Does Repricing Stock Options Work?

Repricing underwater stock options won't help you hold onto top executives, but it can reduce turnover among lower-level employees. So report Mary Ellen Carter and Luann J. Lynch, who have spent five years studying the controversial practice. The results of their research are scheduled to appear in the February 2004 issue of the Journal of Accounting and Economics.

An option is underwater when its exercise price — the price at which the holder can purchase a share — exceeds the market price of the underlying stock. Companies can remedy this situation by reducing the strike price of their existing options. Or they can cancel them and issue new options at a lower exercise price. If the new issue occurs within six months of the cancellation, this also counts as repricing under current accounting standards.

Whatever the method used, critics attack repricing as a transfer of wealth from shareholders to the very executives who should bear the responsibility for a company's woes. In reply, firms that reprice typically characterize the strategy as a critical employee retention tool. In addition, defenders argue, repricing holds down the costs associated with overall turnover, which consultants have estimated at 50% to 200% of salary for each lost employee.

But does repricing really work? That's what Carter, an assistant professor of accounting at the University of Pennsylva-nia's Wharton School, and Lynch, who teaches at the University of Virginia's Dar-den Graduate School of Business Administration, address in their forthcoming article, “The Effect of Stock Option Repricing on Employee Turnover.” After combing through hundreds of proxy statements, they assembled a sample of 74 firms that repriced options in 1998, along with 25 firms with underwater options that did not. (They excluded firms that had repriced in December 1998 because a change in accounting rules had triggered a flurry of repricings then.) All of the companies had similar incentives to reprice, based on a model incorporating factors such as how heavily they relied on options, how far underwater their options were and how well each company and industry had fared over the previous year.

Within this sample, the authors found that repricing had no effect on turnover among a company's top five executives. Between 1998 and 1999, executive turnover increased slightly more for non-repricing firms — by 5.1 percentage points on average, compared with 3.3 percentage points for firms that repriced — but the difference was small enough to be considered coincidental. Controlling for firm size and performance, executive age, prior turnover levels and the magnitude of a firm's underwater option portfolio did not alter this result.

Carter and Lynch explored and discarded a number of alternative explanations for this finding. After collecting detailed compensation information on both sets of companies, they rejected the hypothesis that non-repricing firms offered executives other loyalty-inducing incentives, such as more cash, options or restricted stock. They also found no evidence that executives at non-repricing firms had larger ownership stakes or inferior outside opportunities compared with those at firms that repriced. Instead, they concluded, when it comes to retaining a company's leaders, repricing simply doesn't work.

Outside the executive suite, the story is somewhat different. In 1997 and 1998, overall turnover was about the same at both sets of firms. But in 1999, non-repricing companies experienced nearly twice as much turnover as firms that repriced. (The authors based their analysis on a proxy measure that counted the options that were forfeited, cancelled or expired in a year. This procedure relied on the supposition that employees typically lose unvested and underwater vested options when they leave.)

Carter offers two possible explanations for these seemingly contradictory results. Regular employees, she suggests, may be more sensitive to the status of their options because these account for a larger portion of their wealth. What's more, compared with top-level managers, subordinates who are dissatisfied with their compensation may find it easier to make a move. After all, while each company needs just one chief financial officer, many firms hire legions of programmers, Carter points out.

Repricing options for those legions —even excluding top executives — can be a costly affair. After a repricing, a company must take a charge to earnings if its quarter-end share price exceeds the new exercise price it has set. (Firms sometimes evade this requirement by canceling their options and reissuing them after six months and a day.) In addition, managers must consider less measurable costs. One is the risk of diluting the options' effectiveness as incentives. Another is the danger of alienating shareholders, who often object to granting employees more protection than they themselves receive. However, on the basis of her research, Carter argues that repricing deserves a second look. “It is pigeonholed as bad and evil because it's a wealth transfer,” she says, “but there seem to be benefits that companies should think about as well.”

For more information, contact Carter at carterme@wharton.upenn.edu.