The `repricing’ of executive stock options

qThe authors would like to thank an anonymous referee, Bo Hiler, Kathy Ruxton, DavidYermack, N. Prabhala, Dave Denis, Diane Denis, Jennifer Carpenter, and participants in theseminars at Vienna, Utah, Baruch, Virginia Tech, New Mexico, Alabama, and Boston University forvaluable comments, as well as Senay Agca, Honghui Chen, Calin Valsan, and Wanying Lin forresearch assistance. This work was partially completed while Kumar was visiting the Yale School ofManagement, Yale University. Kumar acknowledges support from a Pamplin College of Businesssummer research grant.

*Corresponding author. Tel.: #1-540-231-5700; fax: #1-540-231-3155.

E-mail address: [email protected] (R. Kumar).

Journal of Financial Economics 57 (2000) 129}154

The &repricing' of executive stock optionsq

Don M. Chance!, Raman Kumar!,*, Rebecca B. Todd"

!Department of Finance, Pamplin College of Business, 1016 Pamplin Hall, Virginia Tech, Blacksburg,VA 24061, USA

"School of Management, Room 518-D, 595 Commonwealth Avenue, Boston University, Boston,MA 02215, USA

Received 1 March 1997; received in revised form 17 March 2000

Abstract

We examine a sample of "rms that reset the exercise prices on their executive options.These repricings follow a period of about one year of poor "rm-speci"c performance inwhich the average "rm loses one-fourth of its value. No other o!setting changes to optionterms or compensation are made, and many "rms reprice more than once. Withoutrepricing, a majority of the options would have been at-the-money within two years. We"nd that when faced with circumstances in which repricing might be chosen, "rms withgreater agency problems, smaller size, and insiderdominated boards are more likely toreprice. ( 2000 Elsevier Science S.A. All rights reserved.

JEL classixcation: G30; G32; J33

Keywords: Executive; Option; Incentives; Repricing

0304-405X/00/$ - see front matter ( 2000 Elsevier Science S.A. All rights reserved.PII: S 0 3 0 4 - 4 0 5 X ( 0 0 ) 0 0 0 5 3 - 2

1Exercise prices of executive stock options are automatically adjusted in the event of a merger,stock split, or stock dividend.

2Technically, &pricing' would refer to the process of determining a market value so the term&repricing' would not strictly be an accurate description of the process of resetting the exercise priceof an option, but we use it here for consistency with the trade vernacular.

. . . the Board of Directors has determined from time to time that it is desirableto reprice certain outstanding options to bring their exercise prices into linewith the then-current market price of the Company1s Common Stock. ¹ypi-cally, this has occurred when market conditions have, in the view of the Boardof Directors, arti,cially depressed the market price of the Common Stock fora protracted period, so that outstanding options are signi,cantly out-of-the-money for reasons not related to the Company1s performance.

HealthSouth Corporation proxyOctober 28, 1994

1. Introduction

Stock options are used widely in compensation and incentive plans of publiclytraded corporations. A typical option grant gives the executive the right to buya speci"ed number of shares at a "xed price, which is usually the stock price atthe time of the grant, up to an expiration day. Ten years is a common time toexpiration on the grant date. Many executive stock options are a combination ofAmerican- and European-style, permitting exercise at any time before expir-ation, with a waiting or vesting period of several years at the start.

Although executive stock options normally have terms that are speci"edexplicitly in proxy statements, some corporations reserve the right to alter theterms of the option contract. One such feature is the right to change the exerciseprice.1 Firms can change the exercise prices of old options and/or cancel oldoptions and reissue new options. The decision to change the exercise pricenormally is made by the compensation committee of the board of directors,though we shall refer to this as simply a board decision. The process of resettingthe exercise price is commonly referred to as &repricing', and for consistency, weshall adopt that terminology.2

Repricing is a somewhat infrequent event. The Wall Street Journal (June 11,1997, p. C11) reports on a survey of 250 high-tech "rms in which 21 reset exerciseprices for employees and executives and an additional 13 reset exercise prices forsome non-executive employees. Brenner, Sundaram, and Yermack (2000) "nd that1.3% of executives they examine had options repriced between 1992 and 1995.

Despite its infrequency, repricing is unquestionably receiving more attention.Many articles in the business, professional, and popular press have attacked the

130 D.M. Chance et al. / Journal of Financial Economics 57 (2000) 129}154

3See for example, USA Today (April 29, 1997, p. 12A), The Wall Street Journal (October 29, 1997,p. B1; April 9, 1998, p. R12; April 9, 1998, p. R4; October 30, 1998, p. B2; November 3, 1998, p. B20;April 8, 1999, p. R5; June 2, 1999, p. B1), The New York Times (July 15, 1998, p. D1), and Risk(October, 1998, p. 13).

4See, for example, The Wall Street Journal (February 17, 1998, p. B6; November 23, 1998, p. B7;March 31, 1999, p. B2).

practice.3 In some cases, an entire news item is devoted to a repricing by a singlecompany.4 In addition there is evidence that securities analysts are beginning topay attention to repricing issues (Credit Suisse First Boston, 1998).

In this paper, we examine a sample of "rms that reset the exercise prices ontheir executive stock options. We determine how the stock performs prior torepricing and whether that performance is "rm-speci"c or driven by market orindustry factors. We compare our sample "rms with a carefully selected matchedsample of "rms in the same industry that experience a similar price decline butchoose not to reprice.

We "nd that the poor performance prior to repricing is not driven by marketor industry factors, that repricings are not accompanied by o!setting factorseither in option terms or other cash compensation, and that many "rms repricemore than once. Investors do not react to the repricing, at least around theproxy "ling date. There is no abnormal performance subsequent to repricing.We also "nd that the majority of repriced options have substantial values priorto repricing. Using actual post-repricing performance, over half of the optionswould have been at-the-money without repricing within 19 months. The directcost to shareholders of repricing is small, though the gain to an individualexecutive can be substantial. Finally, using a matched sample, we "nd thatrepricing is more likely for smaller "rms with insider-dominated boards andgreater agency problems.

Our paper proceeds as follows. Section 2 provides background informationon the practice of repricing. Section 3 describes the data set and the tests. Section4 reports the results of our tests, which examine the performance of the stockaround the repricing event. Section 5 presents an analysis of why "rms reprice.Section 6 provides our conclusions.

2. Background information and previous research on option repricing

A "rm might reprice its executive stock options for a number of reasons. Oneis to remove the loss in option value that could have resulted simply from poormarket or industry performance. The argument, however, goes two ways.During periods of favorable market and industry performance, the stock pricecan rise even when "rm-speci"c performance is poor. An executive's optionscould, therefore, have considerable value not warranted by the executive's

D.M. Chance et al. / Journal of Financial Economics 57 (2000) 129}154 131

5Consider a "rm that grants options with an exercise price of $50. The stock then falls to $40 andthe "rm grants new options at $40, leaving the old options intact. If the stock rises to $48, the optionsissued at $50 have to be exercised "rst to qualify for favorable tax treatment. (The favorable taxtreatment applies only to tax-quali"ed executive stock option plans; the plans covered in this studyare tax-quali"ed.)

performance. It follows that "rms might consider repricing their options upwardafter strong positive market- or industry-driven performance. As we show later,there is plenty of evidence that exercise prices are lowered but rarely, if ever,raised.

When considering this point, however, one must ask whether a manager isresponsible for "rm-speci"c performance or whether there are elements ofrandomness or, as some people would characterize it, luck. Experts are likely todisagree on this point, and we do not believe it can be resolved in this study.Fortunately, our "ndings are not dependent on a resolution of this issue, thoughthe interpretations of certain results are.

Some "rms argue that repricing is necessary to retain managerial talent.Another reason for repricing could be that management is simply too entren-ched. Management might be able to convince the board of directors that it eitherdeserves another chance to straighten out the problems or that the "rm'sproblems are market- or industry-driven. Another reason is given by Gilsonand Vetsuypens (1993), who suggest that "rms in "nancial distress could bepressured by creditors to reprice to reduce the incentive to take on high-riskprojects.

Tax laws can partially explain why "rms reprice. To qualify for favorable taxtreatment, executive stock options must be exercised sequentially. Thus, ifoptions issued earlier are out-of-the-money while options issued later are in-the-money, the former might have to be repriced to qualify for favorable taxtreatment on exercise.5 Alternatively, "rms might consider canceling old optionsand issuing new options. Firms might prefer repricing over cancellation andreissuance, however, because repricing would be modifying an existing contractand would not necessarily require shareholder approval, while cancellation andreissuance could require shareholder approval and, therefore, bring more scru-tiny to the matter.

2.1. Academic research on repricing

Gilson and Vetsuypens (1993) study a sample of "rms that "le for bankruptcyor privately restructure their debt during the years 1981}1987. Twenty-"ve ofthe 77 sample "rms reprice. The median stock price at the time of the repricing isabout half the old exercise price, implying that the typical repricing is a 50%reduction in the exercise price. Firms that reprice signi"cantly underperform the


market for six years prior to the repricing date. Only 11 of the 25 "rms explainthe repricing to their shareholders and only one "rm mentions the performanceof the market as the reason.

Saly (1994) develops a theoretical model and conducts some empirical tests ofrepricing after the October 1987 crash. She argues that repricing is an appropri-ate response after market-induced declines in the stock price. She examinesrepricing indirectly by comparing the number of options outstanding before andafter the crash. She "nds that option grants increase signi"cantly following thecrash and more so for "rms whose stock falls by the largest percentage.Although these results do not examine the act of repricing directly, they areconsistent with the notion that many "rms reprice after market-induced declinesin the stock. The question of whether "rms reprice after signi"cant market-induced runups in the stock price is not addressed.

Acharya et al. (2000) develop a theoretical model that argues that under somecircumstances repricing can be optimal. The key determinant is the set ofmanagerial compensation contracts that the "rm can o!er. With a full range ofpossibilities, Acharya et al. (2000) show that repricing is never in the share-holders' interests. Under typical compensation contracts, however, they showthat repricing can be valuable. In one such scenario, managers are sensitive toeconomy-wide factors and managerial talent is relatively expensive to replace.Even without the Acharya}John}Sundaram model, it is not hard to createcircumstances in which repricing has positive e!ects. Any of the previously citedjusti"cations for repricing could conceivably bring positive bene"ts to share-holders. Whether they do or not is an empirical question.

Brenner et al. (2000) build a model for valuing repriceable options and generatenumerical estimates using hypothetical inputs. They conclude that repricing hasa small e!ect on the ex ante value of the option, but the potential ex post valuecan be large. Using a sample of actual repriced options, they "nd thatthe occurrence of repricing is more likely for smaller "rms and for "rms with poorperformance.

Corrado et al. (1998) provide an alternative to the Brenner}Yermack}Sundaram model by using a utility-maximizing approach that re#ects theilliquidity of these options and by incorporating non-option wealth and vestingrequirements. Their paper, however, does not provide any empirical results ofspeci"c repricings.

In terms of its focus, our paper is closest to that of Brenner, Sundaram, andYermack, but there are important di!erences. In their logit analysis of theincidence of repricing, their observations are at an executive-year level. Inaddition to including all executive-year observations for which there is a repric-ing, they use all executive-year observations in which the options are notrepriced, without making an attempt to determine whether the options are likelyto be out-of-the-money. Moreover, executive-year observations are unlikely tobe independent. In our logit analysis, the observations are at the "rm level, and


for our matched sample of non-repricing "rms, we use only those that performas poorly as the sample "rms and are, therefore, likely to have options thatare out-of-the-money. Later we suggest that our "rm-level approach ismore appropriate. We also suggest that including all non-repricings withoutrespect to performance in the logit analysis might not be appropriate toaddress the question of why some "rms reprice whereas others facing a similarsituation do not. We also provide a number of additional results, includingan event study around the proxy "ling date, an analysis on how the optionsmight have performed had they not been repriced, a more precise quanti"cationof the loss in shareholder wealth that precedes the repricing and over whichperiod this loss is incurred, and an examination of the incidence of multiplerepricings.

3. The data and methods

In 1993 the SEC began requiring "rms to provide information in proxystatements about any instances in which they reprice executive stock options. Ifa "rm reprices in 1992 or later, it must provide a ten-year history detailing anyprevious repricings for at least the CEO and the four highest-paid executives. Therule does not apply to employee stock options. We conduct a keyword searchusing the online National Automated Accounting Research System (NAARS)database created by Mead Data Central of Dayton, Ohio, and available onLexis/Nexis. It comprises about 4000 of the largest publicly traded companies andis maintained by the American Institute of Certi"ed Public Accountants. TheNAARS database contains ten years of annual reports, proxies, and 10Ks. Afterexamining more than 300 "rms that mention certain key words, we obtain 40companies and 74 repricing events with a ten-year repricing history.

We require that the "rm have return data available starting at least 300trading days prior to the event. This restriction provides su$cient data forestimation of parameters. After eliminating multiple repricings of any one "rmthat are clustered so closely as to interfere with estimation of the market modelparameters, we end up with a sample of 37 "rms and 53 events. Twenty-six "rmshave one repricing, seven have two repricings, three have three repricings,and one has four repricings. For a given "rm-event, there are options heldby di!erent o$cers and di!erent exercise prices due to their having been grantedat di!erent times in the past. The repricings occur during the period of1985}1994.

3.1. Descriptive statistics

Table 1 contains descriptive statistics. One-hundred thirty distinct optionissues are associated with the 53 repricings. Panels A and B provide information


Table 1Descriptive statistics from a sample of "rms that reset the exercise prices of (&reprice') their executivestock options. A given event includes all issues repriced on a given date. The number of o$cers is thetotal number of top executives who have options repriced. The number of issues repriced is the totalnumber of distinct options, as measured by the original exercise price and maturity, in which exerciseprices are reset. The number of new options issued can be negative, because in some cases optionsare canceled and new options are issued with the former exceeding the latter. The sample is obtainedby identifying "rms that provide ten-year repricing tables in proxy statements available on theNAARS (National Automated Accounting Research System) database of Lexis/Nexis. The sampleconsists of 37 "rms, 53 repricing "rm-events, and 130 distinct option issues.

Variable Mean Standarddeviation

90thpercentile

10thpercentile

Median

A. Repricing events [N"53]Number of o$cers 3.15 2.11 6 1 3Number of issues repriced 2.21 1.89 4 1 2Number of old options repriced 210,232 358,248 487,632 13,600 77,200Number of new options issued !1,185 25,340 0 !2,320 0

B. Issues repriced [N"130]Percentage change in exerciseprice

!41.33 19.40 !18.29 !66.65 !38.61

Change in months to maturity 9.21 27.02 45 0 0Remaining months to maturity 66.62 32.91 113 25 60(Number of options)](changein exercise price)

331,308 536,644 903,500 9,759 100,098

(New exercise price)/(closingprice on day of repricing)

1.0002 0.20 1.09 0.875 1

6This company raised its exercise price by only a small amount, from $5.20 to $6.00 on one issueand $5.50 to $6.00 on another.

on the events and the issues, respectively. On average, slightly more than threeo$cers have exercise prices reset at each event. An average of slightly more thantwo distinct option issues are reset at each event. The average number of optionsrepriced is over 200,000. The average reduction in the exercise price is about41% with a standard deviation of almost 20%. The reductions range from 7%to 89%. No "rms in the "nal sample increase their exercise prices, although one"rm in the original sample increases its exercise price.6 The average change inthe option maturity is just nine months, although there are actually only 12issues by "ve "rms in which the maturities are extended; their average change inmaturity is 76.5 months.

As an initial estimate of the upper bound on the value of management's gain,we multiply the change in the exercise price by the number of options involved


7 It is easy to show that this estimate is an upper bound. From the Black-Scholes model, we haveLc/LX"!e~rTN(d

2), and since we are referring to the exercise price change as a reduction, we

focus on the absolute value of the change. Prior to expiration, with a positive risk-free rate, and anin"nitesimal reduction in the exercise price, e~rTN(d

2)(1, so the call price will change by less than

the reduction in the exercise price. The actual reduction in the exercise price will be non-in"nitesimalbut can be viewed as the sum of an in"nite number of in"nitesimal changes in X. The change in thecall price can never catch up with the change in the exercise price unless at least one change in thecall price relative to the in"nitesimal change in the exercise price exceeds unity. A typical buterroneous belief in practice is that the exercise price change is the gain in value. Clearly this is but anestimate and potentially a very bad one. We provide a more precise estimate of the value gain later inthe paper.

and obtain an average of $331,308 with a median of $100,098.7 The last row isthe ratio of the new exercise price to the closing stock price on the repricing day.In most cases the new exercise price is extremely close to the closing stock priceon the repricing day as reported by the Center for Research in Security Prices(CRSP), with 80% being within one-eighth on either side of the closing stockprice. These sample statistics are very similar to the statistics from the fullsample of 40 "rms and 74 events.

The Wall Street Journal (November 3, 1998, p. B20) reports that high-tech"rms are frequent repricers. Therefore, we might expect our sample to bedominated by technology-related "rms. An examination of the SIC two-digitindustry code reveals, however, that no single industry dominates, and "rmswith nontechnical products or services make up almost one-third of the sample.

An examination of the reasons given for the repricings reveals some interest-ing justi"cations. Only about one-third of the "rms even mention the repricing,though they provide the necessary tabular information. Evidently an explicitdiscussion about repricing is a rare event. As noted earlier, only 44% of the "rmsin the Gilson and Vetsuypens (1993) study of companies in bankruptcy orreorganization give a reason for the repricing.

The primary reason, cited in some form by 11 of 12 "rms, is that the existingexercise prices do not provide a su$cient incentive. Four "rms note that marketand/or industry factors, which are outside of management's control, had driventhe stock price down. Three "rms simply state that the company's recentperformance had &adversely a!ected the stock'. One "rm justi"es its actions bynoting that a competitor had repriced, and another indicates that repricingwould have only a small cost to the "rm.

The aforementioned Gilson-Vetsuypens study notes that 25 of their 77 "rmsthat had "led for bankruptcy or reorganization repriced. Based on their evid-ence, one might conclude that repricing is often associated with bankruptcy.Our sample, however, is quite di!erent. As we show in the next table, the averageratio of the book value of debt to total assets in the year of the event is only 25%,and almost one-"fth of the sample has 0}5% debt. The book value of leveragefor these "rms does not change materially in the "ve years preceding the


repricing. As a check on whether our sample "rms are (or eventually go) intobankruptcy or reorganization, we conduct a keyword search on the Dow JonesNews Retrieval over the period one year prior to and two years after each event.Even though there are several stories about poor performance and one storyabout the possibility of a future bankruptcy "ling, there are no stories of anactual bankruptcy "ling. As a further check, we examine the 1998 CRSP "les forup to four years after the last repricing date for each "rm and "nd that 29 out ofthe 37 "rms are still trading, seven were involved in a merger, and one wasinvolved in an exchange o!er. We can therefore conclude that bankruptcy orreorganization is not a concurrent or imminent threat for the vast majority ofour "rms and that all of our "rms survive at least 4 years after the last repricing.

3.2. Preliminary observations from accounting data

We "rst examine the performance of these "rms in terms of standard ac-counting ratios. We collect the accounting data from COMPUSTAT for theevent year and the 1}5 years prior to the event. Table 2 contains annual averagesand medians (in parentheses) of various accounting measures of performance,leverage, and risk. The average measures of performance indicate a generaldecline in pro"tability over the "ve-year period prior to the event. Note that theaverage return on equity is negative for each of the six years, culminating ina value of !170% in the event year. Only the pre-tax return on assets showssome improvement over the "ve-year period, but it is only marginally positive inthe event year. The median values, however, show much more stability, whichsuggests that only a small number of our sample "rms have deterioratingperformance prior to the event and that the majority of the "rms do notexperience problems until the event year. As we mention in the previous section,the debt to total assets ratio is relatively stable over the six-year period.

The accounting descriptive statistics thus validate the pro"le of our sample as"rms with poor performance concentrated in the year of repricing but not inimmediate danger of bankruptcy. In the next section we examine how the stocksof these "rms perform prior to and after the repricing.

4. Performance of the stock around the repricing event

4.1. Announcement ewects

In recent years, repricing events are reported occasionally in The Wall StreetJournal, but such stories primarily re#ect an increased journalistic interest in thepractice and not an o$cial release of information. Indeed, we have reason tobelieve that most "rms would rather not make such an announcement. Repric-ing is, however, a partially observable event. Sometime after repricing, the "rm


8We are unable to obtain data for every event, because repricings prior to 1992 were not requiredto be reported in proxies.

Table 2Selected measures of performance, leverage, and risk from annual accounting data of the 53"rm-events in the sample of "rms who reset the exercise prices of (&reprice') their executive stockoptions. Year zero is the "scal year in which the "rm reprices. Years !1 to !5 are the preceding"ve years. The number in each cell is the average with the median in parentheses. Data are obtainedfrom the COMPUSTAT "les.

Year!5 Year!4 Year!3 Year!2 Year!1 Year 0

Gross pro"t margin (%) 34.71 20.58 32.95 6.23 5.50 7.81(34.06) (34.47) (33.91) (34.96) (34.06) (31.62)

Operating margin beforedepreciation (%)

10.96 !15.51 1.07 !18.62 !17.88 !15.80(11.94) (12.11) (11.28) (12.44) (10.25) (8.00)

Operating margin afterdepreciation (%)

3.77 !23.63 !5.48 !25.73 !24.17 !22.19(7.51) (7.59) (6.69) (8.52) (6.20) (3.43)

Pre-tax pro"t margin (%) 0.96 !28.90 !7.50 !26.49 !43.08 !24.02(5.18) (5.23) (3.02) (6.51) (5.26) (0.05)

Net pro"t margin (%) !1.97 !31.27 !9.64 !29.00 !45.54 !25.42(3.08) (3.81) (1.98) (4.16) (3.23) (0.03)

Return on sales (%) 5.54 !24.99 !4.50 !24.27 !42.52 !21.44(7.96) (9.18) (5.62) (8.57) (7.19) (1.62)

Pre-tax return on assets (%) !30.44 3.82 4.42 5.51 5.20 0.82(10.67) (9.88) (8.78) (10.01) (9.44) (3.69)

Return on equity (%) !18.46 !11.13 !113.34 !33.54 !4.65 !170.84(9.11) (10.81) (6.19) (7.80) (9.97) (0.27)

Book to market (%) 53.70 63.03 62.50 56.16 56.49 74.67(42.62) (48.22) (50.06) (44.02) (45.31) (61.49)

Debt to total assets (%) 31.84 26.64 26.63 23.92 24.16 25.79(29.81) (25.11) (18.30) (18.16) (19.70) (25.18)

"les a proxy with the SEC that contains the aforementioned repricing table.Typically this information is simply included with the "rm's next annual proxy.This raises the question of whether the market reacts in any way to the "lingand, therefore, to the public announcement of a repricing. We are able to identifythe proxy "ling dates for 36 of the 53 "rm-events and conduct a standardevent-study analysis, using both value- and equal-weighted CRSP NYSE-AMEX-NASDAQ indexes.8 The results are shown in Table 3. For a window of


Table 3Percentage abnormal returns and corresponding t-statistics for a subsample of 36 repricing eventsfor which SEC proxy "ling dates are available. Day 0 is the "ling date. The market model parametersare estimated over a 250-day period from day !500 to day !251. The CRSP NYSE/AMEX/NASDAQ index is used for the market factor.

Relative day Value-weighted index Equal-weighted index

Percentageabnormal return

t-statistic Percentageabnormal return

t-statistic

!5 0.45 0.62 0.44 0.59!4 0.21 0.29 0.18 0.25!3 !0.18 !0.24 !0.12 !0.16!2 0.61 0.83 0.69 0.94!1 0.98 1.35 1.07 1.45

0 !0.88 !1.21 !0.79 !1.071 !0.33 !0.45 !0.33 !0.452 !0.75 !1.03 !0.72 !0.973 !0.06 !0.08 !0.02 !0.034 0.97 1.33 1.03 1.395 !0.11 !0.15 !0.00 !0.01

$5 days around the proxy "ling date, we "nd no signi"cant reaction. This"nding is not surprising. Proxy "lings, while technically public information, arenot monitored carefully by the majority of investors, and the shareholders mightnot receive the proxy until a signi"cant time period has elapsed. Alternatively,the market does not perceive these events as providing signi"cant new informa-tion about the future performance of the "rm. The results are not consistent witha signi"cant wealth transfer from shareholders to management.

4.2. Market performance prior to and after the repricing

Now we wish to determine how the repricing "rms perform prior to and afterthe actual repricing. Standard event-study methods are used to remove the e!ectof the market so that the remaining variation is attributed to "rm-speci"cperformance. Again, we use both value- and equal-weighted CRSP NYSE-AMEX-NASDAQ indexes as the market benchmark. The results are a!ectedonly slightly by the index portfolio-weighting scheme.

Since some "rms mention the possibility of poor industry performance as thesource of poor company performance, we also incorporate an industry factorinto the event-study procedure. Beginning with the original work of King (1966),industry e!ects have been known to be a source of variation in stock returns.For a given "rm-event, we construct an index of all "rms with data available inthe same two-digit SIC code as the sample "rm. These industry indexesare constructed as both value-weighted and equal-weighted combinations


Table 4Cumulative average residuals (CARs) starting on day !250 of stocks that reset the exercise prices of(&reprice') their executive stock options on day zero and average compound returns for selected daysfor the stocks as well as market and industry indexes. The sample consists of 37 "rms and 53"rm-events. Regressions are estimated over days !500 to !251. The CRSP index is used for themarket factor. The industry factor is an index constructed using all "rms having the same two-digitSIC code and available return data. When the CRSP value-weighted (equal-weighted) index is used,the industry index is also value-weighted (equal-weighted). The variables R4

~250,0, R.

~250,0, and

Ri~250,0

are the average compound returns starting on day !250 on the stock, the market index,and the industry index, respectively, ending on day zero, and R4

~250,250, R.

~250,250, and

R*~250,250

are the average compound returns starting on day !250 on the stock, the market index,and the industry index, respectively, ending on day 250. Student's t-statistic is provided in paren-theses for the cumulative average residuals.

Value-weighted indexes Equal-weighted indexes

Market factoronly

Market andindustryfactors

Market factoronly

Market andindustryfactors

R4~250,0

!24.49 !24.49 !24.49 !24.49

R4~250,250

!10.02 !10.02 !10.02 !10.02

CAR~250,0

!48.49 !48.39 !43.61 !44.98(!4.47) (!4.47) (!4.00) (!4.17)

CAR~250,250

!46.81 !48.42 !40.80 !51.10(!3.06) (!3.17) (!2.65) (!3.35)

R.~250,0

8.49 8.49 10.72 10.72

R.~250,250

23.43 23.43 26.00 26.00

R*~250,0

9.06 8.51

R*~250,250

22.93 21.71

corresponding to whether we use the value-weighted or equal-weighted marketindex. We conduct separate tests using the market factor only and then both themarket and industry factors.

The regression coe$cients are estimated over day !500 to day !251relative to the event. The resulting estimates are used to remove the market andindustry factors for days !250 to #250 relative to the event. Cumulativeaverage residuals and average compounded returns are examined. Table 4presents summary results for tests using both the value-weighted and equal-weighted indexes. Fig. 1 illustrates the results for the value-weighted indexwhen both the market and industry factors are removed. Similar "gures areobtained when removing only the market factor and when using equal-weightedindexes.


Fig. 1. Cumulative average residuals and average compounded returns on stocks on which the "rmsreprice their executive stock options on day zero, average compounded returns on the CRSPvalue-weighted stock index, and average compounded returns on a value-weighted industry indexconsisting of "rms with the same two-digit SIC industry code. The risk adjustment is made byestimating a market model regression over days !500 to !251. Coe$cients from that regressionare then applied to the returns over days !250 to #250. The sample is selected from amonga larger sample of "rms identi"ed through a key work search on the NAARS (National AutomatedAccounting Research System) on Lexis Nexis. The sample consists of 37 "rms and 53 events.

The results show that "rm-speci"c performance is signi"cantly negativeduring the period preceding the repricing. The cumulative average residualusing the value-weighted market and industry indexes for the "rms is !48.39%on the repricing date, which is highly signi"cant with a t-statistic of !4.47. AsFig. 1 illustrates, "rm-speci"c performance falls steadily prior to the repricing.After the repricing, the CARs stabilize and 250 trading days later have a value of!48.42%. The average compounded stock return, starting from day !250, is!24.49% by the repricing date. The corresponding return is 8.49% for themarket and 9.06% for the industry. As Table 4 shows, these results are robust towhether the value-weighted or equal-weighted indexes are used. Comparison ofthe compounded returns for our sample of events with those of the marketreveals that our sample "rms on average start to underperform about 175trading days before the repricing. An examination of the mean compoundedreturns four years prior to the repricing "nds no evidence that on average thisunderperformance starts any earlier.

To verify the robustness of the results, we conduct some additional tests withslightly modi"ed samples. Elimination of multiple repricings of a given "rm orremoval of "rms whose stock price is less than $5 on the repricing day results inessentially the same "ndings. We also examine the sensitivity of our results tothe construction of the industry indexes by using a three-digit SIC code matchinstead of a two-digit match. Again, the results are essentially the same.


4.3. Nonparametric analysis

Given the possibility that these results could be biased by implicit assump-tions about the distributions of the test statistics, we conduct the nonparametricsign-rank test. This procedure requires an explanation, however, because theprocess of accumulating residuals for the parametric t-tests is not appropriatefor the nonparametric tests.

Recall that the average residual for day t is created by "rst cross-sectionallyaveraging the residuals for each of the 53 events. Starting at day !250 theaverage residual is then accumulated by adding each day's average residual tothe sum of the average residuals for the previous days, thus averaging cross-sectionally "rst and then accumulating over time. For the nonparametric testswe obtain the time series from day !250 to #250 of cumulative residuals foreach of the 53 "rms. Since none of our previous tests appear to be sensitive towhether the value-weighted or equal-weighted indexes are used or whether themarket factor only or both the market and industry factors are included, we useonly the value-weighted version of both indexes. The median cumulative resid-ual on day zero is !41.69% and is signi"cant using the sign-rank test at betterthan the 1% level.

4.4. Cross-sectional analysis

We also undertake a test of the relation between the magnitude of thereduction in the exercise price and the performance of the "rm, market, andindustry. Speci"cally, we estimate the following regression:

%*Xj"b

0#b

1R.

~250,0,j#b

2R*

~250,0,j#b

3R4

~250,0,j#e

j, (1)

where %*Xjis the weighted-average percentage change in the exercise price of

the options repriced at event j, R.~250,0,j

is the compounded return on themarket index over day !250 to day zero, R*

~250,0,jis the compounded return

on the industry index over the same period, and R4~250,0,j

is the compoundedreturn on the stock for event j over the same period. Because for some eventsthere are multiple options with di!erent exercise prices that are reset, theweighted percentage change in the exercise price is used. The weighted percent-age change in the exercise price is calculated as a weighted average of thepercentage change in the exercise price of each distinct repriced option. Theweights are based on the number of options repriced.

The results support our hypotheses. The percentage change in the exerciseprice is positively related to the compound return on the stock, a resultconsistent with the fact that the greater is the decline in stock price, the greater isthe reduction in exercise price. The percentage change in the exercise price is notrelated to the compound industry return. The weighted percentage change in theexercise price is also not related to the equal-weighted market return but is


9Diagnostic tests reveal that the variance in#ation factors are small (maximum of 2.63) relative tothe customary critical level (10), which suggests that the e!ect of multicollinearity is trivial. We alsoestimate the regression using an orthogonalizing procedure that removes the market factor from theindustry and stock return. We "nd similar results, though the industry factor is positive andsigni"cant. We "nd, however, that three outliers greatly a!ect the results, and when those areremoved, the results are consistent with the original regressions. (Full details of the test results areavailable from the authors.)

10The propensity of repeat repricings in our sample could be biased upwards because of the SECrequirement imposed in 1993 of providing a 10-year repricing history. As a result, all "rms thatreprice before 1992 and do not repeat in the post-1992 period are not in our sample. In an attempt toadjust for this bias, we eliminate all repricings prior to 1992. For any "rm that reprices in 1992 orlater, we require two repricings before counting it as a repeat repricing, even though the "rm couldhave repriced prior to 1992. This restriction leaves a sample of 40 "rms, of which ten reprice morethan once. Though this is considerably less than in the full sample, it is still one-fourth of our sampleand many of those "rms could yet reprice again.

negatively related to the value-weighted market return.9 Note that if repricingwere being driven by market or industry factors, the weighted percentage changein the exercise price would have been positively related to the market or industryfactors.

4.5. Recidivism

We examine the incidence of repeat repricings by using our full data set of 40"rms and 74 events. We "nd that 22 "rms reprice once, ten "rms reprice twice,four "rms reprice three times, one "rm reprices four times, two "rms reprice"ve times, and one reprices six times. Thus, 18 "rms or 45% of our samplereprice more than once. Of the "rms that reprice more than once, the averagetime between repricings is 705 calendar days, or just barely under two years.The maximum is 2382 days, and the minimum is only 44 days. Three "rmsreprice within 90 days, three reprice from 91}180 days later, six reprice from181}270 days later, three reprice from 271}360 days later, and 19 reprice morethan 360 days later.10 This evidence appears to be more consistent with en-trenchment than with restoration of managerial incentives.

4.6. Valuation ewects on the repricing day

In this section we provide option pricing model estimates of the valuationimpact on the repricing day of the options in our sample. We use the Black-Scholes model to compute the value of the options before and afterthe change in exercise price and calculate the di!erence. We are aware of thelimitations and biases inherent in the Black-Scholes model, especially given theilliquidity of executive stock options. We believe that these biases, however,would likely cancel in computing the change in the value of the options.


The exercise price and time to expiration are obtained from the proxystatement. An estimate of the risk-free rate is obtained by determining theconstant-maturity Treasury rate for bonds with a maturity as close as possibleto the option expiration. This yield is then converted to a continuously com-pounded rate. We use the average of the annualized standard deviation for eachof the two years prior to the event as the volatility estimate. Only nine of the 37"rms pay dividends, with many of those being extremely small and a!ecting thevaluations of only 13 of the 53 events. Rather than make potentially erroneousassumptions about future dividends, we elect to drop those events from thisexercise. We determine the dollar gain for each of the events by summing thechanges in the values of each option issue that a "rm reprices. We also determinethe overall percentage gain for all of the options of a "rm-event.

The mean dollar value increase per "rm-event is about $141,000, with a me-dian of about $65,000. The mean percentage gain is extremely skewed so themedian of 16.5% is more useful than the mean. The largest dollar gain is slightlymore than $800,000. These results seem to suggest that the direct economicimpact to the shareholders is extremely small. This result is consistent with thedaily event study results reported in Section 4.1 in which we "nd no signi"cante!ect on the proxy "ling date.

To determine whether these amounts are signi"cant for the executives, it isnecessary to know how many executives share a gain and how large the gain isrelative to the executive's wealth. Dividing the total gain per "rm-event by thenumber of executives sharing the gain gives an average gain per executive ofabout $46,000 and a median of about $25,000. In six of the "rm-events theaverage gain exceeds $100,000 with two exceeding $200,000; however, 11 of the"rm-events are a gain of less than $10,000 per executive.

We obtain cash compensation information for a subsample of approximately halfof the "rms. The average total cash compensation for the highest-paid executive isabout $480,000 with a median of a little over $300,000. The estimated gain in valuedue to the repricing is at most around 10% of the annual cash compensation.

4.7. How high is the hurdle without repricing?

Some "rms argue that if the options are so deep out-of-the-money, theye!ectively provide no incentive for managers. Therefore, an interesting questionis what kind of performance is necessary for the options to become at-the-moneyunder their original exercise prices. We examine the 130 unique option issues inthe sample to determine the compound annual rate of return necessary for thoseoptions to become at-the-money. The median rate is only 11.3%. Fifty-four outof 130 require a return of less than 10%. Seventy-seven out of 130 requirea return of less than 15%. These "gures suggest that the options are not so deepout-of-the-money as to make the hurdle insurmountable, at least for a largepercentage of the "rms. It is particularly interesting to note that the required


11 The Wall Street Journal (April 8, 1999, p. R5) refers to this process as value-for-value repricingand suggests that more "rms are looking to do so, but its "ndings are essentially based onobservations on only two "rms, Sunbeam and Cendant.

annual rate of return corresponds roughly to the compound annual return onthe industry index in the year following the repricing.

The impression one receives from reading the popular press and hearingthe comments of board members and management is that before repricing theseoptions are practically worthless, but this is far from the truth. Eighty-threepercent of the options are worth more than $1 and almost 40% are worth morethan $4. The average value is $3.98. By comparison, in 1996 the average value ofan equity option traded on the CBOE, though of much shorter maturity, was$3.76.

To determine how well the options would have done had they not beenrepriced, we track the "rm's return performance following the repricing datethrough the end of 1996. This analysis assumes that the "rm's performance is nota!ected by the repricing. For 82 issues out of 130 options that are at-the-moneyby the end of 1996, the average number of trading days required to reach theexercise price is 232, but the median is only 138. Going back to the full sample of130 options, had they not been repriced, one-third of them would have been at-the-money within eight months, and half of them would have been at-the-moneywithin 19 months. Over half of the repriced options would have been at-the-money with the old exercise price in an average time span of two years just byearning the industry return. Note that in Table 1 the average repriced option has"ve and one-half years to go before expiration, suggesting that there would havebeen plenty of time for the options to become in-the-money without repricing.

4.8. Alternatives to repricing

Even though we show that the incentives are still present for most of theseoptions, a "rm concerned about restoring incentives by bringing the options backto at-the-money has other alternatives available to it. It can reprice and shortenthe maturity, but we "nd no "rms that do this. It can also cancel old options andissue new at-the-money options such that the value of the old options equals orexceeds the value of the new options, leaving the repricing value-neutral.11

Our sample includes six events in which a "rm cancels old options. In one ofthose, it extends the maturity of the remaining old options. We estimate theBlack-Scholes value under the old exercise price of the options canceled andthose not canceled, de"ning this total to be the value of the options before therepricing. We then estimate the Black-Scholes value after the repricing, properlyaccounting for any extension of the maturity. The di!erence is the net gain orloss in option value from repricing. We are unable to do this calculation for oneof the six "rms due to dividend payments that make estimation of long-term


12Some "rms are even quite clever in creating value for management. One "rm reduced theexercise price on various options from an average of around 11 to 8 1/4 even though the stock wasabout 2 3/4, apparently leaving the options still signi"cantly out-of-the-money. It simultaneouslyannounced a 3-for-1 reverse split, moving the options back to precisely at-the-money.

13 Interestingly, in one case we "nd reference to the repricing as compensation for a reduction insalary.

option values problematic. For the remaining "ve "rms, there are a few optionsof one "rm in which an individual option issue ends up with less value after therepricing than before. After adding up the values for all options involved fora "rm, we "nd only one "rm that has an overall net reduction in option valuedue to the repricing. Thus, it is apparent that in the overwhelming majority ofthe "rm-events, the option holders receive a net gain from the repricing.12

It is possible that when a "rm reprices, thereby granting management some-thing of value, it simultaneously takes something away in the form of a reduc-tion in other compensation. It is impossible to determine what management'scompensation would have been in the absence of the repricing. To address thequestion of whether a board makes o!setting reductions in other compensation,we examine the proxies of approximately half of the "rm-events in our sample,collecting information on salaries and other compensation for the event yearand years surrounding it as well as scanning the text for obvious references toreductions in salary or other compensation. We "nd no references to a reductionin compensation to o!set the repricing.13 In a few cases, compensation in theevent year is smaller than in the previous year, but there are about as many casesin which event-year compensation is larger than compensation in the previousyear. Overall, we "nd no evidence in half of the sample that there are anyobvious attempts to o!set management's gain with any reduction in value fromsome other source. Admittedly we cannot determine for certain that in exchangefor repricing the options there are no penalties exacted by the board, such asgranting a smaller salary increase or the awarding of fewer shares of stock ora reduction in future option grants. We "nd no evidence of it, however, and aredoubtful that such penalties are imposed.

5. Why 5rms reprice

An important question that remains to be answered is why some "rms chooseto reprice while others facing a similar price decline do not. One way to addressthis question would be to collect a sample of all "rms that do not reprice,irrespective of their stock price performance, and compare them with "rms thatdo reprice, using various quantitative measures of characteristics and perfor-mance. This is the approach taken in Brenner et al. (2000), who use the "rm'sstock performance over the last three years as an independent variable in their


14We also explore the possibility of matching using the repricing "rm's percentage price declineover the one-year period prior to repricing. This creates a problem, however, in that the declines fordi!erent "rms occur over periods of di!erent length. Given that our objective is to "nd matched"rms that have a similar incentive to reprice, we believe that a more logical and simpler way is tomatch using the percentage decline in exercise price.

15Since "rms have been required to report repricing only since 1992, we cannot choose matched"rms from the period prior to 1992, because we cannot determine if they repriced.

logit regression but do not use past performance as a matching criterion forselecting the sample of non-repricing "rms. Such an approach will includea large number of "rms that have improvements in shareholder wealth andwould not even consider repricing. A logit analysis that includes repricing "rms,which we know have poor performance, with all non-repricing "rms irrespectiveof their performance will tend to "nd those factors signi"cant that a!ect thelikelihood of experiencing poor performance, such as the volatility of stockreturns. To determine which factors a!ect the likelihood of repricing, we shouldinclude only those non-repricing "rms that experience poor performance and,therefore, are likely to have options that are out-of-the-money. Such "rms couldlower the exercise prices of their executive stock options but choose not to. It isthe di!erence between only such non-repricing "rms and the repricing "rms thatwill tell us why some "rms reprice and others, facing a similar repricing decision,choose not to. In other words, for each sample repricing "rm, we need a matched"rm that experiences a similar decline in its stock price.

Another important question is whether such an analysis should be done ata "rm level or at an executive-year level as in Brenner, Sundaram, and Yermack.Using the executive-year approach, a "rm that reprices its options for three of itstop "ve executives in one year over the "ve-year period will be included threetimes as a repricing observation and for the remaining 22 times for the "veexecutives over the "ve-year period as a non-repricing observation. The repric-ing decision is likely to depend on "rm characteristics such as size and agencyproblems, so including the same "rm as both repricing and non-repricingobservations (in some cases for the same year) will bias the results away from"nding those characteristics signi"cant. Moreover, given that these character-istics are not likely to change signi"cantly from year to year, we believe that any"rm that reprices only once over a period of several years should not be includedas a non-repricing observation for the surrounding years.

We construct our matched sample following a carefully designed procedure.First, we match each sample repricing "rm-event with a set of candidate "rmsselected from the same four-digit SIC industry code. To meet the requirement thatthe matched "rm has a similar incentive to reprice, it must experience a stock pricedecline similar to the percentage reduction in exercise price for the sample "rm.14

For each candidate "rm, we calculate each possible 250-day return over the1992}1997 period.15 For each sample "rm and event, we then select a candidate


"rm and its associated 250-day period in which the candidate "rm return iswithin $500 basis points of the sample "rm. In other words, if the sample "rmhas a reduction in exercise price of 40%, then we search for matching candidate"rms with losses between 35% and 45% over a 250-day period. The "rm withthe closest match on its return is selected and then examined for two pieces ofinformation: use of executive stock options and no repricing by the time of therelease of the next proxy. In addition, we require several other pieces ofinformation, including proxies, certain accounting items, and market price data.If the information is available, the candidate "rm uses executive stock optionsand does not reprice, then that "rm is chosen as a match. If not, we move to thenext candidate "rm, whose return is next closest. If no candidate "rms can beidenti"ed as a match, we expand the de"nition of a potential match to a three-digit SIC code. If we are unable to match using a three-digit industry code, we goto a two-digit industry code. We obtained satisfactory matches for all but onerepricing "rm-event, which we then discard from this stage of the analysis,leaving us with 52 "rm-events and the corresponding matched "rms. Of the 52control "rms, 21 are matched on the four-digit SIC code, 17 on three digits, andthe remaining 14 are matched on two digits.

To identify the characteristics of "rms that reprice and to distinguish them fromsimilarly performing "rms that do not reprice, we use variables that proxy for size,growth opportunities, dividend policy, and volatility. We hypothesize that "rmsthat reprice have a greater degree of agency problems than "rms that do notreprice. Thus, our logit analysis includes several measures of agency problems,such as inside ownership, insider domination of the board, and free cash #ow.

The variables are shown and described below. Day 0 is the repricing date forsample "rms and the end of the 250-day period of similar performance for thematched "rms.SIZE "market value of equity, measured as of day !250.PAYOUT"dividend payout ratio, measured as the annual dividend divided by

the price at the end of the last "scal year before day 0.FCF/TA "free cash #ow divided by total assets, measured as operating

income before depreciation net of total income taxes, gross inter-est expense, preferred dividends, and common dividends, dividedby the book value of total assets; all items are for the last "scalyear before day 0.

MKT/BK"the sum of the market value of equity and the book value of debtdivided by the book value of total assets; all items are for the last"scal year before day 0.

VOL "volatility of the stock, measured as the standard deviation of thedaily return from day !500 to day !251.

INSOWN"percentage inside ownership, measured as the number of sharesheld by insiders as of the last January 1 or July 1 before day0 divided by the number of shares outstanding on the same


16We categorize directors as insiders, outsiders, or grey, using the criteria of Brickley et al. (1994).Grey directors include bankers, lawyers, investment bankers, and consultants, all of whom areconsidered to have potential business ties to the "rm. Insiders are o$cers, founders, and close familymembers of o$cers and founders. We run separate tests with grey directors included as insiders andwith grey directors included as outsiders. The results of those tests lead to the same conclusions, sowe report only the tests with grey directors included as outsiders.

day; insider shares are obtained from CDA/Investnet Insider Hold-ings (formerly known as Spectrum 6) and shares outstanding areobtained from CRSP.

INSDIR "percentage inside directors, measured as the number of directorswho are o$cers, close family members, or retired o$cers dividedby the total number of directors.16

5.1. Univariate tests

We "rst conduct a univariate comparison of our sample and the matched "rms.The results are reported in Table 5. The most obvious "nding is that the repricing"rms are signi"cantly smaller than the matched "rms. Size could be a proxy forthe extent to which information about a "rm is known, suggesting that "rmsthat are less known "nd it easier to reprice and have fewer negative reper-cussions. Size, however, could well re#ect data availability, making it more likelythat large "rms would be selected for the matched sample. Thus, on a univariatebasis size may not be very informative. In a multivariate test, however, we mustinclude size, since it has the potential to be a relevant covariant.

The percentage of inside directors is signi"cantly higher for the repricing"rms. This result suggests that the boards of repricing "rms are more insiderdominated. Note, however, that the percentage of inside ownership is notsigni"cantly di!erent. Repricing "rms have signi"cantly higher volatility. Usingthe nonparametric test, MKT/BK is signi"cantly lower for repricing "rms.These measures, however, could also re#ect size; thus, we must be careful in ourinterpretation of these univariate results.

5.2. Logit analysis

We next conduct a multivariate test, a logit regression in which the dependentvariable is one if the "rm reprices and zero if not. Because size, volatility, andpayout rate tend to be highly skewed, we use a log transformation on thesevariables.

The results for various combinations of the input variables are presented inTable 6. For all combinations, size is highly signi"cant, with smaller "rms morelikely to reprice. As in the univariate tests, the percentage of inside ownership


Table 5Comparison of descriptive statistics for the sample of 52 "rms that reprice their executive stockoptions and a control sample of 52 "rms that do not reprice and are matched on SIC code anda percentage decline similar to the percentage reduction in the exercise price of the sample "rms'executive stock options. All measures are taken relative to an event day, which is the repricing dayfor the sample "rms and the end of the matched-return 250-day holding period for the matched"rms. SIZE is the market value of equity as of day !250. PAYOUT is the annual dividend dividedby the price at the end of the last "scal year before day 0. FCF/TA is operating income beforedepreciation net of total income taxes, gross interest expense, preferred dividends, and commondividends divided by the book value of total assets. All items are for the last "scal year before day 0.MKT/BK is estimated as the sum of the market value of equity and book value of debt divided bythe book value of total assets for the last "scal year before day 0. VOL is the standard deviation ofreturn based on daily returns over the period !500 to !251. INSOWN is number of shares heldby insiders as of the last January 1 or July 1 before day 0 divided by the number of sharesoutstanding on the same day with insider shares obtained from CDA/Investnet Insider Holdings,formerly known as Spectrum 6, and shares outstanding obtained from CRSP. INSDIR is the numberof inside directors divided by total number of directors, where an inside director is an o$cer, a veryclosely related family member, or a retired o$cer. The di!erence between means is examined usingthe parametric matched pairs t-test. The di!erence between medians is examined using the non-parametric Wilcoxon sign-rank test (p-values are in parentheses).

Variable Sample "rms Matched "rms Di!erence(sample}matched)

Mean Median Mean Median Mean Median

SIZE 185.2 106.3 2847.7 1579.6 !2662.5 !1487.0(0.001) (0.001)

PAYOUT 8.22% 0.00% 12.63% 0.00% !4.41% 0.00%(0.254) (0.077)

FCF/TA 0.0663 0.0933 0.0833 0.1089 !0.0170 !0.0139(0.546) (0.229)

MKT/BK 2.55 1.57 2.94 2.28 !0.39 !0.55(0.424) (0.033)

VOL 3.93% 3.45% 2.74% 2.63% 1.19% 1.05%(0.001) (0.001)

INSOWN 22.9% 19.7% 20.7% 8.0% 2.2% 7.1%(0.614) (0.541)

INSDIR 52.4% 54.5% 33.2% 28.6% 19.2% 17.5%(0.001) (0.001)

has no signi"cant e!ect. A possible reason that inside ownership has no signi"-cant e!ect is that there are two opposing e!ects. As insider ownership increases,the greater is the cost of repricing borne by the insiders, making repricing lessdesirable. As inside ownership increases, however, management becomes moreentrenched and a repricing proposal is more likely to win approval.

The percentage of inside directors has a signi"cant e!ect on repricing in the"rst three models, suggesting that the greater the extent of insider control,


Table 6Parameter estimates and p-values in parentheses of logit regressions of the occurrence of repricingfor the sample of 52 "rms that reprice their executive stock options and a control sample of 52 "rmsthat do not reprice and are matched on SIC code and a percentage decline similar to the percentagereduction in the exercise price of the sample "rms' executive stock options. All measures are takenrelative to an event day, which is the repricing day for the sample "rms and the end of thematched-return 250-day holding period for the matched "rms. SIZE is the market value of equity asof day !250. PAYOUT is the annual dividend divided by the price at the end of the last "scal yearbefore day 0. FCF/TA is operating income before depreciation net of total income taxes, grossinterest expense, preferred dividends, and common dividends divided by the book value of totalassets. All items are for the last "scal year before day 0. MKT/BK is estimated as the sum of themarket value of equity and book value of debt divided by the book value of total assets for the last"scal year before day 0. VOL is the standard deviation of return based on daily returns over theperiod !500 to !251. INSOWN is number of shares held by insiders as of the last January 1 orJuly 1 before day 0 divided by the number of shares outstanding on the same day with insider sharesobtained from CDA/Investnet Insider Holdings, formerly known as Spectrum 6, and shares outstand-ing obtained from CRSP. INSDIR is the number of inside directors divided by total number ofdirectors, where an inside director is an o$cer, a very closely related family member, or a retiredo$cer.

Model 1 Model 2 Model 3 Model 4

Intercept 27.0753 25.0923 26.2231 35.7618(0.001) (0.001) (0.001) (0.001)

LN(SIZE) !2.1694 !2.3645 !2.2558 !2.9648(0.001) (0.001) (0.001) (0.001)

LN(1#PAYOUT) 1.9141 0.9654(0.529) (0.812)

FCF/TA 7.9231(0.016)

MKT/BK !0.2051 !0.0255(0.186) (0.883)

LN(VOL) !1.2143 !0.4658 !0.0732(0.387) (0.763) (0.969)

INSOWN !0.0324 !0.0359 !0.0385 !0.0066(0.119) (0.102) (0.127) (0.792)

INSDIR 0.0397 0.0472 0.0625 0.0447(0.068) (0.049) (0.035) (0.137)

the more likely is the "rm to reprice. This variable becomes insigni"cant inthe fourth model, which includes another signi"cant agency variable, free cash#ow divided by total assets. Given the relative stability of the coe$cient onpercentage of inside directors, we suspect that the reduction in signi"cance of the


percentage of inside directors is due to the higher standard errors resulting frommulticollinearity between these two variables. Though not shown in the table,when grey directors are included as insiders for both sample and matched "rms,the percentage of inside directors is signi"cant in all four models, and the freecash #ow variable remains signi"cant.

Interestingly, volatility is not signi"cant, which is consistent with our earlierobservation that the higher volatility of the sample "rms may simply be a resultof their smaller size. The payout ratio and MKT/BK are not signi"cant, againcon"rming that the signi"cance of MKT/BK in the univariate test may be justpicking up the size e!ect.

Our results are di!erent from those of Brenner et al. (2000) in two importantways. First, we "nd stronger evidence of agency problems for "rms that repriceexecutive stock options, based on the signi"cance of free cash #ow and insiderdomination of the board. Brenner et al. (2000) do not use these variables,possibly because their analysis is at the executive-year level and not at the"rm-event level. Second, with size and past performance as independent vari-ables in their logit regression, they "nd that "rms in more volatile industries aremore likely to reprice, while we "nd that volatility has no e!ect on the incidenceof repricing. A possible explanation is that we match on industry and pastperformance in selecting our control "rms while they do not, and that for "rmswithin the same industry with similarly bad performance, volatility has no e!ecton the probability of repricing. Their "nding could imply that "rms that aremore volatile have a greater probability of experiencing poor performance andconsequently a greater probability of repricing, while our "nding implies thatconditional on industry and poor performance, volatility has no e!ect on theprobability of repricing.

Our evidence on the free cash #ow variable and the percentage of insidedirectors is consistent with the notion that agency problems arising out of theshareholder}manager con#ict are a prime factor in motivating a decision toreprice.

6. Conclusions

In this paper we observe that repricing occurs after a period of overwhelminglypoor "rm-speci"c performance. Over the one-year period before repricing, theaverage "rm loses 25% of its value. The average reduction in the exercise price isabout 40%. Investors do not react to the repricing, at least around the proxy "lingdate. Firm performance following the repricing is normal. We have no directevidence, however, that the poor "rm-speci"c performance prior to repricing isattributable to management or to factors outside of managerial control.

We estimate that the average gain to the executives and loss to the share-holders is less than $150,000 but the gain is about 10% of total compensation to


17 Interestingly, HealthSouth Corporation, from whose proxy we quote at the beginning, issuedthe following statement in its proxy about one year later:

The 1995 Plan prohibits any reduction of the exercise price of outstanding options granted underthe plan except by reason of merger, business combination, recapitalization or similar change inthe capitalization of the Company. The 1995 Plan likewise prohibits the cancellation of outstand-ing options accompanied by the reissuance of substitute options at a lower exercise price.

HealthSouth Corporation proxyMay 13, 1995

the average executive. At least 25% of the repricings are repeat events. If "rmperformance is not a!ected by the repricing, the typical "rm would need to earna compound return of only 11% over the remaining life of the option to becomeat-the-money without repricing or extending the maturity. Using actual post-repricing performance, over half of the options would have been at-the-moneywithout repricing within 19 months. There is no evidence that "rms retireoptions in such a manner as to leave the repricing value-neutral.

A logit analysis of repricing "rms matched with "rms that undergo similarmarket performance but choose not to reprice reveals that repricing "rms aresigni"cantly smaller, have higher free cash #ow, and have a greater percentage ofdirectors that are insiders. Firm volatility, dividend yield, growth opportunities,and insider ownership have no e!ect on the incidence of repricing.

Repricing has created numerous controversies in the "nancial press in recentyears. No fewer than 11 articles on repricing appeared in The Wall Street Journalfrom 1997 through 1999. Yet repricing is a relatively infrequent event, and thewealth transfer from shareholders to management is very small. This mediafrenzy over a relatively infrequent event that results in little cost to the share-holders is consistent with Jensen's (1991) &politics of "nance' view, wherein hecites the negative media attention to the LBO/takeover wave of the 1980s. Whileit is certainly true that the period preceding repricing is almost always character-ized by a substantial loss in shareholder wealth, the repricing itself could benothing more than a symptom of poor performance and agency problemsassociated with small "rms.

Given the preponderance of news stories, however, some "rms apparently arebecoming more sensitive to the negative perceptions of repricing.17

References

Acharya V.V., John K., Sundaram R.K., 2000. On the optimality of resetting executive stock options,Journal of Financial Economics, forthcoming.

Brenner M., Sundaram R.K., Yermack, D., 2000. Altering the terms of executive stock options.Journal of Financial Economics, forthcoming.


Brickley, J.A., Coles, J.L., Terry, R.L., 1994. Outside directors and the adoption of poison pills.Journal of Financial Economics 35, 371}390.

Corrado, C.J., Jordan, B.D., Miller Jr., T.W., Stansfeld, J.J., 1998. Repricing and employee stockoption valuation. Unpublished working paper. University of Missouri, Columbia.

Credit Suisse First Boston, 1998. Employee stock options in the new Americas. Equity Research,November 2, (1998) 21}23.

Gilson, S.C., Vetsuypens, M.R., 1993. CEO compensation in "nancially distressed "rms: an empiri-cal analysis. The Journal of Finance 48, 425}458.

Jensen, M.C., 1991. Corporate control and the politics of "nance. Journal of Applied CorporateFinance 4, 13}22.

King, B.F., 1966. Market and industry factors in stock price behavior. The Journal of Business 34(Part 1), 139}190.

Saly, P.J., 1994. Repricing executive stock options in a down market. Journal of Accounting andEconomics 18, 325}356.


The `repricing’ of executive stock options

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