Contract Renegotiation and the Optimality of Resetting Executive Stock Options

43 Pages Posted: 31 Dec 1998

See all articles by Viral V. Acharya

Viral V. Acharya

New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance

Kose John

New York University (NYU) - Department of Finance

Rangarajan K. Sundaram

New York University (NYU) - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: December 1998

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

Suggested Citation

Acharya, Viral V. and John, Kose and Sundaram, Rangarajan K., Contract Renegotiation and the Optimality of Resetting Executive Stock Options (December 1998). Available at SSRN: https://ssrn.com/abstract=142665 or http://dx.doi.org/10.2139/ssrn.142665

Viral V. Acharya

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Kose John

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0337 (Phone)
212-995-4233 (Fax)

Rangarajan K. Sundaram (Contact Author)

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0308 (Phone)
212-995-4233 (Fax)

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