The effects of stock options accounting regulation on corporate governance: A comparative European study

The use of stock options as executive compensation, after having developed in the United States in the 1980s and 1990s, has spread to continental Europe in the past fifteen years. The increasing weight of stock options in this region of the world raises various issues and feeds a vast literature dealing with the relationship between corporate managers’ pay and performance. A good chunk of that literature is based on agency theory. In this line of thought a principal (the shareholder) delegates the management of the firm to an agent (the manager) and simultaneously sets up a series of control devices to make sure that the agent will act in his (the shareholder’s) interest (Jensen and Meckling, 1976). Agency theory does not limit itself with identifying potential conflicts of interests between managers and shareholders: it also explores the various means through which the firm’s owners try to make sure that managers seek to maximize their (the owners’) objectives. Optimal contracting theory precisely aims at identifying such means. According to that theory, the firm’s compensation policies should contribute to align the managers’ interests on those of the shareholders – to make sure, in other words, that the agent behaves in the interest of the principal (Murphy, 1999). Such a view, applied to executive compensation plans, has been recently exposed to a strong scepticism. The optimal contracting theory has a weak empirical basis, especially when applied to stock options – whose adoption does not seem to lead to a significant improvement of firms’ corporate governance. Several authors have underlined the importance of “pay without performance” (Murphy, 1999). Most empirical studies cannot find a positive relationship between the adoption of stock option plans and a significant improvement in firms’ performance. Several explanations have been proposed to explain that puzzle (such as, for instance, Bebchuk & Fried, 2004), all linked to rent extraction theory. According such theory, managers extract a rent from their position: concretely, they increase their capacity to change their own remuneration. In this scheme, stock-options, by nature, cannot succeed in aligning the agent’s interests on the principal’s; on the contrary, they strengthen or create new agency problems. This discussion can be linked to the theme of stock-options accounting and disclosure, which has been recently transformed by the adoption of international accounting standards in most developed economies. Indeed, according to the IFRS 2, stock-options are to be accounted for as labour costs, implying an increase of net liabilities within a specific reserve, with a value equal to the fair value of the options. This accounting method breaks significantly with the past, when disclosure of stock-options plans were left to the discretion of firms. Such a change in disclosure rules might have an impact on the corporate governance of European firms. Indeed, according to a growing literature (see Verrecchia, 2001, for an exhaustive review), disclosure (which can be defined as the publication of previously private relevant information) mediates the relation between a firm’s owners and managers. When disclosure is failing, corporate governance worsens, in that managers are able to hide the decisions which damage or threaten owners’ interests. In fact, in the current context, characterized by national and international regulatory reforms in favour of a more stringent disclosure, the academic discussion has shifted its focus from the causes to the consequences of disclosure, especially related to corporate governance (see Bushman & Smith, 2001). Turning the previous reasoning on its head, one can argue that, in presence of information asymmetries and agency conflicts between owners and managers, disclosure acquires a strategic value (Healy & Palepu, 2001). In particular, a better disclosure could help reduce contractual problems linked to agency relations (Lo, 2003), through, for instance, corporate reputation. In the (international) context of the adoption of more stringent norms on stock option disclosure (that is their recognition, meaning, as seen above, accounting stock-options as costs in a firm’s financial statement), both discussions are relevant. The new disclosure of stock-options could help reduce the risks of rent extraction tied to that form of compensation and bring them closer to their role as incentives assumed in the optimal contracting theory. The aim of the present work is to understand whether the aforementioned change in stock option accounting regulation has had an impact, and what impact, on the corporate governance of European firms, in the light of the twin literatures cited above. The sample considered here includes all listed Italian and French firms, excluding financial institutions, which have carried out stock option plans in 2005 and 2006, and therefore underwent the change in accounting regulation mentioned above. The analysis relies on qualitative and quantitative data, and focuses on a few key indicators. The findings of the present research suggest that the impact of new accounting rules and more stringent disclosure on listed French and Italian firms is not significant. The firms under study have not shown any substantial change in their management or governance structure, which appear to be still largely driven by the peculiar power distribution proper to each country. Besides, such firms have not received any market premium for introducing executive compensation schemes that theoretically provide incentives for top management to maximize owners’ interests. In any event, those plans remain a minority among listed firms. One could argue, therefore, that in Italy and France, like other countries in the world and the United States in particular, stock options plans have become another instrument used by executive managers to obtain higher remuneration with no link to the true performance of the firm and the interests of its owners. Such a logic is much closer to the rent extraction theory mentioned above (see, for the US, Dechow, Sutton, Sloan, 1996).