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E-MailThe following post comes to us from David Larcker, Allan McCall, and Gaizka Ormazabal, all of the Accounting Department at Stanford University.
In our paper, Proxy Advisory Firms and Stock Option Exchanges: The Case of Institutional Shareholder Services, which was recently made publicly available on SSRN, we examine the role of proxy advisors in the specific context of stock option exchanges, where firms replace underwater stock options with new awards of options, restricted stock and/or cash. We restrict our investigation to this specific transaction because it is a relatively simple, one-time transaction where the set of design choices are well defined and can be collected from SEC filings. In addition, the precise criteria used by Institutional Shareholder Services (ISS) in making the voting recommendation are known, and we can observe the degree to which an option exchange follows or deviates from their criteria. Finally, there is considerable variation across the firms in the structure of their exchange programs and the influence of ISS on proxy voting outcomes. This enables us to examine the performance implications of plan design choices and the role of ISS in these transactions.
Our analysis is based on a comprehensive sample of 264 stock option exchanges announced between 2004 and 2009. For each exchange offer, we measure the degree of conformity to ISS’ guidelines by comparing the observed design to the set of restrictions required by ISS in order to receive a favorable voting recommendation. We then assess whether the degree of conformity with ISS voting criteria is related to subsequent firm performance and executive turnover.
Our analysis produces four important results. First, we find that the stock market reaction to the introduction of exchange plans is positive, but decreasing in the extent to which the exchange plan conforms to ISS guidelines. Second, we document that the increase in operating performance associated with introduction of exchange programs is a decreasing function of the degree of conformity with the ISS voting framework. Third, we show that firms with exchange plans that more closely follow ISS requirements experience higher executive turnover than firms with less restrictive plans.
Finally, patterns in insider trading activity during the months prior to the introduction of the exchange programs suggest that insiders‟ expectations about the effect of these programs are consistent with these results. Specifically, insiders are net buyers for firms conducting exchanges with positive performance consequences. These results are consistent with the conclusion that compliance with ISS guidelines on stock option exchanges limits the recontracting benefits of these transactions and are not value increasing for shareholders.
The full paper is available for download here.
2 Comments
ISS applauds the Rock Center for its continuing effort to produce academic research around important corporate governance issues. At the same time, we caution readers to fully understand the underlying assumptions and limited data set used by Rock’s researchers to reach their conclusions. For that reason and others stated below, we have a concern that the study may be more misleading than informative for investors.
The most important point that the study ignores is that option re-pricings by their very nature are the result of shareholder value destruction. Option exchanges exist as a tool for restoring lost value to employees for the purpose of retention and future reward, but they also can have negative repercussions on long-term shareholder value.
Although, as the study accurately states, option exchanges might lead to a short-term increase in stock price, particularly when top executives participate, sustainable long-term shareholder value creation is far less certain. The limited data set and time periods used by Rock’s researchers distort their conclusion.
With specific regard to ISS, the study covers a very limited data set and imputes ISS vote recommendations, rather than using actual recommendations. Rock’s researchers looked at roughly 264 companies over a five year period. Their researchers criticize ISS for its policy of encouraging constraints on re-pricing programs, but they do not consider the long-term impact on shareholders of option re-pricing without constraints.
We therefore question the efficacy of this particular study effort and caution investors about acting upon its conclusions.
I recently duplicated this research for a client considering an option exchange using more recent data. We saw increasing returns associated with decreasing compliance with ISS standards. (The only standard we exempted was a value-for-value exchange, which we saw as relevant to shareholder value). Those returns were statistically significant. I have seen no research (or theory, really) suggesting that those returns would get reversed over some “long-term.”