Firms’ discretion in the option exercise price adjustments during spinoffs

Abstract

During corporate spinoffs, executives’ original options are converted to new options whose exercise price is reduced. The tax and financial regulations however do not provide specific guidance regarding the option conversion, giving firms considerable discretion over the extent of reduction in the exercise price. This paper finds evidence that firms indeed use discretion to reduce the new option’s exercise price to favor executives during corporate spinoffs. This paper examines two alternative explanations why firms make such discretionary adjustments. The results support that firms with weak corporate governance are more likely to use discretion to reduce exercise prices. The study also finds some evidence suggesting that boards might consider whether the spinoffs benefit shareholders when they make the discretionary reductions in exercise prices.