Revisiting Rescission of Executive Stock Options: Theory and Empirical Evidence

We justify the occurrence of rescission by examining the ex-ante optimality of rescission of executive stock options while considering the associated accounting rules in response to this controversial practice. Rescission may be the least favorable practice from shareholders’ ex-post viewpoint but we find that shareholders will be almost always better off in terms of expected initial payoffs under rescission than under do-nothing policy. Our empirical data show that rescission is followed by a 34.66% drop in stock return and the cumulative abnormal returns of the sample firms nearly fall to −50% on the rescission date. Simulation results show that the subjective value-added to executives for pre-committed rescission feature on ESOs is 14% while the estimated agency cost under rescission is twice as much as that under do-nothing policy. These empirical evidences and analytical predictions provide a more comprehensive and in-depth understanding of rescission, which help shed some light on devising option-based incentive contracts with variable terms.