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Sink or swim? Firms' responses to underwater options.

Abstract: We examine changes in executive compensation that firms make in response to underwater options. Using a sample of firms with underwater options in 2000, we estimate that 81 percent of firms take action to respond to them. We examine explanations for the firms' responses. Opponents argue that it rewards poor performance and transfers wealth unjustifiably from shareholders to executives. We find some support for this argument in that firms with weaker governance structures are more likely to reprice underwater options. Alternatively, firms that respond claim they do so to restore incentives, retain executives, and insulate executives from market-wide or industry-wide factors beyond their control. Our results find evidence in support of these arguments in that restoring incentives and retaining executives seem to be the primary drivers of firms' responses.

INTRODUCTION

Stock options have become an important part of executive compensation, and recent stock market declines have highlighted issues surrounding underwater stock options. This paper examines changes in executive compensation that firms make in the presence of underwater options.

Firms grant stock options to provide incentives that better align the interests of managers and shareholders. Firms also grant stock options to retain valued employees (Kole 1997; Oyer and Schaefer 2002). When the stock price falls below the exercise price of the stock options, the stock options are "underwater" and, as a result, may have diminished incentive effects (Murphy 1999) and result in increased turnover (Leonhardt 2000). Therefore, firms may alter executive compensation in response to underwater options to restore those incentive and retention benefits. Additionally, if options are underwater due to market-wide or industry-wide factors beyond the control of the executive, firms may alter compensation to insulate the executive from those uncontrollable factors.

Anecdotal evidence suggests that firms do alter compensation in response to underwater options; a survey by Financial Executives International reported that 43 percent of public companies would compensate executives for underwater options (Osterland 2001). Further, the business press suggests at least three possible ways to respond: (1) reprice those options, (1) (2) grant additional options, or (3) increase cash-based compensation (Doubleday and Fujii 2001; Fox and Hauder 2001; Osterland 2001 ; Silverman 2001). Recent surveys by Watson Wyatt and iQuantic suggest that firms respond to underwater options by granting restricted stock, granting additional options, repricing, offering a 6 and 1 option exchange, (2) or offering cash in exchange for options (Watson Wyatt Worldwide 2003; Osterland 2001). However, responding to underwater options by increasing compensation is controversial, as opponents of such actions argue that it rewards poor performance and transfers wealth unjustifiably from shareholders to executives.

In this study, we investigate changes in executive compensation in response to underwater stock options. We test four possible explanations for firms' altering executive compensation in response to underwater options: exploiting conflicts of interest, retaining executives, restoring incentives, and insulating executives from factors beyond their control. Our findings provide insight into firms' motives for responding to underwater options and can contribute to resolving the debate over the appropriateness of these actions.

Prior research has not examined concurrent changes in components of compensation in response to underwater options; the literature focuses primarily on specific compensation components or on actions firms take in special situations (e.g., Gilson and Vetsuypens 1993; Saly 1994; Carter and Lynch 2001; Zamora 2003). Rather than focusing on firms that have taken specific actions, we instead begin by identifying firms with the problem of underwater options. Then we provide a more comprehensive examination of whether and how these firms adjust compensation in the presence of underwater options by examining changes in both cash-based and equity-based compensation.

Using a sample of ExecuComp firms with underwater options in 2000, we examine unexpected compensation in 2000 and 2001, and the incidence of repricing and 6 and 1 option exchange programs among those firms. (3) We find that more than 81 percent of firms with underwater options appear to respond to those options being underwater.

Our results provide some support for arguments against firms responding to underwater options. In particular, results suggest that firms with weaker governance structures are more likely to reprice underwater options, but they provide little evidence that executive conflicts of interest increase the likelihood of firms' taking other actions. At the same time, our results also support several of the arguments advanced by firms in defense of their responses to underwater options. We find evidence that firms' desires to retain executives explain their decisions to increase salary and stock option grants. We also find evidence consistent with firms' increasing bonuses, increasing option grants, and offering 6 and 1 option exchanges as options become more underwater, consistent with the desire to restore the incentive component of compensation. Finally, we find some evidence that firms are taking actions to insulate executives from industry-wide factors beyond their control by increasing restricted stock grants.

The paper is organized as follows. The second section provides background discussion. The third section develops the hypotheses and discusses variable measurement. The fourth section describes the data and sample of firms used in the analysis. The fifth section discusses the research design. The last two sections present the results and conclusions, respectively.

BACKGROUND

Prior research documents that firms adjust compensation in response to underwater options by repricing those underwater options (for a summary, see Core et al. 2003). Zamora (2003) studies firms that have chosen to undertake option-based compensation changes and examines the choice among three option-based alternatives: repricing, additional grants, and 6 and 1 exchanges. However, previous research has not provided a comprehensive look at the determinants of whether firms respond to underwater options and how firms respond (including both cash- and equity-based compensation). In addition, FASB Interpretation No. 44 (FIN No. 44, FASB 2000), issued in March 2000 and effective on July 1, 2000 for repricings that occurred after December 15, 1998, requires firms that reprice stock options to record compensation expense. Repricing decreased significantly after the FASB's December 1998 announcement regarding the accounting for repricing (Carter and Lynch 2003). We examine changes in compensation in ExecuComp firms with underwater options in 2000, allowing us to examine firms' actions subsequent to the change in accounting for option repricing.

There are several alternative ways firms can respond to underwater options. Among them are increasing cash compensation, granting additional options, repricing the underwater options, and offering a 6 and 1 option exchange program. In FIN No. 44, the FASB defined repricing to include both changing the exercise price of existing options and canceling and regranting options at a new exercise price within a six-month period. Consequently, firms can cancel and commit to regrant options beyond the six-month period and not classify this action as a repricing, and as a result, avoid the expense required for typical repricings. This practice is commonly known as a 6 and 1 option exchange. Anecdotal evidence suggests that firms may have shifted toward granting additional stock options, or "megagranting" (e.g., Weston 2000) and using 6 and 1 option exchanges (Norris 2000) after the shift away from repricing occurred. Our study examines each of these methods, and identifies factors that explain firms' choices.

HYPOTHESES AND VARIABLE MEASUREMENT

Compensating executives for underwater options is a controversial practice (Lublin 2001). Some parties argue that firms should take no action in response to underwater options because doing so rewards poor performance and transfers wealth from shareholders to executives. However, firms maintain that they respond to underwater options to retain valuable executives, restore incentives, and insulate executives from factors beyond their control. To address this controversy, we test these potential explanations for firms' decisions to compensate executives for underwater options. Table 1 provides a summary of the predictions discussed below.

Exploiting Executive Conflicts of Interest

Altering executive compensation in the presence of underwater options appears to reward poor performance, and is often viewed as an unjustified transfer of wealth to executives that occurs as executives exploit the conflicts of interest that may exist between them and the shareholders. Indeed, prior research suggests that the extent of these conflicts of interest is positively related to executive compensation (see, e.g., Newman and Mozes 1999). If executives exploit these conflicts of interest, we expect that higher conflicts of interest increase the likelihood that firms respond to underwater options by increasing compensation. Although it is likely that executives exploit those conflicts of interest by influencing the board to increase cash compensation, we expect a relation between conflicts of interest and increases in each compensation component because our dependent variables capture both the decision to respond and the form of response.

As a proxy for executive conflicts of interest, we use a measure of the extent to which board structure appears to allow executives to influence board decisions related to compensation. Specifically, we use proxy statement data regarding insider participation on the board and the board's compensation committee, and whether the chairman of the board also serves as the company's chief executive officer to construct an index (CONFLICT) to capture the extent to which executives can influence compensation decisions. The index includes one point for each of the following: chief executive is the same individual as the chairman of the board, the percent of board members being insiders is greater than the median for the sample firms, and at least one insider is a member of the compensation committee. The index ranges in value from 0 to 3, with a higher value indicating a greater ability of executives to influence compensation decisions. If executives are exploiting conflicts of interest to influence the firm to compensate them for underwater options, then we expect a positive relation between CONFLICT and the likelihood of responding.

We next include the proportion of shares owned by executives and officers (EXE_COSHIP) as an additional measure of the extent to which executives can influence board decisions related to compensation, with higher levels of executive ownership indicating greater ability to influence compensation decisions. If executives are exploiting conflicts of interest to influence the firm to compensate them for underwater options, then we expect a positive relation between this variable and the likelihood of responding. However, this variable may also capture the extent to which interests of executives and shareholders are aligned, with higher executive ownership indicating higher alignment of interests. If so, then we would expect a negative relation between this variable and the likelihood of responding. Since the relation between executive ownership and the likelihood of responding is ambiguous, we include this variable but make no prediction regarding the sign of its coefficient.

Retaining Executives

The risk of executive turnover resulting from underwater options is increased as options become a larger component of executive compensation and as some labor markets become increasingly competitive. For example, compensation consultants argue that employees with underwater options may leave their current firm and receive a new market-based compensation package (including stock options) at their new firm (Doubleday and Fujii 2001). Given that it may be costly to bring in new executives (Compensation and Benefits Review 1997; Fitz-enz 1997; Business & Health 1998), retention may be a desired outcome.

Since firms experiencing higher turnover may have a greater desire to take action to retain executives, we use data on employee turnover as our proxy for the desire to retain executives (TURNOVER). Specifically, we obtain industry-level professional employee turnover data for 2000 from the Saratoga Institute. (4) Since firms often use equity compensation for retention purposes (Kole 1997; Oyer and Schaefer 2002), if firms respond to underwater options in order to retain executives, then we expect a positive relation between TURNOVER and the likelihood of firms using an equity-based response. Alternatively, if the firm does not desire to retain the executive, given the firm's poor performance, then we expect to see no relation between TURNOVER and firms' responses.

Restoring Incentives

Agency theory suggests that, under situations of separation of ownership and control, compensation contracts based on stock performance can help to align the interests of managers and shareholders. Stock price performance can provide information regarding managers' otherwise unobservable actions. Indeed, prior research shows that compensation is positively related to firm performance (e.g., Murphy 1985; Coughlan and Schmidt 1985). However, the desired incentive effects of options may be diminished when they are considerably underwater, as they have substantially decreased pay-for-performance sensitivity (Murphy 1999). Restoring the pay-for-performance sensitivity by altering equity-based compensation may help to reinstate those incentives. In fact, prior research finds that increasing the sensitivity of pay to performance may increase future firm performance (Abowd 1990). Accordingly, we expect that firms' desires to restore executive incentives increase the likelihood of responding to underwater options using some form of incentive-based compensation, including bonuses, granting new options, repricing underwater options, offering a 6 and 1 option exchange, or granting restricted stock.

To proxy for the need to restore incentives, we use a measure of the extent to which options are underwater in 2000 (OOM). (5) Since the details of executives' stock option portfolios cannot be exactly reconstructed from publicly available data, we estimate the extent to which those options are underwater. Specifically, we estimate the extent to which options granted to executives during fiscal years 1998 through 2000 are underwater at the end of 2000, as follows:

OOM = wtd avg ex price of exec options granted in 1998-2000--stock price at end of FY 2000/ wtd avg ex price of exec options granted in 1998-2000

We use three years of grants in this calculation because the vesting period of options tend to run from three to five years (McIntosh and Harmetz 2002), and prior research suggests that options typically are exercised soon after vesting (Huddart and Lang 1996). If the desire to restore incentives influences firms' responses to underwater options, then we expect a positive relation between OOM and the likelihood of responding.

Insulating Executives from Factors beyond Their Control

Compensation contracts often use stock price as a measure of performance to provide information about executives' otherwise unobservable actions. However, many factors can affect the stock price that are not within the control of the executive. As a result, firms may want to exclude that portion of stock price movement that is due to market-wide or industry-wide factors that are beyond the control of management. Consistent with the desire to insulate executives from uncontrollable factors, Saly (1994) finds evidence that firms repriced stock options after the 1987 stock market crash. Likewise, if the source of underwater options is poor market or industry performance, altering compensation would help ensure that the executive is not penalized by those factors. Accordingly, we expect that the desire to insulate executives from industry-wide factors beyond their control increases the likelihood that firms respond to underwater options by adjusting compensation. (6)

We use industry returns to proxy for that portion of firms' stock returns that is beyond the control of the executive (IND_RETS). To measure industry returns, we calculate the median cumulative stock return from 1998 to 2000 by two-digit SIC code using all firms from the Center for Research in Securities Prices (CRSP). If the desire to insulate executives from factors beyond their control influences firms' responses to underwater options, then we expect a negative relation between IND_RETS and the likelihood of responding.

SAMPLE AND DATA

Data

We obtain executive compensation data from ExecuComp for 1993 through 2001. (7) We report total compensation (ExecuComp variable TDC1), defined as the total of salary, bonus, other annual compensation, total value of restricted stock granted, total value of stock options granted (using Black-Scholes), long-term incentive payouts, and all other compensation. We also report salary (ExecuComp variable SALARY), defined as the dollar value of the base salary (cash and noncash) earned by the named executive officer during the fiscal year, and bonus (ExecuComp variable BONUS), defined as the dollar value of bonus (cash and noncash) earned by the named executive officer during the fiscal year. In addition, we report the aggregate value of stock options granted to the executive during the year as valued by ExecuComp using the Black-Scholes methodology (ExecuComp variable BLK_ VALUE), and the value of restricted stock granted (ExecuComp variable RSTKGRNT). Because our analysis is at the firm level, we calculate the average compensation per executive per year for each firm by summing the compensation variables across executives, including the CEO, for each year and then dividing by the number of executives reported for that year. In addition, we use a repricing flag (ExecuComp variable PREPRICE) to identify executives whose options have been repriced during the fiscal year. We create a firm-level indicator variable equal to 1 when options of any executive in that firm is repriced during the year, to identify firms that reprice options to executives. Finally, we create a firm-level indicator variable equal to 1 when any executive is offered an exchange of at-the-money options for their underwater options in a 6 and 1 option exchange, using data from tender offer and proxy statements obtained from Carter and Lynch (2004b). (8)

We obtain financial statement data from ExecuComp and stock returns from the Center for Research in Securities Prices (CRSP). We obtain governance data from proxy statements for fiscal year 1999, and actual industry-level employee turnover data for 2000 from the Saratoga Institute.

Sample Selection

We start with the sample of 1,472 firms reported on the 2002 Standard & Poor's ExecuComp database that also have stock returns data available on CRSP, positive book values of equity, and non-zero values of executive stock options outstanding at the end of 1999. To address our research question, we examine the compensation changes made by a sample of firms with underwater options. To obtain this sample of firms, we retain those firms for which the weighted average exercise price of option grants from 1998 to 2000 is greater than the firm's 2000 fiscal year-end stock price. This procedure results in a sample of 548 firms with underwater options in 2000.

Descriptive Statistics

Table 2 compares the 548 sample firms to the 924 other ExecuComp firms, using 1999 data, prior to the sample firms' expected responses to underwater options. With the exception of bonuses, 1999 compensation in sample firms appears similar to that in other ExecuComp firms. The average (median) total compensation per executive for sample firms in 1999 was $2.5 million ($1.2 million), compared to $2.5 million ($1.3 million) for other ExecuComp firms. Executives of sample firms received an average (median) of $330.9 ($294.8) thousand in salary, an average (median) value of $1,482.9 ($423.4) thousand in option grants, and an average of $157.9 ($0.0) thousand in restricted stock. Salary, the value of options, and the value of restricted stock are not significantly different in sample firms than in other ExecuComp firms. In addition, in 1999, only 1.3 percent of sample firms repriced executive options, and no firms offered 6 and 1 option exchanges to executives. However, executives in sample firms received an average (median) of $262.4 ($151.6) thousand in bonus, significantly less than the $354.9 ($190.7) thousand in other ExecuComp firms. This difference is apparently the result of the poor performance of the sample firms, discussed below.

Sample firms have average (median) sales in 1999 of $4.5 billion ($1.1 billion). The average (median) book-to-market ratio is 0.64 (0.51), and the average (median) return on assets is 3.30 percent (4.41 percent). Mean (median) cumulative stock returns for fiscal years 1998 through 2000 are -18.2 percent (-30.1 percent), consistent with these firms having underwater options. Compared to other ExecuComp firms, sample firms have worse accounting and stock price performance and higher book-to-market ratios. These sample characteristics are consistent with sample firms having underwater options, which occur because of poor stock price performance.

RESEARCH DESIGN

Measurement of the Dependent Variables

To examine whether and how firms respond to underwater options by adjusting compensation, we examine a measure of unexpected total compensation and its components in 2000 and 2001, and examine whether the firm increases the use of restricted stock, reprices underwater options, or offers a 6 and 1 option exchange. We examine both 2000 and 2001 because some firms' actions might occur in 2000, some actions might occur in 2001, and some actions might span both years. Examining 2000 and 2001 together in one metric allows for each of these possibilities.

We construct our measure of unexpected compensation as follows. First, we estimate expected compensation in 2000 and 2001 using expectation models of the relation between each compensation component and standard economic determinants of compensation (Smith and Watts 1992; Gaver and Gaver 1993, 1995; Core et al. 1999). Specifically, using data from ExecuComp for 1993 through 1999 for our sample firms, we estimate the following expectation models by industry, where industry is defined as two-digit SIC code. (9,10)

(1) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII.]

where:

Dependent variables (DEP_VA[R.sub.jt]):

LNT[C.sub.jt] = natural log of average total compensation per executive for firm j in year t;

LNSA[L.sub.jt] = natural log of average salary per executive for firm j in year t;

LNBO[N.sub.jt] = natural log of average bonus per executive for firm j in year t; and

LNBL[K.sub.jt] = natural log of average value of options granted per executive for firm j in year t.

Independent variables:

[D.sub.j] = 1 for firm j, 0 otherwise (with n firms in j's industry);

RO[A.sub.jt] = return on assets for firm j in year t;

LNSALE[S.sub.jt] = natural log of sales for firm j in year t; and

BOOK_MK[T.sub.jt] = book-to-market ratio for firm j in year t.

Second, we use the resulting parameter estimates from these models to calculate the expected value of each compensation component for each firm for 2000 and for 2001 (not in natural logs). Third, we calculate unexpected compensation for each year 2000 and 2001 as the difference between actual compensation and expected compensation. Finally, we construct our final measure of unexpected compensation by firm by averaging unexpected compensation for 2000 and 2001 and scaling the resulting average by average expected compensation for 2000 and 2001, as follows:

Unexpected compensation for the firm = ((Unexpected compensation per exec for 2000 + unexpected compensation per exec for 2001)/2)/ ((Expected compensation per exec for 2000 + expected compensation per exec for 2001)/2)

Using the above measure, we construct variables to capture unexpected total compensation (UE_TC), salary (UE_SAL), bonus (UE_BON), and value of options granted (UE_BLK). In addition, we construct indicator variables to capture whether the firm increases the use of restricted stock (RSTK), (11) reprices underwater options (REPRICE), or offers a 6 and 1 option exchange (SIX_&_ONE).

Research Methodology

To examine the motives behind firms' responses to underwater options, we estimate the following OLS regressions: (12,13)

(2) DEP_VA[R.sub.j] = [[beta].sub.0] + [[beta].sub.1] CONFLIC[T.sub.j] + [[beta].sub.2] EXEC_OSHI[P.sub.j] + [[beta].sub.3] TURNOVE[R.sub.j] + [[beta].sub.4] OO[M.sub.j] + [[beta].sub.5] IND_RET[S.sub.j] + [[beta].sub.6] OVERHAN[G.sub.j] + [[epsilon].sub.j]

where:

Dependent variables (DEP_VA[R.sub.j]):

UE_T[C.sub.j] = ((unexpected total compensation per executive for 2000 + unexpected total compensation per executive for 2001)/2)/((expected total compensation per executive for 2000 + expected total compensation per executive for 2001)/2) for firm j;

UE_SA[L.sub.j] = ((unexpected salary per executive for 2000 + unexpected salary per executive for 2001)/2)/((expected salary per executive for 2000 + expected salary per executive for 2001)/2) for firm j;

UE_BO[N.sub.j] = ((unexpected bonus per executive for 2000 + unexpected bonus per executive for 2001)/2)/((expected bonus per executive for 2000 + expected bonus per executive for 2001)/2) for firm j;

UE_BL[K.sub.j] = ((unexpected value of options granted per executive in 2000 + unexpected value of options granted per executive in 200 l)/2)/((Expected value of options granted per executive for 2000 + expected value of options granted per executive for 2001)/2) for firm j;

RST[K.sub.j] = 1 if ((average value of restricted stock per executive in 2000 + average value of restricted stock per executive in 2001)/2) - (average value of restricted stock per executive in 1999) is greater than 0, 0 otherwise;

REPRIC[E.sub.j] = 1 if firm reprices in 2000 or 2001, 0 otherwise; and

SIX_&_[ONE.sub.j] = 1 if firm offers a 6 and 1 option exchange in 2000 or 2001, 0 otherwise.

Independent variables:

CONFLIC[T.sub.j] = index for firm j ranging in value from 0 to 3, with 1 point for each of the following: chairman of the board is the CEO, insider participation on board is greater than sample median, insider participates on compensation committee;

EXEC_OSHI[P.sub.j] = percent of common shares held by directors and executive officers as a group as reported in the proxy statement for firm j;

TURNOVE[R.sub.j] = turnover rate of professional employees in firm j's industry;

OO[M.sub.j] = (weighted average exercise price of options granted in fiscal year 1998 to 2000--market price of stock at fiscal year-end 2000)/(weighted average exercise price of options granted in fiscal year 1998 to 2000) for firm j;

IND_RET[S.sub.j] = median cumulative return for 1998 to 2000 for firm j's industry, as defined by two-digit SIC code; and

OVERHAN[G.sub.j] = number of executive stock options outstanding at year-end 1999/number of common shares outstanding at year-end 1999.

In addition to the variables discussed in the third section, we include OVERHANG, a variant of a measure frequently used by compensation consultants to measure the extent of option use, to control for the firm's use of options. The relation between OVERHANG and firms' responses is ex ante ambiguous. First, if a greater use of options indicates the firm has a larger problem with underwater options to address, then we expect a positive relation between OVERHANG and firms' responses. Second, if a greater use of options increases the tendency of firms to use options in the future, then we expect a positive relation between OVERHANG and firms' responses involving options. Third, if a greater use of options leads to a limited ability to use options in the future, we expect a negative relation between OVERHANG and firms' responses involving additional equity grants. Accordingly, we make no prediction regarding the sign of this coefficient.

RESULTS

Descriptive Statistics

Table 3 provides statistics related to our dependent variables, actions taken by firms with underwater options. Overall, more than 81 percent of firms in our sample appear to respond to underwater options by increasing some form of compensation. Approximately 65 percent of our sample firms increase executive salary more than expected; the mean (median) average unexpected salary in 2000 and 2001 is 16.4 percent (15.2 percent) of expected average salary. Sample firms also have a mean (median) unexpected average bonus in 2000 and 2001 that is 182.2 percent (41.9 percent) of the expected average bonus. For 52.7 percent of our sample, the unexpected bonus is positive, suggesting that 52.7 percent of our sample firms responded to underwater options by increasing the bonus. In addition, 51.6 percent of our sample increase the value of options granted beyond that predicted. Mean (median) average unexpected value of options granted in 2000 and 2001 as a percent of expected value of options granted is 384.1 percent (52.9 percent). While only 0.9 percent of the 548 sample firms reprice and 1.6 percent of the firms offer 6 and 1 option exchanges, 31.3 percent of the firms increase their use of restricted stock during that period. These statistics suggest that most firms do respond to underwater options during our sample period by altering compensation.

Table 4, Panel A describes the independent variables used in the analysis. The mean (median) score of our index of executives' ability to influence the board's compensation decisions is 1.24 (1.00) out of a maximum score of 3. Executive ownership in our sample is an average (median) of 10.8 percent (5.5 percent). The average (median) rate of industry-level professional turnover for our sample of firms is 14.0 percent (13.3 percent). Options granted from 1998 to 2000 are, on average, 29.0 percent underwater. Sample firms operate in industries with an average -19.7 percent cumulative return during the period, suggesting that industry-wide factors beyond the control of executives may have contributed to the options being underwater. Finally, the average (median) executive options outstanding as a percent of shares outstanding for our sample firms is 0.006 (0.004). The correlations among our primary independent variables are reported in Table 4, Panel B.

Multivariate Analysis

Table 5 reports the results of estimating model (2). The ability of executives to influence boards' compensation decisions does not seem to play a significant role in firms' responses to underwater options. Only in the decision to reprice stock options is CONFLICT positive and significant at p < 0.05. (14)

Retention concerns, on the other hand, do seem to be an important driver of firms' responses. The coefficient on our proxy for concerns regarding retention (TURNOVER) is positive and significant at p < 0.01 when the dependent variable captures unexpected total compensation. This seems to result from TURNOVER being an important (positive and significant at p < 0.01) determinant of whether the firms respond with unexpected salary and unexpected option grants. The positive relation between TURNOVER and unexpected salary suggests that employee preferences may have shifted toward cash compensation over the uncertainty of compensation based on stock options, consistent with anecdotal evidence (Osterland 2001; Dunham 2001; The Economist 2001). (15)

Consistent with our predictions, the greater the need to restore incentives, the more likely the firm is to increase incentive-based compensation. OOM is positively and significantly (p < 0.01) related to increases in unexpected bonus compensation and to 6 and 1 option exchanges. OOM also is positively related to unexpected option grants, though only significant at p < 0.10 using a one-tailed test. OOM is significantly negatively (p < 0.01) related to unexpected salary, suggesting that firms are less likely to increase salary, a non-incentive-based compensation tool, when the desire to restore incentives is higher.

There is some evidence that increasing restricted stock is a method used to insulate executives from industry-wide factors beyond their control, as the coefficient on IND_RETS is negative and significant at p < 0.10. Contrary to our prediction, we find that IND_RETS is positively related to unexpected option grants. Though this is not consistent with insulating executives, it is consistent with the desire to retain executives, in that firms appear to be granting more options when the industry is doing well and labor markets are perhaps more competitive.

Finally, though included as a control variable, the coefficients on OVERHANG provide some interesting observations. First, the coefficient when UE_BON is the dependent variable is positive and significant, consistent with firms' substituting cash compensation to avoid additional dilution when firms have more options outstanding. Likewise, firms tend not to grant additional restricted stock when firms have more options outstanding. As in any study, the limitations in the explanatory power of the models should be considered when drawing conclusions.

Further Tests

Another means through which firms can give additional cash to executives is to buy out underwater options (Fox and Hauder 2001; Silverman 2001). Such "cashouts" are captured in ExecuComp as other total compensation (ExecuComp variable ALLOTHTOT). If firms pursue this alternative, then we should see a significant positive correlation between option cancellations and other compensation. However, our data suggests no correlation between the change in option cancellations and the change in other compensation, as the Pearson (Spearman) correlation coefficient between these two variables is 0.11 (0.01), and is not significant at conventional levels.

CONCLUSION

This study examines whether firms respond to underwater options by altering compensation, and tests alternative explanations for these responses. First, we examine unexpected compensation, repricings, and 6 and 1 option exchanges in 2000 and 2001 in ExecuComp firms with underwater options in 2000. Our results suggest that approximately 81 percent of firms do respond to underwater options by altering compensation.

Second, we examine whether executives' conflicts of interest, or the need to retain executives, restore incentive-based compensation, or insulate executives from industry-wide factors beyond their control explain firms' responses to underwater options. Our results suggest that executives' exploiting conflicts of interest is not a primary driver of increases in total compensation or its components in response to underwater options. In contrast, greater conflicts of interest are associated with firms' decisions to reprice underwater options, consistent with arguments of opponents of responding to underwater options. However, our results also support several of the arguments that firms advance in support of responding to underwater options. Specifically, we find evidence that the desire to retain executives explains firms' decisions to increase total compensation, salary, and stock option grants. We also find that the need to restore incentives explains firms' decisions to increase incentive-based compensation (bonus, stock option grants, and 6 and 1 option exchanges). Finally, we find some support that the granting of restricted stock in the presence of underwater options is due to the desire to insulate executives from factors beyond their control.

Our study provides a comprehensive examination of firms' responses to underwater options. We find evidence that firms do respond to underwater options and that those responses occur in both equity- and cash-based components of compensation. Responses to underwater options appear to be motivated primarily by the desire to retain executives and the desire to restore incentives to the compensation package, lending support to firms' arguments for why they respond to underwater options.
TABLE 1
Summary of Predictions

                                          Dependent Variable

                                                Salary       Bonus
Independent Variable                           (UE_SAL)    (UE_BON)

Executive conflicts of interest  CONFLICT         +            +
Executive conflicts of interest  EXEC_OSHIP       ?            ?
Desire to retain executives      TURNOVER         0            0
Desire to restore incentives     OOM              0            +
Desire to insulate executives    IND_RETS         -            -
  from uncontrollable factors

                                   Dependent Variable

                                              Restricted
                                  Options       Stock
Independent Variable              (UE_BLK)      (RSTK)

Executive conflicts of interest      +            +
Executive conflicts of interest      ?            ?
Desire to retain executives          +            +
Desire to restore incentives         +            +
Desire to insulate executives        -            -
  from uncontrollable factors

                                   Dependent Variable

                                 Repricing     6 and 1
Independent Variable             (REPRICE)   (SIX_&_ONE)

Executive conflicts of interest      +            +
Executive conflicts of interest      ?            ?
Desire to retain executives          +            +
Desire to restore incentives         +            +
Desire to insulate executives        -            -
  from uncontrollable factors

TABLE 2
Description of Sample of 548 ExecuComp Firms
with Underwater Options in 2000 (1999 data)

(in thousands except for percents)

                                                Mean
                                  Mean        (Median)
                                (Median)      for 924        p-value
                                for 548        Other         for Mean
                                 Sample      ExecuComp     (p-value for
Variable                         Firms         Firms       Median) (a)

Total Compensation              $2,459.4      $2,534.6         0.74
                               ($1,158.2)    ($1,296.2)       (0.08)

Salary                           $330.9         $334.9         0.65
                                ($294.8)       ($299.4)       (0.96)

Bonus                            $262.4         $354.9         0.00
                                ($151.6)       ($190.7)       (0.00)

Value of options               $1,482.9       $1,445.1         0.83
                                ($423.4)       ($539.7)       (0.20)

Value of restricted stock        $157.9         $148.5         0.84
                                  ($0.0)         ($0.0)       (0.16)

Percent of firms repricing          1.3%           1.1%        0.74
executive stock options

Percent of firms offering 6         0.0%           0.0%        1.00
and 1 option exchange

Return on Assets (b)               3.30%           5.70%       0.00
                                  (4.41%)         (5.09%)     (0.00)

Sales                          $4,529,160    $3,783,491        0.26
                              ($1,097,450)   ($860,520)       (0.02)

Book-to-Market Ratio               0.64             0.45        0.00
                                 ($0.51)          ($0.37)      (0.00)

Cumulative Stock Returns in      ($0.2)           $1.5         0.00
FY 1998-2000                      $0.0           ($0.5)       (0.00)

(a) t-test of difference in means (Mann-Whitney rank sum
test of difference in medians).

(b) Defined as Income before Extraordinary Items/Total Assets.

TABLE 3
Value of Dependent Variables for 548 ExecuComp Firms with
Underwater Options in 2000

Variable                    Mean    Median   % Positive

UE_TC                       0.477   0.148       50.9
UE_SAL                      0.164   0.152       65.3
UE_BON                      1.822   0.419       52.7
UE_BLK                      3.841   0.529       51.6
RSTK                        0.313     NA         NA
REPRICE                     0.009     NA         NA
SIX_&_ONE                   0.016     NA         NA
% of firms responding (a)    NA       NA        81.2

(a) A firm is considered to have responded if the value
of UE_SAL, UE_BON, or UE_BLK > 0, or RSTK, REPRICE, or
SIX_&_ONE = 1.

Variable definitions:

UE_T[C.sub.j] = ((unexpected total compensation per executive
for 2000 + unexpected total compensation per executive for 2001)
/2)/((expected total compensation per executive for 2000 +
expected total compensation per executive for 2001)/ 2) for
firm j;

UE_SA[L.sub.j] = ((unexpected salary per executive for 2000
+ unexpected salary per executive for 2001)/2)/expected
salary per executive for 2000 + expected salary per
executive for 2001)/2) for firm j;

UE_BO[N.sub.j] = ((unexpected bonus per executive for 2000 +
unexpected bonus per executive for 2001)/2)/expected bonus per
executive for 2000 + expected bonus per executive for 2001)/2)
for firm j;

UE_BL[K.sub.j] = ((unexpected value of options granted per
executive for 2000 + unexpected value of options granted per
executive for 2001)/2)/expected value of options granted per
executive for 2000 + expected value of options granted per
executive for 2001)/2) for firm j;

RST[K.sub.j] = 1 if ((average value of restricted stock per
executive in 2000 + average value of restricted stock per
executive in 2001)/2) - (average value of restricted stock
per executive in 1999) is greater than 0, 0 otherwise;

REPRIC[E.sub.j] = 1 if firm reprices executive stock options
in 2000 or 2001, 0 otherwise; and

SIX_&_ON[E.sub.j] = 1 if firm offers a 6 and 1 option exchange
to executives in 2000 or 2001, 0 otherwise.

TABLE 4
Descriptive Statistics and Correlations among Independent Variables
for Sample of 548 ExecuComp Firms with Underwater Options in 2000

Panel A: Descriptive Statistics

              Mean
Variable    (Median)

CONFLICT       1.24
              (1.00)
EXEC_OSHIP    0.108
             (0.055)
TURNOVER      0.140
             (0.133)
OOM           0.290
             (0.248)
IND_RETS     -0.197
            (-0.218)
OVERHANG      0.006
             (0.004)

Panel B: Pearson Correlations

                       EXEC_
Variable    CONFLICT   OSHIP    TURNOVER    OOM     IND_RETS

CONFLICT
EXEC_OSHIP    0.11
TURNOVER      0.05      0.10
OOM          -0.00      0.02      0.21
IND_RETS      0.02      0.07     -0.45     -0.17
OVERHANG      0.12      0.13      0.11      0.14      0.00

Variable definitions:

CONFLIC[T.sub.j] = index ranging in value from 0 to 3, with 1
point included for each of the following: chairman of the board
is the CEO, insider participation on board is greater than sample
median, insider participates on compensation committee;

EXEC_OSHI[P.sub.j] = percent of common shares held by officers and
executives from 1999 proxy statement;

TURNOVER = turnover rate of professional employees in firm j's
industry in 2000;

OO[M.sub.j] = (weighted average exercise price of options granted
in fiscal year 1998 to 2000--market price of stock at fiscal year-
end 2000)/(weighted average exercise price of options granted in
fiscal year 1998 to 2000) for firm j.

IND_RET[S.sub.j] = median cumulative return for 1998 to 2000 for
firm j's industry, as defined by two-digit SIC code; and

OVERHAN[G.sub.j] = number of executive stock options outstanding
at year-end 1999/number of common shares outstanding at year-end
1999.

TABLE 5
Multivariate Analysis of Changes in Total Compensation and Components
for Sample of 548 ExecuComp Firms with Underwater Options in 2000
DEP_VA[R.sub.j] = [[beta].sub.0] + [[beta].sub.1] CONFLIC[T.sub.j] +
[[beta].sub.2] EXEC_OSHI[P.sub.j]+ [[beta].sub.3] TURNOVE[R.sub.j] +
[[beta].sub.4] OO[M.sub.j] + [[beta].sub.5] IND_RET[S.sub.j] +
[[beta].sub.6] OPTION[S.sub.j] + [[epsilon].sub.j]

                    Predicted
                      sign        UE_TC

Intercept                         -0.24
CONFLICT                 +         0.01
EXEC_OSHIP               ?        -0.51
TURNOVER              0/+ (a)      4.87 ***
OOM                   0/+ (b)      0.81 ***
IND_RETS                 -         0.58 **
OVERHANG                 ?        -2.89
n                                  422
Adj [R.sub.2] (c)                  0.05

                    UE_SAL        UE_BON

Intercept            0.03          0.66
CONFLICT             0.01         -0.08
EXEC_OSHIP          -0.02          0.42
TURNOVER             1.01 ***     -2.75
OOM                 -0.15 ***      4.30 ***
IND_RETS            -0.01          0.54
OVERHANG             2.91         74.06 *
n                    422           422
Adj [R.sub.2] (c)    0.03          0.05

                      UE_BLK         RSTK

Intercept             -1.28         -0.37
CONFLICT              -0.03         -0.11
EXEC_OSHIP             0.79         -0.39
TURNOVER              43.14 ***     -0.58
OOM                    2.83 (#)     -0.08
IND_RETS               5.43 **      -1.12 *
OVERHANG            -107.67       -126.40 ***
n                     422           424
Adj [R.sub.2] (c)      0.02          0.08

                     REPRICE      SIX_&_ONE

Intercept            -8.24 ***      -4.57 *
CONFLICT              1.78 **        0.25
EXEC_OSHIP            2.01           2.76
TURNOVER             -3.39         -11.47
OOM                  -0.31           5.89 ***
IND_RETS             -2.19           0.13
OVERHANG             71.19        -174.50
n                     504             506
Adj [R.sub.2] (c)     0.16           0.17

*, **, *** Indicate statistically significant at the 10%,
5% or 1% level, respectively, using a two-tailed test.

(#) Indicates statistically significant at the 10% level,
using a one-tailed test.

(a) For regressions with UE_SAL and UE_BON as dependent
variables predicted sign is 0. For regressions with UE_BLK,
RSTK, REPRICE, and SIX_&_ONE ONE as & dependent variables,
predicted sign is +.

(b) For regression with UE_SAL as dependent variable
predicted sign is 0. For regressions with UE_BLK, RSTK,
REPRICE, and SIX_&_ONE as dependent variables, predicted
sign is +.

(c) Pseudo [R.sup.2] for logit estimations with the
following dependent variables: RSTK, REPRICE, SIX_&_ONE.

Variable definitions:

UE_T[C.sub.j] = ((unexpected total compensation per executive
for 2000 + unexpected total compensation per executive for 2001)/
2)/Expected total compensation per executive for 2000 + expected
total compensation per executive for 2001)/2) for firm j;

UE_SA[L.sub.j] = ((unexpected salary per executive for 2000 +
unexpected salary per executive for 2001)/2)/((expected salary
per executive for 2000 + expected salary per executive for 2001)/
2) for firm j;

UE_BO[N.sub.j] = ((unexpected bonus per executive for 2000 +
unexpected bonus per executive for 2001)/2)/((expected bonus
per executive for 2000 + expected bonus per executive for 2001)/
2) for firm j;

UE_BL[K.sub.j] = ((unexpected value of options granted per executive
for 2000 + unexpected value of options granted per executive for 2001)
/2)/((expected value of options granted per executive for 2000 +
expected value of options granted per executive for 2001)/2) for firm
j;

RST[K.sub.j] = 1 if ((average value of restricted stock per executive
in 2000 + average value of restricted stock per executive in 2001)/2)
--(average value of restricted stock per executive in 1999) is greater
than 0, 0 otherwise;

REPRIC[E.sub.j] = 1 if firm reprices in 2000 or 2001, 0 otherwise;

SIX_&_ONE[S.sub.j] = 1 if firm offers a 6 and 1 option exchange
in 2000 or 2001, 0 otherwise;

CONFLIC[T.sub.j] = index ranging in value from 0 to 3, with 1 point
for each: the following: chairman of the board is the CEO, insider
participation on board is greater than sample median, insider
participates on compensation committee;

EXEC_OSHI[P.sub.j] = percent of common shares held by officers and
executives for firm j from 1999 proxy statement;

TURNOVE[R.sub.j] = turnover rate of professional employees in firm
j's industry in 2000;

OO[M.sub.j] = (weighted average exercise price of options granted in
fiscal year 1998 to 2000 - market price of stock at fiscal year-end
2000)/(weighted average exercise price of options granted in fiscal
year 1998 to 2000) for firm j;

IND_RET[S.sub.j] = median cumulative return for 1998 to 2000 for
firm j's industry, as defined by two-digit SIC code; and

OVERHAN[G.sub.j] = number of executive stock options outstanding at
year-end 1999/number of common shares outstanding at year-end 1999.


We thank the Saratoga Institute for providing industry-level turnover data and Sagar Gajendragadkar for help with data collection. We thank Mike Kirschenheiter, Steve Penman, and Jake Thomas for their helpful comments and discussions. We also appreciate the comments from Somnath Das, George Drymiotes, Tim Gray, Charlie Himmelberg, Chris Ittner (Forum Associate Editor), Scott Richardson, Irem Tuna, an anonymous referee, and workshop participants at the 2002 American Accounting Association Management Accounting conference, the 2002 American Accounting Association Annual Meeting, the 2002 University of Minnesota Empirical Accounting Conference, University of Notre Dame, and Columbia University. Professor Carter gratefully acknowledges the financial support of the Faculty Research Fund at Columbia Business School. Professor Lynch gratefully acknowledges the financial support of the University of Virginia Darden School Foundation.

(1) Repricing can be implemented either by altering the exercise price of an existing option, or canceling and regranting new options within a six-month period.

(2) With a 6 and 1 option exchange, firms cancel and commit to reissue options more than six months later and avoid recording an expense that is required with a traditional option repricing

(3) We focus on executives rather than all employees because data on the components of compensation is publicly available only for executives. In addition, we focus on ExecuComp firms because the data are available in electronic form.

(4) The Saratoga Institute organizes its data into 16 industries. We map our firms into their industry groupings using two-digit SIC codes based on their industry descriptions.

(5) An alternative proxy is the option delta, or sensitivity of the firm's option value to changes in the firm's stock price. There are two reasons why we do not use the option delta as a proxy. First, methods to approximate the option delta perform poorly when the option portfolio contains a significant amount of underwater options (Core and Guay 2002). Second, there are offsetting predictions with the option delta. Firms with lower deltas would be expected to respond with options because at-the-money options would be more sensitive to stock price changes than the current underwater options. On the other hand, the delta captures the sensitivity of the option portfolio in general. In this respect, firms with higher deltas would be expected to respond with options because the value of the firm's options is more highly sensitive to stock price changes.

(6) Firms ex ante could build industry benchmark performance into the design of the stock option by offering indexed options. However, this practice is not widely used, probably because firms must record an expense associated with indexed options.

(7) 2001 data is available for firms that are included on ExecuComp as of September 2002.

(8) Carter and Lynch (2004b) search all proxy and tender offer statements from 1999 through 2002 for firms that engage in 6 and 1 option exchanges. We compare our sample of ExecuComp firms to their sample to identify which of our 548 sample firms offer 6 and 1 option exchanges to executives.

(9) We estimate the model by industry because insufficient data is available to estimate firm-specific models. However, we include an intercept in the model for each firm to allow for differences in compensation between the firm and its industry. We estimate the models over 1993 through 1999 because ExecuComp data is available for years 1993 and afterward and because 1999 is the year prior to the selection of our sample of firms with underwater options.

(10) We winsorize variables that are above (below) the 95th (5th) percentile, in order to mitigate the influence of outliers.

(11) We do not use a continuous variable for restricted stock because so few firms in our sample grant restricted stock prior to 2000 that it is difficult to obtain an expected value of restricted stock through an expectation model.

(12) When RSTK, REPRICE, or SIX_&_ONE is the dependent variable, we estimate using Logit.

(13) We winsorize continuous variables, except CONFLICT, EXEC_OSHIP, TURNOVER, that are above (below) the 95th (5th) percentile, in order to mitigate the influence of outliers.

(14) Prior research (Carter and Lynch 2001) suggests that executive conflicts of interest were not primary drivers of firms' decisions to reprice stock options prior to the 1998 FASB rule change. However, the new financial reporting environment for repricings in the current paper likely changed how executive conflicts of interest influence the repricing decision. This is reinforced by the fact that far fewer firms reprice after the rule change. As shown in Table 3, only 0.9 percent of ExecuComp firms with underwater options in 2000 repriced options in 2000 or 2001. In comparison, 18.3 percent of ExecuComp firms with underwater options in 1997 (identified using the same sample selection procedure) repriced in 1997 or 1998.

(15) Note that we do not find that TURNOVER is related to firms' repricing stock options. Although inconsistent with claims made by firms who reprice stock options, this result is consistent with the findings of Carter and Lynch (2004a) that repricing does not appear to lower executive turnover.

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Sudhakar Balachandran

Columbia University

Mary Ellen Carter

University of Pennsylvania

Luann J. Lynch

University of Virginia
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Publication:Journal of Management Accounting Research
Date:Jan 1, 2004
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