Trust is part of the foundation of public markets. Scandals at firms such as Enron and HealthSouth fractured this foundation and motivated market participants to ask why executives and other employees at these firms misled investors. Some regulators and experts conjecture that the roots of these scandals can be traced to the actions and attitudes of those at the very top of corporate leadership. In the words of Linda Chatman Thomsen (Director, Division of Enforcement, Securities and Exchange Commission) “Corporate character matters—and employees take their cues from the top. In our experience, the character of the CEO and other top officers is generally reflected in the character of the entire company.” In our paper, Suspect CEOs, Unethical Culture, and Corporate Misbehavior, forthcoming in the Journal of Financial Economics, we provide evidence consistent with this perspective by demonstrating an empirical link between CEOs’ revealed character and the misbehaviors of the firms they manage.
Posts Tagged ‘Backdating’
In our paper, Executive Gatekeepers: Useful and Divertible Governance?, which was recently made publicly available on SSRN, we study the role of executive gatekeepers in preventing governance failures, and the counter-incentive effects created by equity compensation. Specifically, we examine the following two questions. First, do executive gatekeepers actually improve governance in the average firm? Second, does the effectiveness of gatekeepers in ensuring compliance and/or reducing corporate misconduct depend on their incentive contracts?
In the paper, Executive Turnover Following Option Backdating Allegations, forthcoming in The Accounting Review, we investigate how the Board of Directors and the managerial labor market (two private-sector monitoring mechanisms) respond to an allegation of option backdating. Allegations have been directed at numerous well-known public companies, including Microsoft, Apple, Home Depot, Costco, and United Health. Backdating occurs when executives designate as the grant date a day earlier than the one on which the board actually made the decision to grant options. Managers typically select an earlier date when the market price was lower, so they receive options that are already “in-the-money” on the actual grant date.
My monograph Rich-Hunt is subtitled “The Backdated Options Frenzy and the Ordeal of Greg Reyes.” But if you have not read the monograph, and if you missed the whole frenzy of 2005–2011, you may well wonder: What is a backdated option? Indeed, you may not even be quite sure about what an option is and how it works. So, let me start there.
An option is a type of security that gives a person the right to buy a share of a company’s stock at a specified price. For example, an option might give you the right to buy a share of Google at $5. That would be a very valuable option. Or an option might give you the right to buy a share of Google at $5,000. That would not be so valuable.
Typically, when a company gives options to its employees as a form of compensation, the employees are allowed to buy shares in the company (which is called “exercising the options”), and the price at which they may buy the stock is called the option’s “exercise price,” or “strike price.” Typically, however, they can exercise their options only after a defined span of time (called “the vesting period”) and before a certain date (called “the expiration date”).
So, the value of such option grants rests entirely on the possibility that the stock will be selling above the strike price during the period of time that the employee is permitted to use the option to buy a share. If the stock price is higher than the exercise price, the employee can reap a profit by purchasing a share of stock at the exercise price and then immediately selling that share on the stock market. Of course, if the stock price does not rise above the strike price between the time that the options vest and the time that they expire, then the options are forever worthless.
In the paper Reputation Penalties for Poor Monitoring of Executive Pay: Evidence from Option Backdating, forthcoming at the Journal of Financial Economics, my co-authors (Yonca Ertimur of Duke University and David Maber of the University of Southern California) and I examine whether directors are held accountable for poor monitoring of executive compensation.
Theoretical and empirical work suggests that outside directors incur reputation penalties in the director labor market for poor monitoring. However, it is unclear whether these penalties extend to poor monitoring of executive pay. A widely held view—articulated by Prof. Bebchuk and Prof. Fried in their book Pay without Performance—is that there is little or no accountability for excessive or abusive pay practices. Yet no study has empirically examined this question. Part of the reason is the difficulty of defining and identifying “poor monitoring” with respect to executive pay. In most cases, pay levels and structures can be justified on economic grounds (e.g. retention, incentives, attraction of talent) and with reference to the behavior of peer firms. Unless these practices are perceived as clearly “outrageous,” it is unlikely that directors will be concerned about reputation costs. Opacity in pay disclosures makes it even more difficult to assess the quality of pay practices.
In our paper, Mechanisms of Board Turnover: Evidence from Backdating, which was recently made publicly available on SSRN, we examine a set of events that involve observable corporate misdeeds: stock option backdating. These misdeeds were generally revealed within a narrow window of time, required the complicity of the board, and in many cases directors benefited directly through backdated grants. Examining board turnover associated with stock option backdating thus enables us to gain more insight about the mechanisms by which directors depart their boards. Although information that would allow us to identify each of these five steps is not publicly available, events that are typically available include the following: (1) whether a director resigns, (2) whether a director appears on the proxy as nominated for reelection, and (3) whether a director is reelected. Additionally, there are press releases that sometimes accompany these decisions, but these announcements must be interpreted with care. For example, when a director does not appear on the proxy, the board and/or nominating committee might have chosen not to renominate the individual for reelection or the director might have declined to stand for reelection (an event that is frequently disclosed, especially if driven by a director retirement policy). However, a director who will not be renominated often is permitted to announce that he or she has chosen to resign or not to seek reelection.
In our paper, Should Size Matter When Regulating Firms? Implications from Backdating of Executive Options [15 N.Y.U. J. Legis. & Pub. Pol’y (forthcoming Winter 2011)], we present a data point relevant to significant issues of policy concerning areas of law where small firms have either been granted exemption from regulations or not investigated for violations of laws that, on their face, apply to them. Whether small firms should be exempted is an empirical question the answer to which depends on the likelihood of such firms violating regulations.
There are numerous instances in the law where small firms have been granted exemptions from regulatory restrictions. The major justification offered by the proponents for this exemption of small firms is the claim that regulation has a disproportionate effect on these companies. For example, in the area of securities law, regulation of small firms has drawn criticism throughout the years. It has been lamented that “the [Securities Exchange Commission] SEC [has] never . . . understood small businesses, their capital needs, their importance to our economy, and the special circumstance they face…” Similarly, since its enactment in 2002, the Sarbanes-Oxley legislation (SOX) has been highly criticized for the level of expense it has imposed upon firms’ efforts to comply with the legislation. In order to decide if regulation should be lenient towards small firms, we need to first understand what types of firms are likely to be engaged in illicit activity. If we knew that small firms are also likely to violate laws, as a matter of public policy, should we continue to exempt firms from regulatory scrutiny solely due to size? That is, should size matter in regulatory policy decisions? Furthermore, should size be a factor when prosecutors target firms for investigation?
Our study contributes to understanding the corporate governance determinants and implications of backdating practices during the decade of 1996-2005. Overall, our analysis provides support for the view that backdating practices reflect governance breakdowns and raise governance concerns. (For recent expressions of the opposite view that backdating did not reflect governance breakdowns, see the recent op-ed by WSJ columnist Holman Jenkins, who argues that backdating was a “meaningless accounting violation.”)
In particular, we find that:
- (i) Opportunistic timing has been correlated with factors associated with greater influence of the CEO on corporate decision-making, such as lack of a majority of independent directors, a long-serving CEO, or a lack of a block-holder with a “skin in the game” on the compensation committee;
- (ii) Grants to independent directors have also been opportunistically timed and that this timing was not merely a by-product of simultaneous awards to executives or of firms’ routinely timing all option grants;
- (iii) Lucky grants to independent directors have been associated with more CEO luck and CEO compensation;
- (iv) Rather than being a substitute for other forms of compensation, gains from opportunistic timing were awarded to CEOs with larger total compensation from other sources; and
- (v) Opportunistic timing was not driven by firm habit but rather, for any given firm, the use of such timing was itself timed to increase its profitability for recipients.
Our analysis suggests that the existence of CEO and director lucky grants as a variable that can be useful to research studying the governance and decision-making of firms. We therefore make available on the website of the Harvard Program on Corporate Governance a dataset (available here) of CEO and director luck indicators based on our work.
Here is a more detailed outline of what our paper (available here) does:
In the paper Reputation Penalties for Poor Monitoring of Executive Pay: Evidence from Option Backdating, which was recently made publicly available on SSRN, my co-authors (Yonca Ertimur of Duke University and David Maber of the University of Southern California), and I examine whether directors are held accountable for poor monitoring of executive compensation.
Theoretical and empirical work suggests that directors suffer reputation penalties in the director labor market for poor monitoring. However, it is unclear whether these penalties extend to poor monitoring of executive pay. A widely held view—articulated by Prof. Bebchuk and Prof. Fried in their book Pay without Performance—is that there is little or no accountability for excessive or abusive pay practices. However, no study has empirically examined this question. Part of the reason is the difficulty of defining and identifying “poor monitoring” with respect to executive pay. In most cases, pay levels and structures can be justified on economic grounds (e.g. retention, incentives, attraction of talent) and with reference to the behavior of peer firms. Unless these practices are perceived as clearly “outrageous,” it is unlikely that directors will be concerned about reputation costs. Opacity in pay disclosures makes it even more difficult to assess the quality of pay practices.
Without question, the first six months of 2009 have been a period of sharply increased enforcement activity at the Securities and Exchange Commission. The financial crisis, the new administration, new SEC leadership, increased funding and the focus of Congress and the media have all combined to encourage heightened government scrutiny. And even though it has only been a few months since a new Chairman took office, already there are tangible signs that the SEC has taken a more aggressive enforcement posture. In this alert, we review the changes the new SEC leadership has instituted and is considering, the observable impact of the new administration on enforcement activity and significant cases in key areas that reflect the agency’s evolving enforcement program.
I. Overview of Changes
A. The Backdrop
The events of 2008 led directly to the current enforcement agenda. The collapse of the subprime mortgage market, the ensuing credit crisis, the demise of several major investment banks and, perhaps most of all, the Madoff case led to a loss of confidence in the agency’s ability to protect investors. This loss of confidence was manifested in Congressional hearings and an intensified media spotlight. At the same time, the SEC’s Inspector General has issued a number of reports critical of the agency, and Congress intensified pressure on the SEC and Department of Justice to bring cases in the wake of the financial crisis. At a March hearing of the Senate Judiciary Committee on the law enforcement response to the financial crisis, Senator Patrick J. Leahy declared, “I want to see prosecutions…. I want to see people go to jail.”