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...risky, negative NPV projects. Repricing may alleviate such incentives. I examine repricing activity by firms in the US gaming industry and find that risk-taking incentives from options are positively related to the incidence of executive option repricing. The results support the hypothesis that repricing assists firms in alleviating excessive risk-taking incentives of senior management.
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Until a change in US accounting standards, the practice of executive and employee stock option repricing was a common topic of scorn in the popular business press (e.g., Byrne, 1998). Recently, Bebchuk, Fried, and Walker (2002) argue that repricing is one consequence of managers exerting power over boards to extract excess rents from shareholders. Meanwhile, theoretic research, including Acharya, John, and Sundaram (2000), Ju, Leland, and Senbet (2002), and Saly (1994), has suggested that repricing stock options may serve as an optimal recontracting mechanism for firm shareholders. Overall, general disagreement exists among academics and practitioners as to whether repricing serves as a mechanism to enrich corporate executives or as a potentially useful tool in restoring proper incentives for managers and employees (as well as in avoiding unwanted turnover).
In this article, I use the continuing incentives argument presented by Acharya et al. (2000) as my motivation for this empirical study of the repricing decision. Although options provide managers with incentives to increase stock prices, options also add incentives to increase risk. Ideally, the incentive to increase risk should complement, rather than substitute for, the incentive to increase share value.
However, stock price changes alter the levels of these two incentives from options. Declining stock prices typically increase risk-taking incentives as a proportion of value-increasing incentives. If risk-taking incentives are high enough relative to the incentives to increase share price, then managers' option holdings may provide inducements to invest in risk-increasing, negative NPV projects. (However, in his 1999 study, Guay notes that if the manager also holds stock, this incentive will be partially offset by the lack of risk-taking incentives provided by the stock holdings.) This type of risk-shifting is similar in spirit to the Haugen and Senbet (1981) and Jensen and Meckling (1976) models.
Repricing of options with excessive risk-taking incentives is one of the recontracting mechanisms that can resolve the potential for such risk-shifting. Lowering the exercise price of existing options (or canceling existing options and immediately granting new options with lower exercise prices) should increase the incentives to increase share price, and under most circumstances, decrease the incentives to increase risk. Thus, if incentives from options become skewed because of high relative risk-taking incentives, repricing should realign option incentives toward the goal of share-price maximization.
The purpose of this article is to analyze the effect of risk-taking incentives on the incidence of executive stock option repricing. Prior empirical research on repricing does not explore the potential of such incentives as a causal factor of repricing. (1) Meanwhile, several papers in the hedging literature find evidence that managerial risk-taking incentives affect hedging behavior. (2) Additionally, the possibility of repricing in response to managerial incentives highlights the importance of "when firms reprice" in addition to the "why firms reprice" question principally addressed in several articles. (3) Because managerial incentives arising from company stock and option holdings change as stock price changes, they can be estimated immediately prior to the date of repricing. To test the hypothesis that managerial risk-taking incentives affect the repricing decision, I use a sample of the highest-paid executives employed at US casino gaming firms during 1993-1998.
During this time flame the gaming industry offers an excellent setting for a repricing study for several reasons. First, I find that stock price performance among casino gaming firms was very weak during 1994-1998 (see Figure 1). Across industry categorizations listed in the Compustat Research Insight database, between 1994 and 1998 the stock price performance of this industry group was 120th of 122 groups.
[FIGURE 1 OMITTED]
Second, I find that in almost all cases, some portion of the sample firms' options was out of the money, and that a majority of firms repriced executive stock options at some point during this period.
Finally, I find that, compared to each other, gaming firms face similar investment opportunity sets and hold similar assets in place. An obvious disadvantage to studying a single industry is that the results may not be generalizable to other industries. However, there are at least two offsetting advantages. One is that managers in the same industry should have similar abilities to impact returns (q in the Acharya et al. (2000) model). Additionally, firms in the same industry should be similarly impacted by external factors ([mu] in Acharya et al.).
Another advantage to the single-industry approach is that managers within the same industry are more likely to have similar opportunities to increase equity risk through operating, investment and financing decisions. To understand why this control is important, consider the following example. Two executives hold options with the same (high) risk-taking incentives. One executive is not capable of impacting equity risk, and the other can affect risk. If the firms recognize this disparity and if firms are concerned with alleviating excessive risk-taking, only the executive who can alter risk will be repriced. In this article, I assume that all executives named in proxy statements have the ability to affect equity risk.
I present evidence suggesting that managerial risk-taking incentives positively affect the decision to reprice. When I examine executives' portfolio holdings of company stock and options, I find that risk-taking incentive measures are statistically significant factors in explaining whether or not firms reprice stock options in a given year. My results are consistent with the hypothesis that managers whose incentives are less aligned with those of shareholders are more likely to have options repriced. This finding is consistent with the implications of Acharya et al. (2000), who argue that the benefit of repricing is to improve the manager's continuing incentives.
The article is organized as follows. Section I reviews the literature on option repricing. Section II provides background on the casino industry during the time of the study. Section III discusses the value-increasing and risk-taking incentives supplied by stock options and how I measure these factors. Section IV introduces my sample and summarizes the data on managerial risk-taking incentives. Section V examines the incentives of repriced firms and executives compared to those not repriced in multivariate analyses. Section VI concludes.
I. Review of Repricing Research
Theoretic models argue that including an option to reprice may be optimal in some instances. Acharya et al. (2000) show that, ex ante, the ability to reset option exercise prices provides more value to shareholders than does a compensation contract that requires no resetting. Saly (1994) shows that optimally, compensation contract renegotiation takes the form of lower exercise prices on existing option grants after a market downturn.
Until recently, empirical papers that focus on repricing have been limited by the lack of data availability prior to 1992 proxy statements. Gilson and Vetsuypens (1993) note that their sample of financially distressed firms often lowers exercise prices of existing executive stock options. They speculate that creditors may prefer repricing to ensure that managers do not engage in risk-shifting behaviors. Saly (1994) examines option grants around the 1987 stock market crash. She finds evidence that option grants increase after the price declines. She interprets her results as indicating that firms reprice options after a systemic decline in stock prices.
Several papers use the recently available data on repricing to analyze this choice. Chance et al. (2000) examine 37 firms (and 53 repricing events) that reset exercise prices on executive options during 1985-1994. They find that repricing follows poor firm-specific performance, and is more likely to occur in firms with greater agency problems.
Brenner et al. (2000) gather repricing data from 1992-1995 for 134 companies and 333 affected executives. They find evidence that firms reprice executive options after poor firm-specific performance. They also show that repricing may be a function of compensation committee conflicts.
Carter and Lynch (2001) compare a cross-section of 263 firms that repriced stock options in 1998 to a control sample of firms that did not reprice executive stock options, despite options being out of the money. They find that firms reprice in response to poor firm-specific performance, but find no evidence that industry performance causes repricing. They also find no evidence that repricing is related to agency problems.
Chidambaran and Prabhala (2003) analyze 213 firm-repricing events from the Execucomp database for 1992-1997. They find that repricing firms have relatively high CEO turnover rates and smaller boards. Additionally, CEOs are often not the beneficiaries of repricings because they have larger share holdings and fewer options. Overall, these authors conclude that repricing does not reflect entrenched management or weak governance.
Both Carter and Lynch (2001) and Chidambaran and Prabhala (2003) find repricing happens most often in high-technology industries. Their findings suggest that repricing serves as a retention tool in competitive labor markets.
None of the empirical papers cited above address the incentive effects associated with repricing. Acharya et al. (2000) argue that the optimality of providing an agent with a "repriceable" option occurs because the benefits from providing the agent with the "right" incentive after stock price declines are greater than the costs associated with the negative incentives provided at the time of the initial option grant.
Johnson and Tian (2000) analyze the initial incentive effects of a repriceable option grant. They illustrate that repriceable options offer lower (relative to Black-Scholes) incentives to increase the stock price, especially as the price falls below the exercise price. They also find that the incentives to increase volatility are greater (relative to Black-Scholes) for executives who hold repriceable options.
The principal contribution of this study is that it provides an examination of the effect of executive risk-taking incentives on the repricing decision. By using variables that proxy for "poorly aligned" incentives, I hypothesize that such incentives are positively associated with repricing.
II. Casino Industry, 1993-1998
The investment, operating, and financing environment of gaming firms between 1993 and 1998 could best be described as "turbulent." The period was characterized by significant revenue growth amid heavy capital spending, declining profitability, and the increased use of debt financing.
Casino gaming industry revenues grew substantially from $7.56 billion in 1989 to $26.29 billion in 1998 (see Rohs and Blaydes, 1999), a 14.8% compound annual growth rate. Native American and riverboat gaming markets generated most of this growth. Nevada, the state synonymous with gambling, saw its share of gaming revenues decline from 62.9% in 1989 to 30.7% in 1998, while riverboat and Native American markets contributed 27.7% and 26.2%, respectively, in 1998 (Rohs and Blaydes, 1999).
The growth in industry revenues during this time frame occurred because of high levels of investment by casino gaming firms. Table I...
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