Managerial Power Hypothesis

I next address whether managerial power is related to executive equity design. While agency theory suggests that executive compensation packages are structured to align managers’ and shareholders’ interests (Fama 1980; Jensen and Meckling 1976; van Essen et al. 2012), managerial power theory suggests that managers are able to influence their own compensation package; therefore, compensation packages may not be able to alleviate the agency problem (Bebchuk and Fried 2005; Bebchuk et al. 2002). Managerial hegemony theory complements managerial theory by suggesting that boards are, on average, closer to top executives than to the shareholders and reliant on management for company and industry information (Hermanson et al. 2012). As a result, boards are more likely to side with managers (Hermanson et al. 2012; Bebchuk et al. 2002) and may not challenge managers’ demand for excessive compensation or the form of compensation (Hermanson et al. 2012) that favours managers’ after-tax payout.

In a Canadian tax setting, tax consequences of stock options at the employee level may be a strong explanation for managers’ preference for stock options over restricted shares or restricted share units. Specifically, the favourable tax treatment of stock options at the employee level (“one-half deduction”) is one very large attraction of stock option grants in Canada and some news outlet even called this generous tax treatment at the employee level

as a “stock option tax loophole” that favours highly paid executives (e.g., Scotti 2017). Therefore, I argue that “one-half deduction” will be attractive to tax savvy highly compensated executives if executives do not expect that the firm will grant substantially higher pre-tax value of RSU grants to compensate for the executives’ tax hit. Such expectation violates the maintained assumption in Scholes-Wolfson framework and explicit in Table B.2 (that generates H1). If one holds the pre-tax $1 value of options or shares the same, I expect managers would prefer stock options. In addition to the one-half deduction of stock options, the tax deferral length of stock options is more flexible than RSUs. Most RSUs vest in three years (Geddes 2010; Lee 2010; Colquhoun et al. 2012), whereas a typical stock option expires in 10 years (Hall and Murphy 2002). By choosing stock option exercise date prudently, managers may be able to use stock options for their personal tax planning and defer their employment-related income taxes longer.

Employee optimism may also be one of the explanations for managers’ preference for stock options. A survey by Hodge et al. (2009) suggests that managers do not understand how to value stock-based compensation and managers’ perceived values of stock options and restricted shares are vastly different from firms’ valuation. Using participants who are most likely to join mid-level management ranks, Hodge et al. (2009) find that managers are more likely to value stock options higher than the Black-Scholes value, a finding echoed by Devers et al. (2007), and restricted shares lower than its fair market value. These survey findings imply that managersprefer $1 fair value stock option compensation to $1 fair value restricted shares in the U.S. setting where there is essentially no taxation difference between the two. Therefore, on the expected value of the equity grants, there is a deadweight loss that arises between the value perceived by the recipient and the cost to the grantor (Hall and Murphy

2002). Differences in perceived value may arise due to managers’ optimism of their employer’s future performance or managers’ preference for a potentially large gain from stock option exercises despite a small probability of achieving such a gain (Spalt 2013; Sun and Widdicks 2016). Combining employee optimism, a highly tax favourable nature of stock options at the employee level, and a longer length of tax deferral, I argue that employees may likely favour stock option grants to corporate tax-deductible RSUs.

If managers can influence the board as the managerial hegemony theory contends, the executive equity compensation may consist of a greater portion of stock options that are perceived as more valuable and tax favourable to employees, leading to a change in executive compensation structure when the board is weak. Assuming executive compensation equity grants consist of corporate tax-deductible RSUs and employee tax-favoured stock options only, I expect a negative association between managerial power and the RSU ratio in Canada.

I posit the second hypothesis as follows:

H2: The RSU ratio is negatively related to managerial power among Canadian firms. While executives may have the power to influence their compensation package, there are several reasons why they may not demand more stock options in their equity compensation. First, stock option grants are associated with “bad reputation” because the public and the government allege that stock option grants lead to excessive risk-taking, and managers engage in stock option backdating to extract rent (Chen et al. 2006; Geddes 2009; Hall and Murphy 2002). Fama (1980) argues that CEOs know that labour market discipline might impose costs on managers that are aggressive in extracting rents by downgrading their human capital value. Second, the economic theory argues that managers discount the Black- Scholes value of the stock options, which is the cost to the firm, because of suboptimal

diversification of managers’ wealth and risk-averse agents (Hodge et al. 2009). Therefore, risk-averse managers discount the Black-Scholes value of stock options due to a greater degree of risk associated with stock option grants as prior research suggests. Therefore, employees may potentially prefer less-risky corporate tax-deductible restricted share units. For these reasons, I may not observe the relation proposed in hypothesis two.

4.4 The effect of managerial power on executive equity mix across corporate