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.
Posts Tagged ‘Backdating’
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.”
In our forthcoming Review of Financial Studies paper Option Backdating and Board Interlocks, we examine the role of board connections in explaining how the controversial practice of backdating employee stock options spread to a large number of firms across a wide range of industries. Given that the practice was not publicly disclosed, it is unlikely that it originated independently in each firm. We focus on the role that director interlocks played in contributing to the spread of backdating since the board of directors has primary authority over the level and structure of executive compensation, including determination of the amount and timing of option grants.
We find strong evidence that board interlocks are related to the spread of backdating. We find that a firm is more likely to begin backdating option grants if the firm has a director who is a board member of another firm that previously backdated its stock options. Our results are both statistically and economically significant. The increase in the likelihood that a firm begins to backdate stock options that can be explained by having a board member who is interlocked to a previously identified backdating firm is approximately one-third of the unconditional probability of backdating in our sample. We also find that a firm is more likely to begin to backdate option awards if directors concurrently receive a stock option grant.
In addition, we identify several other firm and governance characteristics that are associated with the adoption of option backdating. Firms with higher stock-price volatility are more likely to start to backdate options, which is consistent with the fact that higher stock-price variation provides more opportunities to backdate options. A firm is also more likely to begin to backdate, the greater the stock and option holdings of the CEO and when the CEO is younger. Finally, we find that commonalities in firms’ auditors and geographic location also help to explain the initiation of backdating. The fact that commonality in auditor choice and geographic location is associated with the initiation of backdating suggests that other linkages between firms beyond those created through board interlocks may also play a role in facilitating the spread of this practice. In contrast to some earlier research, we find little evidence that other measures of the quality of corporate governance, such as institutional ownership, board size, board independence, and whether the CEO is also the chair of the board, are systematically related to the incidence of backdating.
The full paper is available for download here.
In our paper “The Impact of the Options Backdating Scandal on Shareholders” which was recently accepted for publication in the Journal of Accounting and Economics, we analyze the excess returns that occurred in short windows surrounding ten distinct news events related to backdating of stock option grants.
Our analysis focuses on 129 firms identified by the Wall Street Journal as implicated in the backdating scandal as of December 31, 2006. We independently identify 764 firm specific backdating-related news events taking place on 580 separate firm-dates. For the first news event (typically the announcement of an internal investigation by the firm), we find a statistically significant excess return of about -4.50% in the -20 to -2 window and -2.40% in the -1 to +1 window. The magnitude of the implied wealth changes seems too large to be attributed to any reasonable estimate of direct out-of-pocket costs of the backdating scandal or to the resulting legal penalties disclosed to date (direct cost hypothesis). Therefore, the alternative hypothesis we propose, which we broadly label Agency Hypothesis, is that a firm’s involvement in the backdating scandal has significant economic implications, despite its limited (direct) impact on cash flows. Under this hypothesis, the losses generated by the option backdating scandal can arise because management’s involvement in backdating practices may prompt investors to reassess the agency costs stemming from the separation of ownership and control.
A series of multivariate show that measures we expect to be related to the effect of the scandal on the value of firms’ reputational capital and information risk are significantly related to changes in shareholders’ wealth. Conversely, variables one would expect to be related to the magnitude of direct out-of-pocket expenses, namely the number of past grants and/or their value, are not significantly related or are positively related to shareholders’ wealth effects, inconsistent with the direct cost hypothesis. In addition, consistent with this interpretation, the occurrence of government investigations or delisting notices have no incremental explanatory power, after controlling for firms’ likely culpability. We find that the losses are attenuated when tainted management of less successful firms is more likely to be replaced. We also find that institutional investors reduce their holdings in firms accused of backdating, possibly due to higher monitoring costs, and that firms involved in the scandal are very likely (10% of the sample) to receive arguably fair takeover offers.
Overall, the evidence is consistent with the hypothesis that the loss of investors’ confidence in the firm’s management is a first-order determinant of the economic consequences resulting from the option backdating scandal.
The full paper is available for download here.