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Economic Quarterly

Fourth Quarter 2012

Regulation and the Composition of CEO Pay

Arantxa Jarque and Brian Gaines

A look at the recent trends in the use of grants of restricted stocks and options in the compensation packages of chief executive officers (CEOs) of large, public U.S. companies reveals that there have been important changes. These changes coincide with the introduction of two new regulations: the modifications of reporting requirements for option grants introduced by the Sarbanes-Oxley Act in 2002, and the adoption in 2006 of revised accounting standards from the Financial Accounting Standards Board (FASB) included in statement no. 123R (FAS 123R), which mandated the expensing of option grants. We find evidence indicating that firms may have responded to these regulations by shifting away from options and into stock. Even though after the two changes there is still a significant portion of firms in the sample that choose to grant options to their CEO (about 55 percent of firms, compared to 67 percent before 2002), alone or combined with stock, the fraction of firms that are awarding options but not stock in a given year decreases from 57 percent before 2002 to 19 percent after 2006. However, while only 4 percent of firms used exclusively stock grants before 2002, this percentage increases over the period we analyze to reach 26 percent after 2006. These trends persist when we control for firm characteristics like size and industry classification, as well as for the level of pay. We also find that different compensation instruments do not appear to be perfect substitutes within compensation packages. Perhaps surprisingly, given the decrease in the popularity of option grants starting in the early 2000s, the relative importance of options in relation to the total amount of compensation has not decreased over time for those firms that still include options in their compensation packages.

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