Contract Renegotiation and the Optimality of Resetting Executive Stock Options

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 manager under which this is always 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 for 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.

JEL Classification: G31, G32, G34