Offsetting Compensation Reform: Lessons from the Demise of ESO Repricing

Abstract

Employee stock options go underwater when stock prices decline. Historically, firms responded by ``repricing,'' or lowering option strikes. Institutional investor hostility towards repricing as giveaways to underperforming managers led to a regulatory change that eclipsed repricing after 1998. We analyze the demise of repricing and uncover evidence of a strong Peltzman (1975) effect. Firms offset restrictions on repricing by squeezing out compensation through refresher grants, which turn out to be costlier than repricing. Thus, regulations lead to an offsetting response that creates additional deadweight costs. We explore why firms might rationally incur these costs. We find that the costs are best explained by a wedge between employee and firm valuation of equity incentives. We characterize the properties of the wedge implied by the deadweight costs and offer independent evidence from a tender offer for underwater options. We discuss the implications of our results for the design and reform of incentive compensation.