The 'Repricing' of Executive Stock Options

Abstract

We examine the incidence of corporations lowering the exercise prices of their executive stock options. These options can be viewed as a combination of a down-and-out call option and a down-and-in call option with the exercise price equal to the barrier. Using barrier option pricing theory, we find that at a minimum this features adds 7-10 percent to the value of the options on the grant date. We also examine the market, industry and firm-specific performance of a sample of 37 firms and 53 reset events. The period covered was 250 days before and after the day on which the firm reset the exercise prices of its executive stock options. The evidence strongly supports the conclusion that resetting the exercise price follows a period of poor firm-specific performance. The magnitude of the reduction in the exercise price was positively related to the firm's stock price performance and using a value- weighted market portfolio, it was negatively related to the market's performance. No evidence supports the contention that lowering the exercise price brings an end to the firm's problems and leads to an increase in shareholder wealth. Though the direct dollar impact at the time of the reset is relatively small to the shareholders, it is not insignificant to management. Allowing for the possibility of resetting after a stock price decline can create a perverse incentive under certain circumstances for managers to deliberately drive the stock price down further. In addition management has a greater incentive to engage in high risk projects than it would have with ordinary non- esettable options. These incentives and our results that the resets are indeed done, sometimes repeatedly, following poor firm-specific performance suggest that resetting is not in the best interests of shareholders, who should certainly question this practice.

JEL Classification: G13, G14, G32