REPRICING UNDERWATER STOCK OPTIONS SEEN AS REWARD FOR MISGUIDING SHIP: STUDY LINKS RESETTING TO NEGATIVE RETURNS

The stock market’s recent gyrations have led to a wave of repricings of underwater stock options.

While repricing obviously benefits the employees who hold the options, whether it serves any purpose for the company or its shareholders has been the subject of much debate.

Now three professors from the Stern School of Business at New York University have written a report concluding that resetting option prices is “overwhelmingly associated with negative returns” and tends to reward managers when their corporations perform poorly.

Furthermore, the report states: “resetting represents a windfall for poorly performing managers rather than a necessary adjustment in incentives or a device for retaining talent. A stronger version of this claim is that managers use their power over corporate governance in order to appropriate wealth from stockholders in various forms, including resetting.”

“Altering the Terms of Executive Stock Options,” by Menachem Brenner, Rangarajan K. Sundaram and David Yermack of the Stern School’s Department of Finance, studied a sample of 396 executives whose options terms were reset in the 1992-1995 period.

conflict of interest seen

A large majority of the sample had exercise prices reset to the stock market price, causing a reduction in the typical option’s exercise price of about 40%. The report also points out the exercise price was lowered by 50% or more in more than one-third of the cases, and, in a 10th of all cases, the exercise price was lowered by at least 70%.

Another important finding is that when repricing occurs, there often is a disclosed conflict of interest on the board of directors’ compensation committee, that is, a member of the committee is in line for repriced options. “When such a conflict exists, the frequency of resetting is almost 80% higher than otherwise,” the report states.

There is also an association between options’ repricing and additional compensation, according to the study, “implying that executives with abnormally large pay packages are more likely rather than less likely to have their options reset.”

Resetting the prices of options for executives with large pay packages “is hard to justify,” says Hoffer Kaback, president of Gloucester Capital Corp. in New York. Still, option repricing “is a more difficult question when you’re talking about middle-management people who aren’t highly compensated,” he adds.

The data also indicate an inverse relationship between repricing and company size. During the sample period, while less than 0.3% of executives of Standard & Poor’s 500 stock index companies had their option prices reset, the frequency jumps to 1.2% for S&P mid-cap 400 companies and almost doubles again to more than 2% for S&P small-cap 600 companies.

“This relation also suggests that firms are more likely to reset options when the event delivers a greater improvement in incentives, since at-the-money options issued by small companies have greater pay-performance sensitivity than the same value of options used by large companies,” according to the report.

None of this surprises Patrick McGurn, vice president and director of corporate programs for Institutional Shareholder Services in Bethesda, Md. He pointed to the “steady stream of repricings” that have taken place since last summer’s stock market swoon, particularly with many small high-technology companies.

“A lot of these small-cap companies are still below their 52-week highs,” he says, and many are resetting their options’ prices.

The argument for repricing — that it helps underperforming firms retain good managers — is discussed in the report. The assumption is that “a firm should want to retain managers who oversee a stock price decline,” according to the study. That presumes there will be more repricing when all companies in an industry have poor performance, suggesting “they are victims of a common negative shock rather than bad management.”

Still, there are “no discernible patterns” showing industrywide options repricing, the report states. “Indeed, the distribution of returns across industries with some resetting is almost identical to that across industries with none,” according to the study.

This leads to the conclusion that repricing doesn’t occur because of industrywide shocks, and there is no evidence repricing is concentrated in industries where managerial talent is important.

Crain News Service