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In late 2008, a crisis of unprecedented proportion unfolded on Wall Street that called for the government bailout of institutions. Although the crisis wreaked havoc on the lives of firm stakeholders and taxpayers, many of the executives of these rescued firms received bonus compensation as the year closed, which called into question the relationship between pay and performance. Equity compensation is viewed by many as the answer to the principal–agent dilemma. By giving an executive stock in the firm, as an owner, his interests will now be aligned with those of shareholders, and the executive will work to enhance firm performance. Equity compensation was on the rise during the 1990s when stock options became the largest component of executives’ compensation packages [Murphy, K. J. (1999). Executive compensation. Handbook of Labor Economics, 3, 2485–2563]. During the first decade of the new millennium, usage of restricted stock in compensation plans contributed to the executives’ total package. Whatever the form, equity compensation should induce managers to make decisions for the betterment of the firm.

Empirical evidence, however, has contradicted this ideal notion that mangers who are partial owners of the firm work to maximize firm value. Rather, managerial power in the form of earnings management and manipulation of insider information come to the forefront as a means by which executives can maximize the equity portion of their compensation packages. The Sarbanes–Oxley Act of 2002 as well as new accounting rules set forth by the Financial Accounting Standards Board may help to remedy some of the corporate ills that have surfaced in the past. This will not be possible, however, without compliance and increased corporate governance on the part of firms and their executives. Compensation committees must take great care in creating a compensation package that incites the executive to not only act in the best interest of his firm but also consider the welfare of the common good in his actions.

Internal Revenue Code section 162(m) limits tax deductibility of executive compensation to $1 million per covered executive, with an exception for performance-based compensation. Both stock options and annual bonuses can qualify as performance-based, but they vary in the difficulty of qualification and the degree of additional compensation risk that qualification imposes on the executive. Most stock-option grants easily qualify with little change in risk, but qualification increases the risk associated with annual bonus compensation relative to what it was prior. The results of this study show that the propensity to issue stock options has increased for affected executives as a percentage of total compensation. Additional analysis suggests that this increase in stock-option compensation is substituting for lower increases in salary for affected executives, but not for annual cash bonuses. In fact, the results suggest that bonus compensation is also increasing as a percentage of total compensation. In summary, the results indicate that firms and their executives are acting in a way consistent with the incentives provided by section 162(m).

In some contexts, this illiquidity of executive stock options is referred to as non-transferability. In others, the problem is cast in terms of the highly concentrated portfolios that managers hold, an implication of which is that managers could not trade the options to diversify. The notion of option liquidity usually conjures up images of trading pits at the Chicago Board Options Exchange or other exchanges. The existence of an active trading pit gives a powerful visual image of liquidity, but, as evidenced by the success of electronic options exchanges such as New York's International Securities Exchange and Frankfurt's EUREX, a trading pit is hardly a requirement for liquidity. The existence of a guaranteed market for standardized options as implied by options exchanges (whether pit-based or electronic) further gives a misleading appearance of high liquidity. There is also a very large market for customized over-the-counter options. It is a misconception to think that these options are not liquid when they are simply not standardized. If an investor can create a highly customized long position in an option, that investor should be able to create a highly customized short position in the same option at a later date before expiration. If both options are created through the same dealer, they will usually be treated as an offset, as they would if they were standardized options clearing through a clearinghouse. If the two transactions are not with the same dealer, they would both remain alive, but the market risks would offset. Only the credit risk, a factor we ignore in this paper, would remain. Hence, these seemingly illiquid options are, for all practical purposes, liquid.²

The purpose of this paper is to discuss how executive stock options help in reducing agency costs in the firm and to address problems experienced by the firm when stock options are used as incentives.

The paper initially discusses types of agency problems caused by company managers and then explains why stock options can reduce the problem of excessive risk aversion displayed by some managers. It then addresses the problems that may occur with the introduction of executive stock options by the firm and finally offers methods to reduce these problems.

The paper explains the methods available to reduce the problems caused by executive stock options such as indexing the stock options to the S&P 500 index and structuring the Board of Directors in a manner that helps ensure the stock options are used appropriately.

This paper is valuable to firms using executive stock options as incentives to managers. It outlines the problems stock options can help solve and the problems which may occur by their use. In addition, the ways to reduce the problems produced by executive stock options in the firm are discussed.

Agency theoretic models have been used in the past to justify the use of stock options as an effective incentive alignment mechanism to create a common fate between principals and agents. In this paper, we use behavioral theory to reach the opposite conclusion – namely, that the design characteristics of the typical stock option plan foster perverse incentives for loss‐averse agents, leading to decisions with detrimental consequences for principals. We also consider alternative stock option designs and other equity‐based executive compensation plans and argue that they may suffer from the same problems as traditional stock option plans – namely, that loss‐averse executives will try to protect the endowed value of that equity through self‐serving decisions that do not enhance shareholder wealth.

The purpose of this paper is to illuminate issues surrounding executive compensation as it relates to current understandings of Islamic business law.

The emerging bodies of literature in the fields of executive compensation and opinions of stock options under Shari'a law are reviewed.

It appears that the trend in offering employee stock options as part of a Shari'a compliant compensation package is acceptable in most cases, yet because of its close association with the more problematic idea of derivative transactions, the company must be vigilant in obtaining the approval from its Shari'a Standards Board before offering it as part of an overall compensation package.

Existing quantitative data in this area are limited. Given the qualitative, exploratory nature of the design, generalizability is not as robust as other designs.

The paper makes recommendations about the inclusion of employee stock options as part of a Shari'a compliant executive compensation package.

This paper advances the extant literature on the ethics of executive compensation in general as well as adding to the extant literature on Shari'a compliance of executive compensation packages.

This chapter examines the determinants of managerial incentives at the time of an Initial Public Offering (IPO) on the Alternative Investment Market (AIM) of the London Stock Exchange. We identify a trade-off relation between board monitoring and incentives that is specific to CEOs. We also investigate the role of stock option grants and share transactions at the IPO. We find that the IPO may be used as a wealth diversification opportunity. We report that undiversified managers with large pre-IPO shareholdings receive smaller stock options grants and sell more shares in the IPO than more diversified managers.

Until 2005, corporations could choose whether to expense incentive options or to disclose the value in the financial footnotes. During 2004, however, the Financial Accounting Standards Board adopted the revised Statement No. 123, which requires public corporations to measure the cost of stock options on grant‐date and expense that cost over the vesting period of the grant. This study investigates the impact of SFAS 123(R) on the type of executive incentive pay‐option versus restricted stock.

Comprehensive compensation data was collected from Standard & Poors ExecuComp data base for the period 2002‐2006 for two industries identified by SIC codes 73 (business services) and 35 (electronics). The study tracks the percentage of pay in the form of incentive stock options or restrictive stock grants before and after SFAS No. 123(R) was adopted in 2004. A series of multivariate regression models test whether the restricted stock percentage of total compensation can be partially explained by the adoption of SFAS 123(R).

The results show that the average fair value of stock awards is higher and the average fair value of option awards is lower after 2004. In addition, after 2004, stock compensation as a percentage of total pay is positively related to stock price volatility. The data also suggest that those companies substituting restricted stock for options actually increase total incentive pay.

The study's findings may suggest that those companies substituting restricted stock for options increase total executive pay. This would be a side effect from the adoption of SFAS 123(R), in that most companies use the Black‐Scholes model to value executive options. Given the long life of these options and the high volatility in certain industries the option value is quite high. Therefore, the amount of substituted restricted stock is also inflated.

The adoption of SFAS 123(R) was highly contested by executives in industries with high stock price volatility. The authors document that, in the case of two industries, executive incentive pay structure was affected.

Reviews previous research on the timing of employee stock option exercise decisions and share price performance before and after insider trading. Analyses the 1992‐1993 exercise behaviour of top executives at 65 large US firms using the Black‐Scholes (1973) value (less anticipated dividends) as a benchmark to compare with the intrinsic value (market price minus exercise price) at the date of exercise. Finds options are exercised when the two values are roughly equal, i.e. that executives’ decisions are not risk‐averse or biased by private information. Also shows a tendency for the subsequent change in share prices to be lower when the intrinsic value is less than the Black‐Scholes value at the time of exercise. Considers consistency with other research and the implications of the findings.