January 12, 2007
Study Links Options Backdating to Corporate Governance Weaknesses
by Bill Baue
Harvard Professor Lucian Bebchuk and colleagues use a new method of identifying CEO and outside
director manipulation of stock option timing and assert correlations to governance problems.
Back in 2004, many companies were arguing against a Financial Standards Accounting Board
(FASB) rule mandating
stock option expensing (or reporting the estimated value of outstanding options, since the exact
value is not determined until options are exercised.) In February of that year, University of Iowa
Professor Erik Lie submitted
his now-celebrated study that broke open the options
(for which 120 companies have by now come under scrutiny) upon its May 2005 publication in
Management Science. Talk about duplicity--many companies claimed the value of options is
too difficult to calculate with precision (and so their value should not be reported at all) while
executives were busy calculating when to retroactively exercise options to reap windfalls stolen
from shareowner value.
The idea of manipulating stock option timing was first
introduced in a 1997 paper by New York University Professor David Yermack. A few
papers followed, with researchers scratching their heads over how executives could possibly predict
the fortuitous stock movements reflected in the statistical anomalies of exercise timing documented
in their research, until Prof. Lie surmised the unthinkable. Perhaps these fortunate executives
were not predicting the future but rather tracking the past--a supposition Prof. Yermack had
trouble believing at first because the "whole idea was so sinister," even in the post-Enron world
when executive fraud was exposed as widespread. A flurry of academic activity has followed, mostly
looking at stock price patterns before and after options were exercised (in addition to the
investigative activity and string of executive resignations and dismissals spurred by the
Now Harvard Professor Lucian Bebchuk and colleagues have
taken the next step of correlating option manipulation with corporate governance strength (or, more
precisely, weakness.) This is the same connection asserted by the socially responsible investing
(SRI) community in demanding option expensing as a form of strong governance. Also, Prof. Bebchuk
Grinstein from Cornell and Urs Peyer from INSEAD
introduce a new method for identifying what they facetiously call "lucky" options--those granted at
the lowest price of the month (and hence guaranteed to rise in value.)
were more likely when the company did not have a majority of independent directors on the board
and/or the CEO had longer tenure--factors that are both associated with increased influence of the
CEO on pay-setting and board decision-making," the authors write. "These findings are consistent
with the view that grant date manipulation reflects governance problems."
2006 paper, entitled Lucky CEOs, also
examined the scope of the scandal, estimating that about 1,150 lucky grants resulted from
manipulation and that 12 percent of public firms (720) provided one or more manipulated lucky grant
between 1996 and 2005. As if "lucky" grants were not bad enough, the study finds about 1,000
"super-lucky" grants awarded at the lowest price of the calendar quarter, about an estimated 62
percent of which were due to manipulation.
To underscore the connection between management
and boards in option manipulation, the trio issued a companion paper, Lucky Directors. The
December 2006 study finds outside directors at seven percent of firms received manipulated lucky
grants during the 1996 to 2005 period.
"We estimate that about 800 lucky grant events
owed their status to opportunistic timing, and that about 460 firms and 1,400 outside directors
were associated with grant events produced by such timing," they write in the paper.
They also document a correlation between director "luck" and poor corporate governance.
"Grant events were more likely to be lucky when the firm had more entrenching provisions
protecting insiders from the risk of removal [and] when the board did not have a majority of
independent directors," state the researchers in the paper. "And outside directors' luck was
correlated with CEO luck."
"The Sarbanes-Oxley Act (SOX) reduced the incidence but did not eliminate the
opportunistic timing of directors' grants," they add.
Unfortunately, even the flood of
research on options backdating will not necessarily result in justice.
"I believe that
only a minority of firms that have engaged in backdating of option grants will be caught," says Prof. Lie on
his website. "In other words, we will never see the full iceberg."
Prof. Lie cites two
reasons. First, backdating can be hard to identify.
"[Second, both] the regulators and
the investment community might be content to set some precedents based on a limited set of
backdating cases to send a signal that backdating and similar behavior will be punished severely,"
Prof. Lie states. "In any event, resources will likely be put in place to improve the disclosure
requirements for option grants and enforce existing regulations."