Academic journal article Academy of Accounting and Financial Studies Journal

The Performance and Determinants of Firms That Reprice Options during a Bear Market

Academic journal article Academy of Accounting and Financial Studies Journal

The Performance and Determinants of Firms That Reprice Options during a Bear Market

Article excerpt


In 2001 stock markets declined. The decline caused incentive stock option holdings to become deep out-of-the-money ("underwater") for numerous employees. In response, many firms repriced employee stock options by lowering the exercise prices of these options. This practice of repricing of employee stock options is controversial.

Proponents of repricing argue that options are often underwater because the stock market or industry declines, not because of firms' poor performance. The repricing of employee stock options can realign employee incentives with stockholders' interests by retaining valuable employees (Gillan, 2001).

Consistent with the proponents' argument, Acharya, John, and Sundaram (2000) develop a model showing that repricing can increase firm value. They argue that although option repricing may weaken the employees' initial incentives to maximize firm value due to their knowing that their options may be repriced, repricing does allow firms to restore incentives of employees whose options are underwater.

Saly (1994) argues that option repricing is optimal if poor stock price performance is industry- or market-driven. The results in her study suggest that leaving exercise prices of employees' options unchanged penalizes employees for factors outside their control and result in reduction of employees' work incentives. Therefore, repricing may restore employees' work incentives and subsequently enhance firm value.

Repricing proponents further argue that employees can effectively reprice options themselves by accepting new employment with firms that offer options as part of the compensation package. This creates undesired managerial and employee turnover that may decrease a firm's value. Furthermore, managers and employees who are most likely to leave the firm for opportunities elsewhere are usually those with valuable transferable attributes. Those that remain are more likely to engage in value decreasing activities. Restoring employee incentives through option repricing realigns the interest of employees with shareholders.

Repricing opponents ascribe declines in stock prices to firm-specific factors. They argue that repricings reward poor performance and serve to entrench poorly performing managers, employees, and board of directors, and transfer wealth away from shareholders (Chance, Kumar, and Todd (2000)).

To investigate the reasons why firms reprice their options I address the following research questions: (i) is the poor stock price performance prior to repricing due to market (industry) or firm-specific factors; and (ii) are option repricings associated with greater agency problems that benefit employees at the expense of shareholders or do repricings realign employees' incentives with shareholders' interest.

I find that the stock performance of repricing firms is highly associated with the industry in which they operate. Industry returns at the 4-digit SIC code explain over 56% of the repricing company's one-year return prior to the repricing. In other words, the poor performance of firms with underwater options was mainly due to industry-related factors. I also find that compared to a match-sample of non-repricing firms, repricing firms are less likely to have agency problems because repricing firms are larger, less likely to have the CEO as the chairman of the board, and CEO stock ownership is lower. Moreover, repricing firms have a greater need to realign incentives because they have options that are more out-of-the-money ("underwater"). In short, the results in my paper support the proponents' repricing arguments.

Finally, if repricing realigns employees' incentives with shareholders' interest, the long-term stock price performance of firms after the repricing should be better than similar firms whose options are also underwater but choose not to reprice them. To investigate if repricings realign incentives and improve performance I address the following research questions: (i) is the repricing filing date associated with positive abnormal returns; and (ii) does option repricing improve long-term stock price performance after the repricing. …

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