We predict and find that firms use annual grants of options and restricted stock to CEOs to manage the optimal level of equity incentives. We model optimal equity incentive levels for CEOs, and use the residuals from this model to measure deviations between CEOs’ holdings of equity incentives and optimal levels. We find that grants of new incentives from options and restricted stock are negatively related to these deviations. Overall, our evidence suggests that firms set optimal equity incentive levels and grant new equity incentives in a manner that is consistent with economic theory.

We use an option pricing framework to model equity valuation when firms face costs associated with violating accounting-based debt covenants. Our model shows that the value of equity depends on two factors: the economic value of the firm and the probability that the firm violates the covenant. Consistent with the model's prediction that the `covenant' effect is greatest for firms near covenant violation, we find that responses to earnings that are less informative about future cash flows (losses and transitory earnings) are significant only for thrift institutions that are near violation of regulatory net worth covenants.

We find that measures of board and ownership structure explain a significant amount of cross-sectional variation in CEO compensation, after controlling for standard economic determinants of pay. Moreover, the signs of the coefficients on the board and ownership structure variables suggest that CEOs earn greater compensation when governance structures are less effective. We also find that the predicted component of compensation arising from these characteristics of board and ownership structure has a statistically significant negative relation with subsequent firm operating and stock return performance. Overall, our results suggest that firms with weaker governance structures have greater agency problems; that CEOs at firms with greater agency problems receive greater compensation; and that firms with greater agency problems perform worse.