Viral Acharya, Kose John, Rangarajan Sundaram
ABSTRACT
Recent empirical work has documented the tendency of corporations to reset
strike prices on previously-awarded executive stock option grants when
declining stock prices have pushed these options out-of-the-money. This
practice has been criticized as counter-productive since it weakens
incentives present in the original award.
This paper sets up a theoretical model for study of this issue. We find
that when the menu of compensation contracts is unlimited, resetting
cannot increase, and may actually reduce, shareholder value. In more
realistic settings, however, when only commonly-observed compensation
instruments may be used, we find that allowing for the possibility of
resetting can, in fact, result in increased shareholder value; we identify
specific conditions on the effort-aversion of the manger under which this
is the case. We also find that the relative importance of resetting may
increase as the impact of external (economy-or industry-wide) factors on
the firm's performance increases; this offers one possible explanation of
why resetting has been far more common in small firms than large ones.
Finally, we also analyze the relationship between the relative optimality
of resetting and managerial control over returns generation. In summary,
our results suggest that current criticism of the practice of resetting
may be misguided, and that resetting may be a value-enhancing aspect of
corporate compensation contracts.
Subject Category: Corporate Finance/Corporate Governance/Agency Theory
Classification: Theoretical
Acharya: (212) 998-0316
vacharya@stern.nyu.edu
John: (212) 998-0337 kjohn@stern.nyu.edu
Sundaram: (212) 998-0308 rsundara@stern.nyu.edu
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