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

27 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 operating performance. Specifically, I estimate: ΔROA t = δ 0 + δ 1 ΔROA t-1 + δ 2 Restrictive + δ 3 ApprovalReq + δ 4 NotImplemented + δ 5 ΔROAInd + θ Controls + ε. (6) My measure of operating performance is the change in return on assets (defined as net income scaled by total assets), ΔROA t, which is calculated as ROA t ROA t-1 where t is the fiscal year of the inception date of the option exchange. ΔROAInd is ROAInd t - ROAInd t-1, and ROAInd t is the median ROA for all firms with the same 2-digit SIC code. All other variables are as defined in the prior tests. I include ΔROA t-1 to control for mean reversion in ROA, and ΔROAInd to control for industry effects on firm performance. As in my prior tests, I also estimate equation (6) separately for firms requiring shareholder approval, and those who do not. Table 4 presents the results of estimating equation (6). The coefficients of Restrictive and RMCompliant are negative and statistically significant (t-stat. of and -2.35), suggesting that more restricted plans are associated with lower increases in profitability in the year of the exchange Executive Turnover A commonly cited reason for the implementation of an exchange program is to retain key employees at a critical time for the firm. If the alternative hypothesis is correct, the inability to implement an optimal exchange program will reduce the program s incentive effects, including retention incentives, and I should see increased turnover in firms implementing more restrictive programs. Using data from BoardEx, I define Turnover as the number of executives that left the 25

28 firm during years t and t+1, where t is the fiscal year of the inception date. 16 Because turnover follows a censored probability distribution, I estimate the following tobit model: Turnover i = δ 0 + δ 1 LagTurnover i + δ 2 Restrictive i + δ 3 ApprovalReq i + δ 4 NotImplemented i + δ 5 Nexecs i + θ Controls i + ε i. (7) LagTurnover, defined as the number of executives that left the firm during years t-1 and t-2, is included to mitigate self-selection concerns, i.e., firms with higher turnover could selfselect into more restrictive exchanges. If that were the case, the association between Turnover and Restrictive would hold in general, not as a consequence of the exchange, and including LagTurnover in the specification would subsume the explanatory power of Restrictive. Because firms with more executives tend to have higher turnover, I include the number of executives covered in the BoardEx database, Nexecs as an additional control variable. The rest of the variables are as defined in previous tests. Table 5, panel A, presents the results of estimating equation (7). Panel A reveals that more restricted exchanges and exchanges that comply with Risk Metrics voting recommendations are associated with higher turnover (t-stats. of 1.81 and 3.14). Table 5, panel B, presents results of testing the association between executive turnover and ROA. Panel B reveals that higher turnover is associated with lower contemporaneous ROA (t-stat. of -1.74), suggesting that reducing executive turnover is desirable for these firms Future Performance 16 BoardEx collects data on over 380,000 individuals, mainly in Europe and North America, mainly from publicly listed and major private enterprises ( Their data comes from publicly available sources, such as firm filings and press releases. For a given firm, the data collected is not limited to directors and officers disclosed in the firm s proxy statement, but includes other executives for whom verifiable information is available. In our sample of 262 firms for which we have all control variables, 251 are represented in BoardEx. 26

29 The previous tests show that restrictions in option exchange programs are negatively associated with firm performance and value. However, equations (5) to (7) do not inform about whether stock option exchanges are, on average, beneficial to shareholders. If stock option exchange programs are optimal recontracting mechanisms to align incentives, the introduction of such programs should lead to better future firm performance. Thus, finding that option exchange programs were positively associated with future firm performance would be further evidence that restricting the board discretion to recontract with key employees is detrimental for shareholders. To test whether option exchange programs are associated with future firm performance, I use two control groups of firms that did not engage in stock option exchanges. The treatment group is formed by option exchange transactions. The first control group is formed by a one-toone matching on industry and size. The second control group is formed using propensity-score matching. 17 I use two control groups because it is not possible to find in the CRSP/Compustat universe control pairs that so that the treatment and control sample are balanced across all the covariates. I measure future performance as future changes in ROA (ΔROA t+1 ), namely ROA t+1 - ROA t, where t is the fiscal year of the option exchange, and buy and hold market-adjusted returns over the 6 months after the inception date of the plan (BHRadj(0,+180)). The control variables are the same as in the previous tests. Table 6, panel A, shows the covariate balance between the two control groups and the treatment group. Consistent with the results in table 2, panel A shows that, compared to their industry peers (control group 1), exchangers exhibit significantly lower past stock returns. In contrast, when matching on the propensity of adopting an option exchange plan (control group 2), the treatment and control groups have similar past firm and industry return performance, but 17 We obtain the propensity score by estimating a logit regression on the introduction of stock exchange programs on the control variables of equation (1). Matched pairs are obtained using Derigs (1988) algorithm, which forms pairs by minimizing propensity score differences and maximizing treatment differences. 27

30 exhibit important imbalances in other covariates such as Size or Ninstit. This result confirms that past return performance and industry affiliation are important determinants of option exchanges. Table 6, panel B and C, shows that exchangers (the treatment group) are associated with higher future increases in ROA and buy-and-hold future stock returns. When ΔROA t+1 is the dependent variable, the t-statistics of the coefficient on Treatment are 2.57 and 2.31, respectively. When BHRadj(0,+180) is the dependent variable, the t-statistics of the coefficient on Treatment are 2.42 and 1.30, respectively Insider Trading The previous tests analyze the effect of stock option exchange plans and their characteristics from an ex-post perspective. Analyzing insider trading activity before the introduction of the exchange plans allows examining the potential effects of the plans from an ex-ante perspective. Insiders ex-ante perspective on the potential effects of the plan is important, because it informs about whether managers and directors anticipated the constraints they would face in the design of the exchange plan. If opposition from proxy advisory firms were a surprise, it would be possible to observe a different equilibrium where a significant number of firms initiate the recontracting process but end up abandoning it. I analyze separately open market purchases and sales by insiders in the previous six months before the inception of the stock option exchange. Nbuys is the average number of firm shares bought by insiders in open market transactions scaled by the number of shares outstanding in the firm. Nsells is the average number of firm shares sold by insiders in open market transactions scaled by the number of shares outstanding in the firm. As in previous tests, I regress these variables on Restrictive, to test whether the insider trading activity is associated 28

31 with the restrictiveness of the exchange plan. 18 To control for the economic significance of the insider transactions, I include in the tests the dollar value of transactions (PurchaseValue and SaleValue). I also compare insider trading activity between firms engaging in an option exchange and a control group of similar size and industry affiliation (control group 1). Table 7, panel A and B, present results of cross-sectional differences in the trading activity of the sample and control firms (control group 1). Panel A shows that insiders of exchanging firms make more purchases of company stock in the months prior to the exchange than insiders of the control firms (t-stat. = 3.28). Panel A also reveals that the purchasing activity is concentrated in firms with less restrictive exchanges (t-stat. = -1.98) and those that do not comply with the Risk Metrics voting criteria (t-stat. = -2.37). In contrast, panel B shows that no such cross-sectional differences exist in terms of selling behavior. I interpret these results as suggesting that, on average, exchanges are considered value-increasing by insiders, but less so if the exchange is more restrictive. To measure the profitability of the insider trades, I calculate Alpha as the 6-month average abnormal return of insider trades estimated using the four-factor model (Fama-French plus momentum). Table 7, panel C presents the results. The results are parallel to those in panel A, namely trades of insiders of firms with more restrictive exchanges are less profitable (t-stat. = -1.72), and trades of insiders of firms that comply with the Risk Metrics criteria are less profitable than those of insiders of firms that do comply with the Risk Metrics criteria (t-stat. = ). Finally, to test whether this insider trading activity is concentrated in the months previous to the inception of the exchange program, I interact the variables of interest with PreEPeriod, an indicator variable that equals one if the transaction date is in the (-6,-1) month period before the 18 Because there are firms with no insider trading activity, we use tobit regressions when Nbuys and Nsells is the dependent variable. 29

32 implementation date and zero if the transaction date is in the (-12,-6) month period before the inception date. Table 7, panel D, presents the results. Panel D shows that the cross-sectional patterns in the purchasing activity shown in panel A are unique to the months leading to the exchange. 5. Conclusion I examine the shareholder value implications of third party proxy advisor recommendations on the execution of underwater stock option exchange programs. Across all firms that decided to pursue an exchange program, I find that the value of the program to shareholders was decreasing as a function of the degree to which the program complied with the policies of the proxy advisors. I believe this exposes the weakness of a rule-based (i.e. checkthe-box ) policy for making complex institutional decisions. My results support the assertions of critics of the proxy advisors policies that such systems neglect to consider to the firm-specific dynamics of the proposals being voted on, and prevent firms from implementing programs that optimally address the firm s needs. However, I cannot extend my inferences beyond those firms who initiated an exchange program due to the inability to see firms first decision of whether or not to choose to begin the process of an exchange program. For instance, I cannot rule out the possibility that proxy advisors policies dissuaded some firms who would have otherwise chosen to implement value reducing exchange programs from moving forward with these programs. This study reinforces the need for research into the policies of proxy advisory firms voting policies. Proxy advisory firms have been in existence for a long time, but both research and anecdotal evidence indicate a dramatic increase in their influence as a result of regulatory changes. Unfortunately, the details of these firms voting policies remain private, limiting the academic community s efforts to evaluate their impact. This study utilizes a setting that I view 30

33 as the most structurally simple voluntary management proposal possible. Other proposals, including equity compensation plans, executive bonus plans, director elections and mergers and acquisitions may have a larger impact on investor returns, but have substantially less well defined voting policies on the part of proxy advisors combined with longer and more nebulous horizons and greater difficulty in measuring outcomes. Experiential evidence indicates that the recommendation policies developed in these other contexts may be equally rigid, however the algorithms by which those policies are developed are not clearly disclosed. My results suggest that better understanding of the policies of the proxy advisory firms is warranted. 31

34 References Aboody, D., Johnson, N. B., and Kasznik, R., Employee stock options and future firm performance: Evidence from option repricings. Journal of Accounting and Economics 50, Acharya, V., John, K., and Sundaram, R. K., On the optimality of resetting executive stock options. Journal of Financial Economics 57, Alexander, C., Chen, M., Seppi, D., and Spatt, C., The Role of Advisory Services in Proxy Voting. NBER Working Paper Series. Belinfanti, T., The proxy advisory and corporate governance industry: the case for increased oversight and control. Stanford Journal of Law, Business and Finance, 14(2): Bhagat, S., Bolton, B., and Romano, R The promise and peril of corporate governance Indices. ECGI Working Paper Series in Law. Carter, M., and Lynch, L., An examination of executive stock option repricing. Journal of Financial Economics 61, Carter, M., and Lynch, L., The effect of stock option repricing on employee turnover. Journal of Accounting and Economics 37, Chance, D., Kumar, R., and Todd, R., The repricing of executive stock options. Journal of Financial Economics 57, Chidambaran, and Prabhala, N., Executive stock option repricing, internal governance mechanisms, and management turnover. Journal of Financial Economics 69, Choi, S., Fisch, J., and Kahan, M. Director Elections and the Role of Proxy Advisors. Southern California Law Review 83, Choudhary, P., Rajgopal, S., and Venkatachalam, M. Accelerated vesting of employee stock options in anticipation of FAS 123-R. Journal of Accounting Research 47, Coles, J., Hertzel, M., and Swaminathan, K. Earnings management around employee stock option reissues. Journal of Accounting and Economics 41, Cremers, K., and Nair, V., Governance mechanisms and equity prices. The Journal of Finance 60, Cremers, K. and Romano, R., Institutional investors and proxy voting on compensation plans: The impact of the 2003 mutual fund voting disclosure regulation. SSRN elibrary. Daines, R., Gow, I., & Larcker, D., Rating the ratings: how good are commercial governance ratings? Journal of Financial Economics 98,

35 Davis, G., and Kim, E., Business ties and proxy voting by mutual funds. Journal of Financial Economics 85, Davis, S., Millstein, I., and Thompson-Mann, M., Policy Briefing No. 3. In T. M. C. f. C. G. a. Performance (Ed.), Voting Integrity: Practices for Investors and the Global Proxy Advisory Industry: The Millstein Center for Corporate Governance and Performance. Grein, B., Hand, J., and Klassen, K., Stock Price Reactions to the Repricing of Employee Stock Options. Contemporary Accounting Research, 22, Ng, L., Wang, Q., and Zaiats, N., Firm performance and mutual fund voting. Journal of Banking and Finance, 33, National Investor Relations Institute (NIRI), Proxy advisory services: the need for more regulatory oversight and transparency. National Investor Relations Institute and Society of Corporate Secretaries and Governance Professionals. Rothberg, B., and Lilien, S., Mutual funds and proxy voting: new evidence on corporate governance. Journal of Business and Technology Law 1, Securities Exchange Commission (SEC), Disclosure of proxy voting policies and proxy voting records by registered management investment companies. Release No (January 31). Winter, S., Trends in shareholder voting - The impact of proxy advisory firms. American Bar Association Corporate Governance Committee. 33

36 Option Exchange variables PriceFloor IssuanceDate ValueforValue ShrRestr Vesting Eligibility ApprovalReq Restrictive NotImplemented Appendix A. Variable definitions 1 if there is a price floor restriction in the exercise price and 0 otherwise 1 if the exchangeable options are only those issued before or after a certain date and 0 otherwise 1 if it is a value for value exchange and 0 otherwise 1 if the proposal restricted the use of cancelled shares, 0 otherwise 1 if there is a vesting period for the new options and 0 otherwise 1 if officers or directors are excluded from the plan and 0 otherwise 1 if shareholder approval is required and 0 otherwise Number of restrictions in the plan, calculated as the sum of PriceFloor, Vesting, Eligibility, ValueforValue, IssuanceDate, and ShrRestr (see Appendix B) 1 if the plan was not implemented and 0 otherwise Control variables Size BM Leverage ROA PastReturn IndustryadjRet IdVol Beta Ninstit Options Prob(ISS Dgrmt) Natural logarithm of market value (CRSP) Book-to-market ratio (CRSP and Compustat) Total liabilities divided by total assets (Compustat) Return on assets; net income scaled by total assets (Compustat) Annually compounded return over the previous fiscal year using daily stock return data (CRSP). Annually compounded median stock return of all the firms in the same 2-digit SIC code over the previous fiscal year (CRSP). Annualized Idiosyncratic volatility. Standard deviation of the residuals in a regression of daily returns on the value weighted market return over 365 days prior to fiscal year end multiplied by squared root of 250 (CRSP) Coefficients in a regression of daily returns on the value-weighted market return over 365 days prior to fiscal year end (CRSP) Number of institutions owning company s shares (Thompson) Intensity of option compensation in the firm calculated as the number o options scaled by the number of shares outstanding (Compustat). Probability of voting with Risk Metrics conditional on existing disagreement between the management s recommendation and Risk Metrics recommendation (NPX voting data). EIPlandate 1 if the stock plan was approved in or before 2002, or if the plan has been in effect since IPO, and 0 otherwise (hand-collected from SEC filings). Nactivists TotalComp PctIndepDir Nbusy Number of activists (as defined by Cremers and Nair, 2005) that own stock in the company (Thompson) Average total compensation of the company s top executives (Equilar) % of independent directors (Equilar) Number of busy directors (Equilar) 34

37 Appendix B. ISS Exchange Program Policies ISS does not publicly disclose the specific rules behind its voting recommendation policies. Below is the published voting guideline for stock option exchange programs from the ISS 2006 US Proxy Voting Guidelines Summary: Vote CASE-by-CASE on management proposals seeking approval to exchange/reprice options taking into consideration: Historic trading patterns; Rationale for the repricing; Value-for-value exchange; Treatment of surrendered options; Option vesting; Term of the option; Exercise price; Participation. If the surrendered options are added back to the equity plans for re-issuance, then also take into consideration the company s three-year average burn rate. Vote FOR shareholder proposals to put option repricings to a shareholder vote. Below is a summary of the specific the ISS voting recommendation criteria regarding option exchanges and their mapping into my variables to capture those rules: ISS Consideration ISS Rule Restriction Variable Historic trading patterns Recommend AGAINST any exchange PriceFloor program that includes options with a strike price less than the 52 week high Rationale for the repricing Recommend AGAINST any exchange IssuanceDate that includes options granted in the prior year Value-for-value exchange Recommend AGAINST any plan in ValueforValue which the exchanged options have value less than the awards offered in return Treatment of surrendered options If the total equity compensation program ShrRstr plan cost is too high (as measured by a proprietary cost model), recommend AGAINST an exchange that allows share recaptured in the exchange to be used for future awards Option Vesting Recommend AGAINST any exchange in Vesting which new award vesting schedules are less than the greater of 6 months and the original award vesting schedule Term of the option Recommend AGAINST any plan in which the term of new stock options is greater than the term of the original options Exercise Price Participation Recommend AGAINST any plan in which replacement options have an exercise price less than or equal to the current stock price (not applicable to restricted stock) Recommend AGAINST any plan in which named executive officers or directors are allowed to participate None in practice I do not observe firms extending the term of options in my sample None changes to income tax regulations (409A) effectively eliminated the awarding of stock options with a strike price less than the stock price at grant Eligibility 35

38 Appendix C. Examples of Stock Option Exchange Programs Intel Corp.: Plan required shareholder approval Key Event Dates March 23, 2009 May 20, 2009 September 22, 2009 November 5, 2009 Details File SEC Form PRE 14A, a preliminary proxy statement, which contains the shareholder proposal regarding the exchange program: o Officers and Directors are not eligible o Only stock options with strike price greater than the 52 week high and granted prior to the 12 months preceding the exchange are eligible o Exchange will be approximately value-for-value o New awards will carry a new 4-year vesting schedule o Surrendered stock options will be cancelled and not re-issued File SEC Form SC-TO-C, tender offer communication, which contains communication from the CEO to employees regarding the exchange program shareholder proposal Shareholder meeting, program approved File SEC Form SC-TO-I, tender offer initiation o Employees are provided term sheets and instructions for the tender offer transaction o Employees have until 10/30/09 to make participation election File SEC form SC-TO-I/A, amendment to the tender offer stating that the exchange program tender offer closed 10/30/09 o 217,436,251 (~66% of those eligible) were accepted for cancellation o 83,046,296 new options were granted in return Limelight Networks: No shareholder approval required Key Event Dates April 14, 2008 May 15, 2008 July 14, 2008 Details File SEC form SC-TO-C, tender offer communication disclosing communication from the CEO to employees regarding exchange program: o Officers and Directors are not eligible o Options granted within the past year will be eligible for exchange o Employees can receive 1 share of restricted stock for every 2 options surrendered (not value-for-value for some options) o New awards will vest semi-annually over 2 years (shorter than the original vesting) File SEC Form SC-TO-I, tender offer initiation o Employees are provided term sheets and instructions for the tender offer transaction o Employees have until 6/16/08 to to make participation election File SEC form SC-TO-I/A, amendment tot the tender offer stating that the exchange program tender offer closed 10/30/09 o 2,002,100 (~55% of those eligible) were accepted for cancellation o 1,001,051 new restricted stock units were granted in return 36

39 Table 1. Descriptive Statistics This table presents descriptive statistics of firms that initiated an option exchange program. Panel A reports the industry distribution and year distribution of the exchanges. Panel B reports descriptive statistics about the restrictions and other characteristics of the option exchange plans. Panel C reports descriptive statistics for the main variables used in the statistical tests. See Appendix A for variable definitions. Panel A. Industry and year Distribution Fiscal year Total Business Services Electric Equipment Computers Pharmaceutical Products Trading 4 4 Entertainment Healthcare Insurance Measuring and Control Equipment Machinery Restaraunts, Hotels, Motels 4 4 Medical Equipment Petroleum and Natural Gas Retail Communication Wholesale Other Total Panel B. Characteristics of Option Exchanges Not Required Required Total Number of exchanges Restrictions Average number of restrictions Price Floor 72.41% 75.00% 73.86% Vesting 83.62% 97.97% 91.67% Employee eligibility 76.72% 87.16% 82.58% Value for Value 49.14% 78.38% 65.53% Issuance Date 11.21% 3.38% 6.82% Share Restrictions 1.72% 16.89% 10.23% Other characteristics and outcomes Average % of options eligible 50.89% 47.35% 48.95% Average % of eligible options exchanged 79.65% 79.11% 79.37% Average % overhang reduction 3.67% 2.28% 2.94% Average days between inception and closing 51.22% % 86.28% Compliant with Risk Metrics criteria n.a % n.a. % of plans approved n.a % n.a. % votes in favor n.a % n.a. Number of exchanges implemented

40 Panel C. Distributional Statistics of Control Variables Shareholder Approval Not Required Shareholder Approval Required Variable Mean Median Std Mean Median Std Size BM Leverage ROA PastReturn IdVol Beta

41 Table 2. Economic Determinants This table reports results for estimating the cross-sectional determinants of adopting an option exchange plan. Panel A presents results of the cross-sectional determinants of adopting an option exchange plan. The control group is formed by all the firms in the same Fama-French industry group in the fiscal year of the exchange. Panel B presents results of the determinants of the restrictiveness of the plan. Panel C presents results of how the restrictiveness of the plan determines its breath and participation. See Appendix A for other variable definitions. *, ** and *** denote significance at the 10, 5 and 1% significance level. IndustryRet and PastReturn are expressed in %. Panel A. Economic Determinants of Exchange Programs Exchange (logit) (1) Exchange (logit) (2) Exchange (logit) (3) Variable coef t-stat coef t-stat coef t-stat Constant Size BM Leverage ROA IndustryRet PastReturn IdVol Beta Ninstit Options Prob(RM dgrmt) Nactivists ChairOutsider TotalComp PctIndepDir Nbusy Adj R % 14.85% 15.55% N 11,252 5,718 8,059 39

42 Panel B. Characteristics of the Exchange Program Restrictive (ologit) ApprovalReq (logit) Variable coef t-stat coef t-stat coef t-stat coef t-stat Intercept omitted omitted Size BM Leverage ROA IndustryRet PastReturn IdVol Beta Ninstit NotImplemented ApprovalReq Prob(RM dgrmt) EIPlandate % 26.77% Adj R % % N Panel C. Outcomes of the Exchange Program PctEligible (Tobit, double censored) PctExchanged (Tobit, double censored) Variable coef t-stat coef t-stat Intercept Restrictive Size BM Leverage ROA IndustryRet PastReturn IdVol Beta Ninstit NotImplemented Adj R % 3.41% N

43 Table 3. Market Reaction to Option Exchange Programs This table presents the results of regressing daily returns from the period between the inception and close date of the option exchange plan. Panel A presents cross-sectional differences in average abnormal returns from the inception to the closing of the option exchange program. The dependent variable, abnormal returns, is calculated as the average daily abnormal return over the exchange period estimated as the stock return minus the fitted value of the three-factor model plus momentum, estimated over a period of -6,+6 months around the implementation date. Panel B presents abnormal returns on a (-2,+2) window around significant days of the exchange program. Panel C presents results of testing differences in abnormal returns from the 6-month period previous to the inception of the plan. t-statistics are adjusted for heteroskedasticity, and clustered by firm to adjust for cross-sectional correlation in panel C. See Appendix A for other variable definitions. ***, **, and * denote statistically significant at the 0.01, 0.05, and 0.10 levels (two-tail) respectively. Abnormal returns are expressed in %. All stands for All exchangers, S.A. stands for Shareholder Approval Required, and No S.A. stands for No Shareholder Approval Required Panel A. Abnormal Returns from the Inception to the Closing of the Option Exchange Program (only implemented plans). All Alpha Variable (1) (2) S.A. Alpha No S.A. Alpha Intercept (3.53) (3.72) (2.67) (3.40) RMCompliant (-1.78) Restrictive (-2.11) (-2.55) PriceFloor (-0.87) Vesting (-0.92) Eligibility (-1.10) ValueforValue 0.00 (-0.01) IssuanceDate (-0.51) ShrRestr (-0.18) ApprovalReq (-1.08) (-0.93) N R % 3.68% 2.13% 4.20% 41

44 Panel B. Abnormal Returns on Significant dates of the program Inception date Alpha Approval date Alpha Implementation date Alpha Variable All S.A. No S.A. All S.A. No S.A. All S.A. No S.A. Intercept (1.18) (0.65) (2.08) (2.40) (1.35) (2.74) (3.42) (1.65) (3.24) Restrictive (-0.75) (-1.79) (-2.06) (-2.66) (-2.74) (-2.83) RMCompliant (-0.60) (-1.84) (-1.68) NotImplemented (0.93) (0.94) (-2.10) (1.05) (0.79) (23.12) ApprovalReq (-0.31) (0.18) (-0.51) N R % 2.36% 1.77% 4.41% 3.37% 8.13% 3.52% 1.98% 5.07% Panel C. Abnormal Returns During the Exchange Period vs the Non-Exchange Period Shr Approval Required Alpha No Shr Approval Required Alpha All Exchangers Alpha Variable coeff t-stat coeff t-stat coeff t-stat Intercept Restrictive EPeriod Restrictive*EPeriod RMCompliant EPeriod RMCompliant*EPeriod ApprovalReq N 43,148 25,028 18,120 R % 0.03% 0.12% 42

45 Table 4. Option Exchanges and Accounting Performance This table presents results from estimating the association between implementation of option exchanges and accounting performance. The dependent variable, ΔROA t, is calculated as ROA t -ROA t-1, where t is the fiscal year of the option exchange. ΔROAInd is ROAInd t -ROAInd t-1, where ROAInd is the median ROA of all firms with the same 2-digit SIC code. t-statistics are based on heteroskedasticity-adjusted standard errors. ***, **, and * denote statistical significance at the 0.01, 0.05, and 0.10 levels (two-tail) respectively. PastReturn are expressed in %. All Exchangers Shr Approval Required No Shr Approval Required Variable coef t-stat coef t-stat coef t-stat Intercept ΔROA t Restrictive RMCompliant ApprovalReq NotImplemented Size BM Leverage PastReturn ΔROAInd IdVol Beta Ninstit Adj R % 31.11% 25.31% N

46 Table 5. Option Exchanges and Executive Turnover This table presents results from estimating the association between executive turnover and characteristics of the option exchange programs. Turnover is the number of executives that left the company during t and t+1, where t is the fiscal year of the exchange program. LagTurnover is is the number of executives that left the company during t-2 and t-1. ***, **, and * denote statistical significant at the 0.01, 0.05, and 0.10 levels (two-tail) respectively. IndustryRet and PastReturn are expressed in %. Panel A. Option Exchanges and Executive Turnover Dep. Var: Turnover All Exchangers Shr Approval Required No Shr Approval Required Variable coef t-stat coef t-stat coef t-stat Intercept LagTurnover Restrictive RMCompliant ApprovalReq NotImplemented Nexecs Size BM Leverage ROA PastReturn IndustryRet IdVol Beta Ninstit Adj R % 12.95% 12.37% N Panel B. Executive Turnover and Performance ROA Variable coef t-stat Intercept Turnover Size BM Leverage ROA PastReturn IndustryRet IdVol Beta Ninstit Adj R % N 251 1

47 Table 6. Exchangers vs Non-exchangers. Future Performance This table presents results from estimating the association between the introduction of option exchange programs and future firm performance option using two control groups of firms that did not engage in these transactions. Panel A shows differences across covariates between the treatment group (Trtm) and two control groups (Ctrl 1 and Ctrl 2). Ctrl 1 is formed by matching on industry and size. Ctrl 2 is formed using propensity-score matching. The treatment group is formed by option exchange transactions. Panel B presents results of analyzing differences in ROA (ΔROA t+1 ) between the treatment group and the two control groups. ΔROA t+ 1 is ROA t+1 -ROA t, where t is the fiscal year of the option exchange. ΔROA t is ROA t -ROA t-1. Panel C presents results of analyzing differences in buy and hold market-adjusted returns over the 6 months after the inception date of the plan (BHRadj(0,+180)) between the treatment group and the two control groups. PastReturn is the buy-and hold return over the 6 months before the inception date. t-statistics are based on hetereoskedasticity-adjusted standard errors. ***, **, and * denote statistical significant at the 0.01, 0.05, and 0.10 levels (two-tail) respectively. Panel A. Control Groups Means Medians Variable Trtm (1) Ctrl 1 (2) (1)-(2) t-stat Ctrl 2 (3) (1)-(3) t-stat Trtm (1) Ctrl 1 (2) (1)-(2) t-stat Ctrl 2 (3) (1)-(3) t-stat Size BM Leverage ROA PastReturn IndustryRet Idvol Beta Ninstit Panel B. Option Exchanges and Future Accounting Performance Dep. Variable: ΔROA Control Group 1 (Ctrl 1) Control Group 2 (Ctrl 2) Indep. Variable coef t-stat coef t-stat Intercept DROA t Treatment Size BM Leverage PastReturn DROAInd IdVol Beta Ninstit Adj R % 22.61% N

48 Panel C. Option Exchanges and Future Stock Price Performance Dep. Variable: BHRadj(0,+180) Control Group 1 (Ctrl 1) Control Group 2 (Ctrl 2) Indep. Variable coef t-stat coef t-stat Intercept Treatment Size BM PastReturn Adj R % 2.35% N

49 Table 7. Option Exchanges and Insider Trading Panel A, B and C present results of the insider trading activity over the 6 moths previous to the inception of the option exchange program. Nbuys is the average number of firm shares bought by insiders in open market transactions scaled by the number of shares outstanding in the firm. Nsells is the average number of firm shares sold by insiders in open market transactions scaled by the number of shares outstanding in the firm. PurchaseValue and SaleValue are, respectively, the dollar value of the purchases and sales. Alpha is the 6-month average abnormal return of insider trades estimated using the four-factor model. PreEPeriod is an indicator variable that equals one if the transaction date is in the (-6,-1) month period before the implementation date and zero if the transaction date is in the (-12,-6) month period before the inception date. The treatment group is formed by companies that introduced an option exchange program. The control group is formed by matching by SIC code and size. Panel C presents results of testing differences in purchasing behavior between the (-6,-1) and the (-12,-6) month periods previous to the inception of the plan ***, **, and * denote statistical significant at the 0.01, 0.05, and 0.10 levels (two-tail) respectively. Panel A. Open Market Buys in the 6-month Period Before the Inception of the Exchange Exchangers vs non-exchangers Nbuys Exchangers. Shr. Approval Required Nbuys Exchangers. Shr. Approval Not required Nbuys All Exchangers Nbuys Variable coef t-stat coef t-stat coef t-stat coef t-stat Intercept Treatment RMCompliant Restrictive ApprovalReq NotImplemented PurchaseValue Adj R % 5.88% 6.59% 5.76% N Panel B. Open Market Sells in the 6-month Period Before the Inception of the Exchange Exchangers vs non-exchangers Nsells Exchangers. Shr. Approval Required Nsells Exchangers. Shr. Approval Not required Nsells All Exchangers Nsells Variable coef t-stat coef t-stat coef t-stat coef t-stat Intercept Treatment RMCompliant Restrictive ApprovalReq NotImplemented SaleValue Adj R % 0.50% 1.66% 1.58% N

50 Panel C. Profitability of trades in the 6-month Period Before the Inception of the Exchange Exchangers vs non-exchangers Alpha Exchangers. Shr. Approval Required Alpha Exchangers. Shr. Approval Not required Alpha All Exchangers Alpha Variable coef t-stat coef t-stat coef t-stat coef t-stat Intercept Treatment RMCompliant Restrictive ApprovalReq NotImplemented NetTradeValue TradeVolume Adj R % 9.24% 1.72% 4.90% N Panel D. Comparing Open Market Purchases in the (-12,-6) and (-6,-1) Month Periods Before the Inception Exchangers vs non-exchangers Nbuys Exchangers. Shr. Approval Required Nbuys Exchangers. Shr. Approval Not required Nbuys All Exchangers Nbuys Variable coef t-stat coef t-stat coef t-stat coef t-stat Intercept PreEPeriod Treatment Treatment*PreEPeriod RMCompliant RMCompliant*PreEPeriod Restrictive Restrictive*PreEPeriod ApprovalReq NotImplemented PurchaseValue Adj R % 5.51% 78.96% 29.05% N 1,