The Role of Proxy Advisory Firms in Stock Option Exchanges

Transcription

1 The Role of Proxy Advisory Firms in Stock Option Exchanges Allan L. McCall Graduate School of Business Stanford University January, 2011 I thank the Rock Center for Corporate Governance and Compensia, Inc. for providing a portion of the data used in this paper. I am grateful for the expert guidance of Dave Larcker and Gaizka Ormazabal in executing this project, and also for helpful comments of Ron Kasznik and Anne Beyer.

2 The Role of Proxy Advisory Firms in Stock Option Exchanges Abstract: This paper examines whether the voting policies of proxy advisory firms cause firms to change the design of compensation programs, and, if so, whether such changes increase or decrease shareholder value. To do so, I examine stock option exchanges. Due to recent changes in the regulatory environment, this new recontracting scheme is more subject to the influence of proxy advisory firms than the traditional repricing. I find that firms adopting stock option exchanges that follow more closely the proxy advisory firms recommendations exhibit a less positive market reaction at the announcement of the transaction, lower increases in return on assets, and higher executive turnover. Consistent with the notion that insiders anticipated these results, I also find cross-sectional differences in the insider trading activity during the six months previous to the exchange. Overall, my results suggest that the recommendations of proxy advisory firms on stock option exchanges are not value increasing.

3 1. Introduction Over the past decade, institutional investors have increasingly disambiguated the decision making process for making firm-specific investments and casting votes on shareholder ballots for the firms in which they have invested. In many institutions, the investment managers who make the decision to buy or sell shares, and who also regularly communicate with management through earnings calls and investor conferences and conduct firm specific research, have no ability to influence their institution s vote on a shareholder proxy. Some institutional investors subscribe to third party proxy advisory services to supplement or outsource the process of determining votes on shareholder ballots. Others maintain separate internal departments that determine voting policies. Regulatory changes in recent years have substantially increased the influence of proxy advisory firms on the proxy voting outcomes of public companies. Two changes in particular, revised exchange listing requirements for the NYSE and NASDAQ and the SEC s implementation of mutual fund voting disclosure rules have combined to, respectively, increase the relative influence of institutional investors on the voting outcomes for equity compensation plan proposals and to increase the influence of proxy advisory firms on the voting behavior of mutual funds. To date, however, the incentives of the proxy advisory firms remain unclear and there has been very little research into the impact of their voting recommendations on shareholder value. Potential conflicts between shareholder and proxy advisor interests have been well documented (see, for instance, Davis et al. (2009)). The proxy advisory firms websites and disclosure materials contain detailed descriptions of their potential conflicts of interest as well as policies and practices implemented to mitigate these conflicts, and they claim that their shareholder voting recommendations are developed with focus solely on the best 1

4 interests of investors 1. On the other hand, critics argue that, in addition to potential conflicts, proxy advisors practice of applying a single set of policies across all firms, without considering the facts and circumstances unique to each firm leads may lead to voting recommendations that are not aligned with shareholders best interests (NIRI, 2010). The purpose of this paper is to examine whether the voting policies of proxy advisory firms cause corporations submitting proposals to shareholders to change the design of compensation programs, and, if so, whether such changes increase or decrease shareholders value resulting from the program. The need for research on the role of proxy advisors has been recognized by regulators, including SEC Chairwoman Mary Schapiro who noted that the SEC will be examining the role of proxy advisory firms. Both companies and investors have raised concerns that proxy advisory firms may be subject to undisclosed conflicts of interest. In addition, they may fail to conduct adequate research, or may base recommendations on erroneous or incomplete facts. 2 My study examines the role of proxy advisors in the context of the specific transaction of underwater stock option exchanges and repricings 3, in which firms replace underwater stock options (options with a strike price that is greater than the current stock price) with new awards of either options, restricted stock or cash. I restrict my investigation to the specific transaction of stock option exchanges because it is a relatively simple, one-time plan to evaluate. Compared to equity incentive plans, which typically live for up to 10 years and overlap with prior and subsequent plans, stock option exchanges are one-time transactions that are reasonably well defined and have a consistent range of possible implementation attributes. Further, there is Speech by Mary Schapiro, from NACD Directorship Magazine, Dec. 2010/Jan. 2011, p The term repricing and exchange are often used interchangeably. Historically, the transactions designated as repricings have been a subset of the transactions we call exchanges, we use the term repricing to mean a transaction in which the strike price of an outstanding stock option is reduced, and exchange to mean a transaction in which an underwater option is replaced with any new award, including stock options with lower exercise prices (i.e. repricings). 2

5 variation across the firms in the structure of their exchange programs as well as their exposure to the third-party proxy advisors, which allows us to examine the performance implications of various aspects of the plan designs. Lastly, the requirements of the proxy advisory firms are relatively clear and can generally be viewed as constraints on possible program designs, for instance they require that officers and directors be excluded from the exchange and that any new awards granted may not have a value greater than the value of the awards cancelled, and whether firms design their plans to meet these criteria is visible in the SEC filings, providing a relatively clear platform for examining the impact of the proxy advisors structural requirements. I examine the performance implications of constraints imposed on the exchange programs by the proxy advisory firms. Because these constraints are applied across-the-board to all firms proposing option exchanges, rather than being tailored to a company s specific circumstances, I hypothesize that, where these constraints prevent firms from adopting an unconstrained optimal exchange program, the benefits of the program will be reduced. I find that across the measures of program value examined, stock price reaction to plan implementation, operational performance, executive turnover and insider trading, the results are consistent with the constraints imposed by the proxy advisory firms policies being valuedecreasing for firms that implemented an exchange program. My findings also extend the stock option repricing literature to the setting of stock option exchanges, providing evidence that these transactions are optimal recontracting between the firm and employees rather than rent extraction on the part of entrenched management. The remainder of this paper proceeds as follows. Section 2 discusses the institutional background and related literature, and develops the hypotheses. Section 3 describes the sample and measurement choices. Section 4 reviews my results. Section 5 provides concluding remarks. 3

6 2. Institutional background, literature review and hypotheses development 2.1. The influence of proxy advisory firms on stock option recontracting Two recent changes to the shareholder monitoring environment have increased substantially the influence of proxy advisory firms on option recontracting: the 2003 changes in stock exchange listing requirements, and the 2003 requirement for mutual funds to disclose their voting on all shareholder proposals. First, in 2003, both the NYSE and NASDAQ changed their listing requirements to require that any new equity compensation plan 4, or any material modification to an equity compensation plan receive shareholder approval. Unless the ability to reprice or exchange stock options was explicitly provided for in a shareholder approved plan, such a transaction was considered a material modification and required shareholder approval. Explicit authority to conduct an exchange is generally opposed by proxy advisory firms, so firms with this provision tend to be those with plans that were approved prior to the changes, or those with less exposure to proxy advisory recommendations. For instance, plans approved by shareholders prior to a firm s IPO do not receive opinions from proxy advisory firms, and many include the authority to conduct an exchange. The listing requirement also changed to require firms to consider proposals regarding equity incentive plans as non-routine, which meant that shares held in street name which were not directed by the owner could not be voted by the broker (broker nonvotes) on these matters. Prior to this, broker non-votes were routinely cast in favor of equity compensation plan proposals. Because retail investors frequently do not vote their shares, this 4 There are some minor exceptions to the shareholder approval requirement that are not relevant to our setting of stock option exchanges. 4

7 change further concentrated the weight to institutional investor votes in the approval of stock plans and stock option exchanges 5. Also in 2003, the SEC implemented a requirement for mutual funds to disclose their voting on all shareholder proposals, as well as the policies and procedures used to determine the vote. One of the SEC s objectives was to reduce conflicts of interest between financial services firms operating mutual funds and the funds shareholder interests (SEC, 2003). As a result many mutual funds began to weigh more heavily, and in some cases exclusively, the recommendations of third party proxy advisory firms, such as Institutional Shareholder Services (ISS) and Glass- Lewis (Ng et al., 2009), when the mutual funds might be perceived to have conflicts of interest arising from other business dealings with the corporations. Rothberg and Lilien (2006) and Davis and Kim (2007) investigate conflicts of interest in mutual fund voting after implementation of the voting disclosure rules and do not find any evidence of conflicts under the new rules. However, because voting records are unavailable prior to the disclosure rules, they can not determine whether conflicted voting existed prior to the rules. A second objective of the new disclosure requirements was to encourage mutual funds to become more active in monitoring firms through the proxy voting mechanism (SEC 2003). Cremers and Romano (2009) investigate mutual fund voting behavior before and after the disclosure rules and conclude that mutual funds are not more likely to vote against management subsequent to the rules, however they acknowledge that endogeneity in the decision to submit a matter to shareholders and the shareholder vote may confound their results. Consistent with mutual funds efforts to separate the voting decision from other potential conflicts, anecdotal evidence from managers and professionals indicates that, subsequent to the changes to the mutual fund voting disclosure rules, the ability of the mutual fund investment 5 As an example of the impact of this rule change, in our sample the average broker non-votes represented 18% of the shares eligible to vote in the meetings we examined. 5

8 managers to influence the fund s voting decreased dramatically. Because many investment firms either walled-off the proxy voting process from the investment managers or outsourced it completely to third party proxy advisors, businesses were unable to make their case or provide context to shareholders around the proposed programs. As a result, firms with exposure to this third-party monitoring regime were generally forced to design plans to meet their approval guidelines or risk non-approval. Firms that were not required to submit an exchange program directly to shareholders for approval still had to consider potential indirect shareholder feedback through director elections or voting on other management proposals, such as equity compensation plans. Research into the voting recommendations of proxy advisors has been limited. Choi et al. (2009) examine the role of proxy advisors in uncontested director elections and find significant differences between the likelihood of issuing a withhold recommendation between four proxy advisory firms 6 in 2005 and Further, they find that the determinants of withhold votes were different across the various advisors. This raises the question of whether subscribers to the respective services understand how recommendations are developed given that the differences in the algorithms is not made public by the firms. Alexander et al. (2010) examine the effect of ISS voting recommendations on contested director elections, and conclude that an ISS recommendation in favor of the dissident slate can serve as both an indicator for the likelihood that the dissident slate is elected, and as a certification of the value of the dissidents to shareholders. The setting of contested elections, however, is quite different from that of stock option exchanges, particularly as it relates to ISS. ISS has a separate research team for evaluating contentious M&A transactions and proxy contests. This team will also engage in active dialog with the interested parties, including the firm, the dissidents and significant 6 The four firms examined were ISS, Glass Lewis, PROXY Governance and Egan Jones. 6

9 investors as part of the recommendation determination process (Winter 2010). This contrasts with the process of evaluating stock option exchanges, in which the proposed programs are compared to a rigid set of guidelines that are applied across all companies, and direct input from interested parties is not sought. Other research on proxy advisors that is relevant to my study include Bhagat et al. (2007), who examine various indices of corporate governance, including those provided commercially by subscription, and conclude that the process of using fixed rules to convert governance into a single measure does not reflect the flexible regulatory regime of corporate governance in the U.S. Daines et al. (2010) extend this work and show that there is little useful information for shareholders in governance ratings and they show that there is also little relation between the governance ratings of ISS and their proxy voting recommendations. Lastly, Belinfanti (2009) examines agency concerns in the interaction of ISS and shareholders from a legal perspective and concludes that the relationship between ISS and institutional shareholders as it stands, does not provide appropriate incentives to ISS to act in the best interests of investors because they bear no risk resulting from bad recommendations and benefit from high barriers to entry in the proxy advisor market Changes in the accounting treatment of stock option recontracting The accounting treatment of option recontracting can be classified in three periods: the period prior to 1999, the period from 1999 to 2005, and the period from 2005 to present. I next discuss institutional features and related research in these three periods. Prior to 1999, transactions were commonly implemented as straight repricing in which the strike price of outstanding underwater stock options was unilaterally reduced to the current market price or a slight premium to the current market price. Direct disclosure in this time 7

10 period was driven primarily by the SEC s 1992 proxy disclosure rules which required a repricing to be disclosed in the proxy statement for ten years if the repricing transaction involved named executive officers (NEOs). However, if NEOs did not participate in the transaction, it might not have to be explicitly disclosed and identifying such transactions was difficult. Straight repricings were favored in these transactions because (a) the accounting was favorable as long as the new exercise price was greater than or equal to the stock price when the transaction occurred, there was no charge to earnings as a result of the transaction, and (b) as long as the transaction was unequivocally beneficial to the option holder (e.g. a reduction in the strike price with no other change to the terms of the contract), the transaction could be executed without the option holder s approval, and more importantly, without requiring a formal tender offer to be filed with the SEC. Stock option repricings in the period before 1999 were controversial. Critics argued that option repricings were mechanisms used by entrenched managers to extract rents from shareholders by reducing the downside of their contracts. In support of this hypothesis, Brenner et al. (2000) find a negative relation between firm performance and repricing activity, and Chance et al. (2000) find repricings to be positively associated with insider-dominated boards and proxies for agency problems. Alternatively, Acharya et al. (2000) argue that allowing some exchange of underwater stock options is almost always ex ante optimal relative to a commitment to not adjust initial contracts after they have gone underwater. Consistent with this idea, Carter and Lynch (2004) find that repricing leads to lower non-executive turnover, and Aboody et al. (2010) show that firms that exchange underwater options have larger subsequent increases in operating profits and cash flows. Grein et al. (2005) document that Canadian firms that reprice between 1994 and 2001 have significantly positive market adjusted returns around the announcement. Also, Chidambaran and Prabhala (2003) find that repricing firms have 8

11 abnormally high CEO turnover, and that 40% of repricing firms in their sample exclude the CEO from the transaction, which is inconsistent with the entrenchment hypothesis. Effective for fiscal years beginning on or after December 15, 1998, FASB revised its interpretation of the most commonly used standard for accounting for stock options (APB 25). The new interpretation was that either a repricing, or a cancellation and re-grant of outstanding stock options within a short period would lead the award to be deemed variable rather than fixed accounting treatment under APB 25, and would therefore result in a charge to earnings (stock options did not otherwise result in a charge under APB 25). 7 It was ultimately determined that a short-period was six months, leading to what have been termed 6+1 or 6-months-anda-day repricing. 8 Because a tender offer was generally required to execute the repricing (the transaction was not unequivocally beneficial to the option holder), firms began to consider exchanges in which fewer shares were promised in return, or in which additional vesting conditions were attached to the new awards compared to the original options. However, stock options remained the predominant award currency as firms desired to maintain the favorable accounting treatment of stock options over other alternatives. Coles et al. (2006) show that the timing gap between the cancellation of old options and the granting of new awards under 6+1 repricing transactions created incentives for firms to depress their stock price prior to the reissuance date by reporting abnormally low discretionary accruals in the period following announcements of cancellations of executive stock options up to the time the options are reissued. 7 Carter and Lynch (2003) document that repricing increases during and decreases after, the announcement and effective dates of this change in the accounting standards. 8 In a 6+1 repricing, employees agree to have some or all of their underwater stock options cancelled, and in return, are granted new options at the then-current market price six months and one day after the original options are cancelled. As long as the new award is in stock options, the 6+1 transaction maintains the no accounting charge treatment of the original awards. 9

12 In 2005, FASB required public companies to adopt FAS 123R. The new standard required that the grant date fair value of all equity awards be recognized as stock-based compensation expense, and in the case of modifications to awards (which covers exchanges), any increase in fair value of the awards on the date of the modification must also be recognized. Choudhary et al. (2009) show that, in the months previous to the introduction of FAS 123-R, several firms accelerated the vesting of stock options to avoid recognition of unvested stock options at fair value. However, the literature is silent about the effect of the new accounting standards on stock option recontracting Option exchanges and the role of proxy advisory firms The recent changes in the shareholder monitoring environment and the accounting standards made the traditional option repricing impractical, and gave rise to a new type of recontracting, known as option exchanges. These new transactions incorporate important cross-sectional differences in the recontracting process that did not exist or were not observable in the traditional repricing transactions examined by previous research. 9 Specifically, these new option exchanges vary cross-sectionally along the following dimensions: option eligibility what options are eligible to be exchanged in terms of (1) their exercise price and (2) the issuance date; (3) exchange value the value of the awards offered in return for tendered options (relative to the value of the tendered options); (4) treatment of cancelled shares are the shares forfeited in the exchange transaction available for future equity grants; (5) vesting schedule of the awards offered in exchange for tendered options; (6) participation - who is eligible to exchange options; 9 An additional factor effecting the design and execution of exchange programs are the tender offer rules. Generally speaking, unless a firm simply reduces the exercise price, without changing any other terms of the outstanding underwater options, or limits participation to a small group of employees (5-10), an exchange program must be executed through a tender offer. Under the tender offer, employees may choose whether or not to participate in the exchange program. Also, tender offers require timely filing of all relevant communications, enhancing our ability to identify the dates these programs become public knowledge. 10

13 and (7) exchange currency what type of award is offered in return for tendered options; Appendix C shows two examples of stock option exchanges. Because proxy advisory firms have stated policy positions on all of these characteristics except for the exchange currency (see appendix B), this setting allows us to assess the consequences of following proxy advisory firms recommendations. In addition, analyzing option exchanges also sheds light in the debate on the optimality of recontracting in the context of executive and employee compensation. The null hypothesis for this study is that third party advisory firms are unbiased representatives of shareholder interests, and that their policies protect shareholders from inappropriate programs on the part of entrenched management. This is well summarized in ISS s stated mission of Enabling the financial community to manage governance risk for the benefit of shareholders 10. In the context of stock option exchange programs, if the null hypothesis is true, I expect that firms implementing exchange programs that are more aligned with the policies of the proxy advisory firms will result in better firm performance than programs that are not well aligned with the policies. Alternatively, the proxy advisory firms incentives may not be perfectly aligned with shareholders interests. In particular, it is possible that the advisory firms are motivated to design policies that are more restrictive than is optimal in response to incentives such as the generation of consulting revenue or to demonstrate vigilance to subscribers and politicians. If the alternative hypothesis is true, management may be restricted from implementing an optimal exchange program, leading to worse firm performance for firms that comply with proxy advisory firms policies. 3. Sample and measurement choices

14 3.1. Data and Sample Construction My primary sample includes 272 that initiated stock option exchanges between December 2004 and December My primary data source is data collected by Compensia, Inc., a leading executive compensation consulting firm. Firms in the Compensia database were identified using searches of firm SEC filings, press relations and professional contacts. The data includes the date of the exchange, program design details which I use to identify the individual components of compliance with proxy advisory firm policies (except for restrictions on share usage, which I collect separately), and the outcome of the shareholder votes where applicable. I cross-referenced the list of firms identified by Compensia with a list of firms published by Radford, another compensation consulting firm, and identified six additional firms for which I hand collected the relevant data from each firm s SEC filings. In addition to the data collected by Compensia, for each firm I collect four dates: (i) the date of the first disclosure related to the option exchange, (ii) the date the program was approved by shareholders or the board of directors, (iii) the date the exchange program was actually implemented, and (iv) the date the exchange program was closed. Lastly, for each firm that submitted a plan to shareholders, I identify whether firms implemented additional restrictions on the use of shares cancelled in the option exchange program. I collect data on daily stock returns from the CRSP Quarterly Update daily stock file and accounting data from Compustat. The intersection of these datasets results in 251 firms and 264 exchange transactions. Additionally, the empirical tests require data on institutional ownership. Data on institutional ownership are collected from the Thomson-Reuters database of 13-F filings, also known as CDA/Spectrum. The Spectrum data file contains information on quarterly 12

15 institutional holdings for all institutional investors with $100 million or more under management. Requiring institutional ownership data does not induce further sample attrition. Executive turnover is measured using data from the BoardEx database, maintained by Management Diagnostics Ltd. The database collects information on all firm executives that can be confirmed in publicly available sources, including employment start date and end date, which I use to identify turnover Descriptive Statistics Table 1 provides descriptive statistics for the sample of firms conducting exchanges. Panel A shows the distribution of firms conducting exchanges by year and industry. Examining the industry distribution, it is clear that the firms conducting exchanges have been concentrated in technology firms. In general, technology firms rely on stock options more heavily as a component of compensation, and use them more broadly across the organization than firms in other industries. The distribution by year shows a noticeable increase in the transactions in 2008 and 2009, mirroring the sharp decline in general market price levels in conjunction with the financial crisis. Panel B of Table 1 provides some characteristics of the firms conducting exchanges. My sample of 264 firms is comprised of 116 firms (43.9%) that implemented the plan without shareholder approval, and 148 firms (56.1%) that sought shareholder approval for their exchange program. The second section of Panel B shows restrictions on the exchanges implemented by the sample firms. On average firms not requiring shareholder approval implemented plans with 2.95 restrictions compared to 3.58 for firms that sought shareholder approval. With the exception of the IssuanceDate restriction, the prevalence of every restrictive component was higher for firms requiring approval than for those that did not. In the third section of Panel B, I 13

16 can see that the average percentage of options that are eligible for the program, as well as the percentage that are actually exchanged are slightly higher for firms without shareholder approval. Of particular note is the time period from inception to close. While this transaction is generally not something that is done quickly even for firms not requiring shareholder approval, where the average transaction took days to complete, the additional burden of shareholder approval more than doubled the length of the time to complete the transaction to an average of days. Panel B also shows that the number of cases where the exchange was finally not implemented is higher among exchanges requiring shareholder approval. Panel C provides distributional statistics for the control variables between those requiring shareholder approval and those who do not. In general, the two groups exhibit relatively similar characteristics, although firms requiring shareholder approval are more leveraged and experienced lower returns than those not requiring shareholder approval Measurement of the restrictiveness of the exchange plan As explained in section 2, as a result of the new regulatory setting, boards of directors face constraints in the design of stock option exchanges that did not exist in the repricing transactions of the nineties. In particular, if a firm follows the recommendations of proxy advisory firms to ensure that the stock option exchange plan will obtain shareholder approval, the result will be transactions that are more restrictive than traditional repricing. Because the influence of proxy advisory firms is not homogeneous across firms, it is possible to observe cross-sectional variation in the restrictiveness of stock option exchange plans. I measure the restrictiveness of the plan using the six criteria used by proxy advisory firms to issue voting recommendations regarding stock option exchanges (see Appendix B). Specifically, I construct six indicator variables that measure whether the stock option exchange 14

17 plan is constrained along each of the six dimensions. PriceFloor equals 1 if there is a price floor restricting the exercise price of eligible options to be strictly greater than and 0 otherwise. IssuanceDate equals 1 if the exchangeable options are only those issued before or after a certain date and 0 otherwise. ValueforValue equals 1 if it is a value for value exchange and 0 otherwise. ShrRestr equals 1 if the proposal restricted the use of cancelled shares, 0 otherwise. Vesting equals 1 if there is an extension of the vesting period for the new options and 0 otherwise. Eligibility equals 1 if officers or directors are excluded from the program and 0 otherwise. To measure the restrictiveness of the exchange program, I construct the variable Restrictive as the sum of the previous six indicator variables. Thus, Restrictive measures the number of restrictions in the plan, and ranges from 0 to 6. A higher value of Restrictive indicates that the exchange program more closely aligns with proxy advisory firm policies. For firms whose plans require shareholder approval, the data from Compensia, Inc. includes an assessment of whether the exchange plan is compliant with Risk Metrics recommendations. Based on this information, I construct an indicator variable, RMCompliant, that takes the value of 1 if the stock exchange plan is compliant with ISS 11 recommendations and 0 otherwise Empirical tests 4.1. Economic determinants of stock option exchange programs My first set of tests investigates whether the economic determinants of exchange programs in the period after 2005 are consistent with findings of prior research on exchanges in earlier periods. I use logistic regression to evaluate the cross-sectional determinants of initiating 11 In 2007 ISS was acquired by RiskMetrics Group (RMG), and its services were branded under the RiskMetrics. In 2010, RMG was aquired by MSCI, and the original ISS business was rebranded as ISS. Throughout this paper, references to ISS and RMG refer to the original ISS business. 12 Compensia does not assess whether exchange plans that do not require shareholder approval are compliant with Risk Metrics criteria because they are, per ISS polices, not compliant by not having submitted the matter to shareholders. 15

18 an exchange program. I examine each exchange transaction against all other firms in the exchanging firm s Fama-French industry group in the year of the exchange initiation for which all of the variables in the specification are available. Specifically, I estimate the following logit regression: Exchange = δ 0 + δ 1 Controls + δ 2 Options + δ 3 Ninstit + δ 4 Prob(RM dgrmt) + δ 5 Nactivists + δ 6 BoardCharact + δ 7 TotalComp + ε. (1) Exchange is a dichotomous variable equal to 1 if the firm initiated an exchange in fiscal year t, and 0 otherwise. Controls is a vector of control variables found in previous literature to be associated with characteristics of compensation contracts and repricing of stock options (Core and Guay, 1999; Core et al., 1999; Carter and Lynch, 2001), including Size, BM, Leverage, ROA, IdVol and Beta. Size is the natural logarithm of the market value of equity (in millions). BM is the book to market ratio. Leverage is total liabilities divided by total assets. ROA is net income divided by total assets. IdVol is the annualized idiosyncratic volatility over the prior fiscal year and Beta is the firms market beta. PastReturn is the stock return over the previous fiscal year. IndustryRet is the annually compounded median stock return of all the firms in the same 2-digit SIC code over the previous fiscal year. Because a firm that is more reliant on stock option compensation will have greater incentive to conduct an exchange, I also include a measure of the extent to which the firm uses stock options in its compensation contracts. In particular, Options is calculated as the total number of stock options outstanding at the end of the fiscal year, scaled by total shares outstanding. Ninstit is the number of institutions holding shares in the firm, this is used as a measure of the intensity of shareholder monitoring in the firm and the potential influence of proxy advisory firms voting recommendations. 16

19 I also develop a more refined measure of the influence of ISS voting recommendations for each firm. I use data from the RiskMetrics Voting Results database and, for each firm, I compute Prob(RM dgrmt) as the probability of institutional shareholders following the ISS vote recommendation conditional on existing disagreement between management s recommendation and the ISS vote recommendation. 13 Thus, Prob(RM dgrmt) is the probability that management loses the vote if ISS opposes the proposal. I are able to compute this measure for 178 firms in the sample. Because doing a stock option exchange is a decision of the board or directors, equation (1) also include variables widely used in the corporate governance literature. Nactivists is the number of activist investors as defined by Cremers and Nair (2005). BoardCharact is a vector of characteristics of the firm s board of directors: ChairOutsider is a dichotomous variable equal to 1 if the chairman of the board is an outside director, 0 otherwise; PctIndDir is the percentage of directors on the board that are independent (as captured by Equilar); and Nbusy are the number of busy directors, defined as the number of outside directors who serve simultaneously on at least two boards. Lastly, because higher levels of compensation could indicate managerial entrenchment, I include TotalComp as the average total compensation of the executives in the proxy statement, as computed by Equilar. 13 RM stands for Risk Metrics and dgrmt for disagreement. Specifically, Prob(RM dgrmt) is computed as ( ) Pr( dgrmt ) Pr RM dgrmt using voting data on all the shareholder proposals during the three fiscal years previous to the stock exchange, where RM is equal to 1 if the vote outcome was the same as the ISS recommendation, and dgrmt is equal to 1 if the ISS recommendation is not the same as the management recommendation. The results are not sensitive to the estimating this probability using two or four years. In 56 of the firms we do not find cases of disagreement between management and ISS s voting recommendations. For those firms, we take the unconditional probability of investors voting following ISS s recommendations. Excluding these 56 firms from the analysis or using for all firms the unconditional probability of investors voting following ISS s recommendations leads to similar inferences. Also, the inferences do not change when we estimate Prob(RM dgrmt) weighting the number of funds that each institution has in the firm. 17

20 Table 2, panel A, shows results using three different specifications based on equation (1). 14 Consistent with previous literature related to option repricing, I find that option exchanges are concentrated among firms and industries with poor past performance (in model 1 the t-stats. of the coefficients on PastReturn and IndustryRet are, respectively, and -7.37), and significant use of options in compensation contracts (in model 2 the t-stat. of the coefficients on Options is 10.83). In other words, exchangers tend to be firms with a significant number of underwater options. Panel A also shows that exchangers have higher idiosyncratic and systematic risk (in model 1 the t-stats. of the coefficients on IdVol and Beta are, respectively, 2.27 and 2.67). The results of model 2 show that Prob(RM dgrmt) is not associated with the introduction of option exchanges, perhaps suggesting that firms whose voters are more influenced by proxy advisors simply adjust their program to assure approval rather than not pursuing an exchange program. Finally, model 3 reveals that exchanging firms have fewer institutions in their ownership structure (the t-stat. of the coefficient on Ninstit is -2.15), executives with higher levels of pay (the t-stat. of the coefficient on TotalComp is 2.31), and fewer independent directors on their boards (the t-stat. of the coefficient on PctIndepDir is ), suggesting that the adoption of these exchange programs is associated with weaker governance. Next I evaluate the determinants of exchange program restrictions. Specifically, I estimate the following ordered logistic regression: Restrictive = δ 0 + δ 1 NotImplemented + δ 2 ApprovalReq + δ 3 Prob(RM dgrmt) + θ Controls + ε. (2) 14 We use three different specifications because some of the independent variables have a significant number of missing values. 18

21 Restrictive is defined in section 3.3, and measures the restrictiveness of the stock option exchange plan. NotImplemented equals 1 if the stock option exchange plan was never fully implemented by the firm, and 0 otherwise. ApprovalReq is a dichotomous variable equal to 1 if the firm submitted a proposal to shareholders for approval of the plan, and 0 otherwise. Submitting a proposal to shareholders provides shareholders (and therefore proxy advisors) with a direct mechanism to influence the exchange program. I predict that management will design a more restrictive plan if shareholder approval is required in order to ensure that the plan is passed (i.e. the coefficient will be positive). Prob(RM dgrmt) is as in equation (2). I predict that firms in which ISS has greater influence on voting outcomes will design more restrictive plans, therefore the coefficient will be positive. Controls is the vector of control variables described in equation (1). The first set of columns of table 2, panel B, presents the results of estimating equation (2). The positive coefficients of ApprovalReq and Prob(RM dgrmt) (t-stats.of 5.14 and 2.46) suggest that firms where the exchange plan has to be approved by shareholders and where proxy advisory firms have more influence are more likely to introduce restrictions in their exchange programs. As noted in section 2, it is not necessarily the case that a firm requires shareholder approval to conduct an exchange. If the firm s equity incentive plan (as approved by shareholders) permits an exchange program without shareholder approval, it can be executed with only approval of the board of directors. I expect that plans are more likely to contain this provision if they were approved by shareholders at a time when proxy advisory firms had less influence on a firm s voting outcomes. To explore the determinants of requiring shareholder approval for the stock exchange plan, I estimate the following equation using logistic regression: 19

22 ApprovalReq = δ 0 + δ 1 NotImplemented + δ 2 Prob(RM dgrmt) + δ 3 EIPlandate + θ Controls + ε. (3) The variables ApprovalReq, NotImplemented, Prob(RM dgrmt) and Controls are as in equations (1) and (2). EIPlandate is a dichotomous variable equal to 1 if the most recently approved equity incentive plan in effect at the time of the exchange was approved by shareholders either prior to 2003, or prior to an IPO, and zero otherwise. Prior to 2003, the changes in the shareholder monitoring environment had not taken place, providing firms with greater ability to implement equity incentive plans that did not meet the requirements of proxy advisory firms. Also, plans approved by shareholders prior to IPO (i.e. while the firm is private) are generally not covered by the proxy advisory firms. The variables of interest are Prob(RM dgrmt) and EIPlandate. Because the proxy advisory firms will generally vote against stock plans that permit exchange programs without shareholder approval, I predict that ApprovalReq will be increasing in Prob(RM dgrmt). I predict that the coefficient on EIPlandate will be negative, as those firms with older plans would have been more likely to get approval of a plan that allows an exchange without a shareholder vote. The second set of columns of table 2, panel B, presents the results of estimating equation (3). The positive coefficients of Prob(RM dgrmt) (t-stat. = 2.46) suggest that firms where proxy advisory firms have more influence are more likely to require shareholder approval in their option exchange programs. Panel B also reveals that the likelihood of requiring shareholder approval for option exchanges is lower in firms with older equity plans, approved before the change in regulatory setting (the t-stat. of the coefficient on EIPlandate is -2.35). Lastly I examine whether the restrictiveness of the plan is associated with the percentage of total outstanding stock options that are eligible for the exchange program and the percentage 20

23 of eligible options that are actually exchanged. If the restrictions significantly limit the choice set of the board and the employees, I predict a negative relation between the restrictions and the dependent variables. I estimate the following equations using a double censored tobit regression: PctEligible = δ 0 + δ 1 Restrictive + δ 2 NotImplemented + θ Controls + ε. PctExchanged = δ 0 + δ 1 Restrictive + θ Controls + ε. (4a) (4b) All of the explanatory variables are as described previously. PctEligible is the number of stock options that are eligible for the exchange program, divided by the total number of stock options outstanding at the start of the exchange. PctExchanged is the total number of stock options that were tendered in the exchange, divided by the number of stock options eligible for the exchange. For both tests, I predict that the coefficient δ 1 is negative. Table 3, panel C, presents the results of estimating equation (4a) and (4b). The negative coefficients of Restrictive (t-stats. of and in equations (4a) and (4b), respectively) confirms that more restrictive plans translate into fewer options available to exchange and lower participation, which is consistent with the proxy advisor requirements meaningfully limiting the exchange program design Market reaction to stock option exchanges In the option repricings of the nineties, U.S. firms typically only disclosed repricings in their form 10-K or, if executive officers participated, in proxy statements months after the actual repricing date. In contrast, in the new regulatory setting, option exchanges generally require immediate filings (such as proxy statements, tender offer filings and/or 8-K filings), thus making possible to isolate the market reaction to the introduction of exchange programs, and test the value implications of these recontracting mechanisms. If stock option exchanges represent an optimal recontracting transaction resulting in improved incentives, and if the restrictions related 21

24 to the influence of proxy advisory firms prevent boards from implementing the program that would have been optimal in the absence of these restrictions, the market reaction to the introduction of exchange programs will be negatively correlated with those restrictions. On the other hand, if unrestricted stock option exchanges are an avenue for rent extraction on the part of managers, restrictions imposed by proxy advisors should have a positive relationship with expected future cash flows and therefore be positively associated with returns. I test the market reaction to stock option exchange programs over the period from the first announcement of a program (Inception date) to the close of the exchange offer (Close date), I refer to this time frame as the exchange period. I use the entire exchange period because some uncertainties regarding the plan are resolved at different times. For instance, for plans that are submitted to shareholders, the plans must be approved by shareholders, and also, conditional on approval, the board of directors must decide to implement the program. Because the length of the exchange period can vary, my dependent variable, Alpha, is the average daily abnormal return over the exchange period. 15 Because the exchange period is defined by the close date, my sample excludes firms that did not implement exchange plans subsequent to the inception date. To test whether the stock market reaction to the introduction of stock exchanges is associated with the restrictiveness of the exchange programs, I first regress abnormal returns over the exchange period on Restrictive. I include ApprovalReq as a control for possible differences in market reaction to the plans based on whether or not shareholders had direct access to approval of the programs. Alpha i = δ 0 + δ 1 Restrictive i + δ 2 ApprovalReq i + ε i (5) 15 We estimate abnormal returns as the stock return minus the fitted value of the three-factor Fama-French model plus momentum. The coefficients of the model are estimated over a period of -6 to +6 months around the inception date. 22

25 Second, to explore which restrictions drive the market reaction, I decompose Restrictive into the six types of restrictions: PriceFloor, IssuanceDate, ValueforValue, ShrRestrequals, Vesting, and Eligibility. Additionally, to validate my inferences regarding shareholder approval, I segregated those firms requiring shareholder approval from those that do not. For the firms that required shareholder approval, I regress Alpha on RMCompliant (as defined in section 3.3). If hypothesis H1 is true, I expect to observe a negative coefficient on RMCompliant. For firms that do not require shareholder approval, I regress Alpha on the Restrictive variable, and again expect the coefficient to be negative. Table 3, panel A, presents the results of estimating equation (5). Panel A shows that firms with more restrictive plans exhibit lower abnormal returns over the period of the exchange (the coefficient of Restrictive is negative and significant with t.stat. of and using all exchange transactions and those with no shareholder approval, respectively, and the coefficient of RMCompliant is also negative and significant, with t-stat. = -1.78). Decomposing the variable Restrictive into its components (model 2) reveals that the six types of restrictions are negatively associated with abnormal returns, although their coefficients are not statistically significant. My next set of tests investigates abnormal returns around critical dates in the exchange program. For each of the Inception Date, Approval Date, and Implementation Date I repeat the previous tests computing Alpha around the window -2 to +2 days around the respective date. Table 3, panel B, shows that the negative reaction documented in panel B also holds in small windows around the key dates of the exchange program. In exchanges requiring shareholder approval, the reaction is mostly concentrated in the approval date. In exchanges that do not require shareholder approval the market reaction is present in the three dates, probably reflecting 23

26 the fact that those three dates are either the same or very close in a significant number of those exchanges. Even in the absence of stock option exchanges, the Restrictive and RMCompliant could be related to daily returns because these variables capture omitted risk or another omitted determinant of the cross-section of returns that is correlated with the number of restrictions in the exchange program. To address this concern, I compare the daily abnormal returns from the six months prior to the inception date with the returns over the exchange period. Specficically, I construct and indicator variable, Eperiod, that equals 1 for days within the exchange period and 0 otherwise. I interact Eperiod with Restrictive and RMCompliant to test whether the association between abnormal returns and these variables is unique to the exchange period. Table 3, panel C, confirms that the market reaction is unique to the exchange period. The positive coefficient on EPeriod (t-stat. = 2.70) suggests that the positive abnormal returns during the period of the exchange are unique relative to the period previous to the exchange. The interaction between EPeriod and Restrictive is negative and significant (t-stat. = -1.96), indicating that the cross-sectional differences in abnormal returns across firms with different levels of restrictiveness in their exchange plans did not exist in the control period Accounting Performance Examining a firm s accounting performance subsequent to a stock option exchange provides another avenue for differentiating the null and alternative hypotheses. As with the market reaction, if stock option exchanges represent an optimal recontracting transaction resulting in improved performance incentives, and if the restrictions imposed by the proxy advisory firms prevent the firm from implementing the optimal program, then the relationship between program restrictions and operating performance should be negative. Alternatively, if 24