The literature indicates that high quality corporate governance tools should follow compensation packages in order to deal with manipulation, as monitoring weaknesses allow managers to manipulate their executive stock option gains (Goldman & Slezak, 2006;
Marinovic & Varas, 2019).
We look at four specific governance features of companies that relate to how much control managers have over their plans in order to evaluate B3 companies. First, we observe how firms classify in the B3 Corporate Governance segments. B3 establishes governance rules and classifies firms according to their level of – voluntary - commitment. These rules are not mandatory by the Brazilian legislation. The highest classification for Public companies is “New Market” (NM), followed by “Level 2” (L2) and “Level 1” (L1). Firms in these three categories adopt corporate governance practices superior to the ones set by Brazilian legislation. Firms that only adopt mandatory governance rules classify in the “Traditional Market” (TM).
We also look at two dimensions of governance: i) board of directors independence (Leung et al., 2014) and; ii) if a firm’s CEO is also a board chairman (Prencipe & Bar-Yosef, 2011). In order to obtain proxies for these measures, we observe whether companies follow ideal clauses set by B3, which indicates that companies’ governance codes should state: i) that the directors board should be mostly composed by external members and at least one third of the board members should be independent and; ii) that the CEO should not also be the board chairman. If firms do not include these criteria in their governance codes, we consider their corporate governance to be not ideal.
At last, we observe whether firms compensate only their statutory board members or also their board of director’s members through ESOP. Compensating only statutory board members is ideal, given that board of director members have larger discretion over financial reporting and other corporate policies that might allow them to manipulate stock and strike prices. We obtain corporate governance data for only 68 companies of our sample. Table 3 presents data on our four measures of Corporate Governance.
Overall, firms that adopt ESOP present good governance practices. Most of the companies classify in the NM (48 firms; 70,58%), which is the highest segment according to
B3 standards. Also, only 2 companies (2,94%) do not adhere to the ruling regarding CEOs not being board of directors’ chairman. At last, most of the companies (45 firms; 66,17%) only compensate their statutory board with stock options and do not compensate board of directors’
members. However, 52 companies (76,47%) do not include ideal rules regarding board independence in their governance codes, which indicates that board independence is an issue on most of the companies that adopt ESOP.
Table 3: Corporate Governance data for firms that adopt ESOP (n = 68) New
Market Level
2 Level 1 Traditional Market
Includes B3's Directors Board Independency Rule
CEO is not the Board Chairman
Firms that do not compensate their Board of Directors
with ESOP
48 5 5 10 16 66 45
70,59% 7,35% 7,35% 14,7% 23,53% 97,05% 66,17%
* two companies of our sample did not present complete corporate governance data Percentages consider a total of 68 companies.
Source: research data
We find that both companies in which the CEO is also the Board of Directors’ Chairman compensate their directors’ board with stock options. This reinforces the idea that this sort of governance weakness (CEO as Chairman of the board) might be undesirable, because in both firms CEOs have large discretion over aspects of their own compensation. Additionally, these two companies do not include B3’s ideal ruling regarding Board Independence.
4 Conclusion
We perform a literature investigation to identify which are the ideal features of an ESOP in order to generate effort and reduce manipulation, and then compare these to the practices of B3 traded companies.
Overall, most of the B3 companies that adopt ESOP include long vesting periods. This is a positive aspect of these plans, as long-term incentives within the manager’s tenure offset the negative impact of manipulations (Marinovic & Varas, 2010). However, most of the companies do not include restrictions on selling the acquired stocks after options exercise. This is not ideal, as restrictions after vesting deal with incentives for short-term price manipulations (Bebchuk & Fried, 2010).
Empirical evidence indicates that managers deliberately influence their own firm’s market prices negatively before grant dates, as firms usually set their exercise prices based on this metric. Hence, ideally, we suggest that firms should not use market prices (or weighted average) as their strike price if managers are aware of grant dates in order to avoid manipulations. However, most of the Brazilian companies do not satisfy this suggestion and usually set their strike prices as the weighted average of a small period before grant dates.
Another aspect we find is that, contrary to theoretical arguments on the optimality of including a strike price reset mechanism (Acharya et al., 2020), B3 firms generally do not pre-commit to exercise price resetting when options go underwater. Hence, in the face of the economic crisis generated by the COVID-19 pandemic, Brazilian companies did not reset ESOP incentives.
Shareholders’ tax considerations are another aspect to consider when setting an ESOP.
Most of the companies in our sample do not include dividend protections, which might lead managers to reduce dividend payments before their options vest, as they avoid stock-price-reductions at the ex-dividend dates. This is particularly problematic for shareholders in the Brazilian market, because dividends usually are untaxable, while capital gains are.
At last, we observe that companies that adopt ESOP generally present high quality corporate governance. Most of the companies classify in the highest corporate governance segment according to B3 classification, do not compensate their director’s board members with options and do not name their CEOs as Chairman of the board. However, board independence is an issue for most companies.
Overall, we conclude that Brazilian exchange traded companies design their ESOP well.
However, there is room for improvement. We also notice that a substantial amount of companies has given up on their ESOP, completely terminating stock-based compensation or substituting stock options for other forms of payments related to market value. Examining the reasons that have led these companies to abandon their ESOP is an important issue for future research. It would be interesting to investigate whether these plans have not reached their goals regarding incentivizing managers and, if so, whether their design was ideal. While we do not focus on this issue in the present paper, we notice that some companies that have cancelled their ESOP have had problems with market manipulation by managers, including frauds that have led to criminal convictions.
Regarding our research limitations, we evaluate only incentives of ESOP. Firms adopt other forms of compensation alongside ESOP that could complement the flaws in stock option compensation (or nullify their success). Additionally, this study is mostly descriptive. Hence, there is no guarantee that the ESOP features we study actually generate ideal incentives.
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