roke r .

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warner stock market reaction to management incentives plan adoption an overview

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