Sink or Swim? Firms' Responses to Underwater Options

We examine changes in executive compensation that firms make in response to underwater options. Using a sample of firms with underwater options in 2000, we estimate that 81 percent of firms take action to respond to them. We examine explanations for the firms' responses. Opponents argue that it rewards poor performance and transfers wealth unjustifiably from shareholders to executives. We find some support for this argument in that firms with weaker governance structures are more likely to reprice underwater options. Alternatively, firms that respond claim they do so to restore incentives, retain executives, and insulate executives from market-wide or industry-wide factors beyond their control. Our results find evidence in support of these arguments in that restoring incentives and retaining executives seem to be the primary drivers of firms' responses.