Rescission and Repricing of Executive Stock Options

1. Rescission and Repricing of Executive Stock Options Jerry T. Yang Eller College of Business and Public Administration University of Arizona  Willard T. Carleton Eller College of Business and Public Administration University of Arizona First draft: October 2001 Current draft: March 2002

2. Repricing options is a process of canceling existing outstanding options and reissuing new options at a lower strike price. [Traditional repricings simply lower the exercise prices of existing options.]

3. Rescission is a business practice in which employees are allowed to cancel already-exercised options when share prices fell. [Essentially, this practice allows companies to buy back the shares resulting from previous option exercises at original strike prices which are higher than current market values. Replacement options are usually issued following the cancellation. This tax-motivated strategy is designed to rescue employees who would not have sufficient proceeds from selling the stock to pay the tax occurring after option exercise, because of subsequent stock price declines.]

4. Generally, we ask: • To reprice (rescind) or not to reprice (rescind)? • Do accounting (variable) charges matter?

5. HH= (1+u)2fhh whh P(ah) H [ ah ] P(a) HL= 1 - u2fhlwhl 1-P(ah) I [ a] LH= 1 - u2flhwlh P(ai) L [ al ] 1-P(a) LL= (1-u)2fllwll 1-P(ai) 7. Model - Figure 1 t = 0t = 1t = 2 Share ValueAgent's payoffs Figure 1. A two-period binomial model and distribution of terminal cash flows.

6. Risk neutral for both agent and principal • All payoffs are assumed to be received at the terminal date t = 2 • No layoff and bankruptcy will occur throughout these two periods. • All discount rates are zero to simplify the notation. • Our model in essence is a one-period model with an interim period in which possible occurrence of repricing or rescission is anticipated by both parties. • The agent is compensated with stock options only. Assumptions

7. Homogeneous expectation: • p(H) = qm + (1-q)a = 1-p(L), where H = 1+u, L = 1-u • a  [0,1]is taken by the agent. • m [0,1]: the influence of external factors • q  [0,1]: the influence of agent's action on p(H) • To keep our focus on the issues motivating this paper, we assume that m and q are common knowledge between the principal and the agent. • Only the tax benefit (or liability) resulting from the new accounting rulings has an economic impact on firm value. • Exogenous probability (p ) of underwater options being repriced at node L (but both the principal and the agent have the same expectation about p.) • All options are granted at the money. Assumptions

8. Scenarios Do Nothing Repricing Rescission Repricing + Rescission fhh fhl HL HL HL + pca (1-HL) HL + pca (1-HL) flh LH LH fll LL LL + pca [ (1-L) + (LL-L) ] LL LL + pca [ (1-L) + (LL-L) ] The principal's expected share values at the terminal date. Model -Table 1 • BR ( = pca [ (1-L) + (LH-L) ] ) is the tax benefit resulting from the accounting charges associated with repricing, where pc is the corporate tax rate. • * Repricing occurs at node L; reset the exercise price to L for all a options.

9. Scenarios Do Nothing Repricing Rescission Repricing + Rescission whh a ( fhh - 1)* a ( fhh - 1) a ( fhh - 1) a ( fhh - 1) whl 0 0 0 0 wlh 0 a ( flh - L) 0 a ( flh - L) wll 0 0 0 0 The agent's terminal payoffs if initial a call options on firm's terminal value are granted. Model - Table 2 ** Note that personal taxes are ignored and the options are granted at-the-money (hence the exercise price is unity). ** Repricing occurs at node L; reset the exercise price to L for all a options.

10. Scenarios Do Nothing1 Rescission2 whh a( fhh - 1) - T a( fhh - 1) - T whl a( fhl - 1) - T 0 wlh 0 0 wll 0 0 The agent's terminal payoffs if initial a call options are exercised at node H Table 3 * Personal taxes are considered. * T = pca(H-1) is the tax liability (benefit) for the agent (principal). * fhh= fhl=

11. Scenarios Do Nothing1 Rescission2 HH fhh fhh HL fhl > HL + pc a (1- HL) 3 LH LH LH LL LL LL The principal's net terminal payoffs if initial a call options are exercised at node H. Table 4 * Personal taxes are considered. * T = pca(H-1) is the tax liability (benefit) for the agent (principal). * fhh= fhl=

12. Under the do-nothing strategy, the agent's best responses A(a) = {a, ah , al } are al = 0, (3.8) ah(a) = min{1, a (1-q)( fhh -1)/k }, a(a) = min{1, (1- q) Uh (a) / k } where fhh = (pc: corporate tax rate) Uh (a) = [ p(ah (a)) ][ a (fhh -1) ] - (1/2) k [a h (a)]2 Then the principal's expected initial payoff given W and A(a) is V(a, Vh ,Vl ) = p(a) Vh + [1- p(a)] Vl The principal's objective is to choose an initial grant, a*, to maximize his/her expected initial payoff, given the agent's compensation profile W and expected actions A(a) = {a , ah , al }. Model - Equilibrium under Do-nothing

13. HH= (1+u)2fhh whh P(ah) H [ ah ] P(a) HL= 1 - u2fhlwhl 1-P(ah) I [ a] LH= 1 - u2flhwlh P(ai) L [ al ] 1-P(a) LL= (1-u)2fllwll 1-P(ai) 7. Model - Figure 1 t = 0t = 1t = 2 Share ValueAgent's payoffs Figure 1. A two-period binomial model and distribution of terminal cash flows.

14. <1>Shareholders concern about: [1] why not penalize employees for poor performance or why they even reward employees' poor performance by repricing underwater options. [2]"If the company doesn't fare well, it completely undermines the purpose of an option plan to simply change the rules," said Eric Roiter, general counsel for Fidelity Management & Research Co.

15. <2>Employers or top executives concern about: [1] finding an effective way to attract and retain top talent. [2] boosting employees' morale. [3] protecting self interests

16. <3>Employees concern about: [1] having no money to pay tax bills and margin loans when the stock price plummeted. [2] "sell to cover"? [3] finding another job which pays "real" money. [4] At 40% of companies that issues stock options in 1999, those options were underwater in January 2001, according to TIAA-CREF

17. Reasons for Using Executive Stock Options [1] Align executives' interest with shareholders'. (However, with convex payoff structures, options have no value unless they are in-the-money.) [2] Attract and/or retain key employees (especially for cash-starved companies) [3] The only form of compensation that does not result in financial expense for the company. (Companies do not have to deduct the cost of options from their income, as they must for wages paid in cash.) [4] Tax deduction

18. Contributions • Lay foundation of evaluating repricingalternatives • Shed light on optimality of repricing whileconsidering dilution effects and tax effects. • Examine the optimality of rescission.

19. Conclusion • Repricing is indifferent, on average, from no-repricing in terms of the principal's expected initial payoffs.(see table) • Repricing loses its ex-ante dominance over do-nothing strategy as claimed by AJS after we incorporate dilution effects and the tax effects of new accounting rules associated with repricing.

20. Conclusion • The principal is, on average, better off in terms of expected initial payoffs under rescission than under a do-nothing policy.(see table 7) • Under rescission, we see little change on the principal`s initial incentive contract decision, a higher a*, and a slightly lower a*h(negative feedback effect).

21. Conclusion • Under some conditions, ESOs do indeed encourage agent`s risk-taking actions, even from an ex-ante viewpoint. • Estimate a wide range of agency costs.(see table 5)