DO SCANDALS TRIGGER GOVERNANCE CHANGES? EVIDENCE FROM OPTION BACKDATING

• Published date: 01 March 2018
• Author: Lalatendu Misra,Yilun Shi,Atul Gupta
• DOI: http://doi.org/10.1111/jfir.12140
• Date: 01 March 2018

DO SCANDALS TRIGGER GOVERNANCE CHANGES?

EVIDENCE FROM OPTION BACKDATING

Atul Gupta

Bentley University

Lalatendu Misra

University of Texas at San Antonio

Yilun Shi

Independent

Abstract

We examine whether firms charged with backdating option grants make discernible

changes to board structure and activity and whether such changes help recoup value

losses from the revelation of option backdating. We find that these firms increased board

size, reduced duality, and increased board independence. In addition, the boards and the

compensation committees of these firms experienced significant increases in meeting

frequency. We also find that firms in the same sectors that had not been identified as

backdating option grants experienced similar changes in board activity and some

elements of board structure. Additional analysis reveals that increases in board size,

chief excutive officer turnover, and the meeting frequency of the audit committee are

related to buy-and-hold abnormal returns in the postscandal period.

JEL Classification: G30, J33

I. Introduction

Reputational damage resulting from public revelation of corporate misconduct has a

significant negative impact on a firm’s stakeholders (e.g., Alexander 1999; Gande and

Lewis 2009; Bernile and Jarrell 2009; Karpoff and Lott 1993; Karpoff, Lee, and Martin

2008a, 2008b; Palmrose, Richardson, and Scholz 2004). The likelihood of corporate

misconduct is itself strongly related to the presence of financial incentives in the form of

option-based compensation and the quality of the firm’s governance systems (e.g.,

Collins, Gong, and Li 2009; Carver, Cline, and Hoag 2013; Minnick and Zhao 2009).

Corporate actions designed to stem the damage and rebuild reputation generally include

replacing top executives, improving board independence, and possibly restructuring

elements of executive compensation.

We contribute to this literature by focusing on firms charged with backdating

(BD) stock option grants and asking a series of broad questions. First, do these firms

We thank an anonymous associate editor and referee for their helpful comments. Earlier versions of the paper

were presented at the Southern Finance Association and the Southwestern Finance Association meetings.

The Journal of Financial Research Vol. XLI, No. 1 Pages 91–111 Spring 2018

91

© 2018 The Southern Finance Association and the Southwestern Finance Association

experience discernible changes in board structure and activity in the period following the

scandal? We focus on three measures of board structure—board size, independence, and

duality—and three measures of board activity—the meeting frequency of the full board,

the compensation committee, and the audit committee. Second, are there spillover effects

on oversight and governance for other firms in the same industries as those charged with

BD? Third, are any such changes transitory and restricted to the year of the scandal or are

improvements in board structure and activity observable in later years? Finally, do

changes in board structure and activity help reduce the financial damage triggered by the

scandal?

Our work is similar in spirit to Far ber (2005) and Marciukaityte et al. (2006),

who examine the effectivene ss of governance changes at firms charged with fraud.

These firms had weak governance structur es in the year preceding the fraud charges

but implemented a variety of chan ges over the next three years tha t brought their

governance characteristi cs in line with the set of control firms. Farber reports that firms

charged with fraud experience d superior stock price perfor mance in the years

following the governance ch anges, but Marciukaityte et al . do not find abnormal stock

returns or improvements in o perating performance follow ing the changes in corporat e

governance.

The findings of Farber (2005) and Marciukaityte et al. (2006) apply to firms that

engaged in fraudulent activities with potentially severe implications for corporate

valuation. The BD scandal, in contrast, was primarily a reputational event; the practice

did not have significant cash-flow consequences and the revelation of option BD had a

relatively small effect on shareholder returns (Bernile and Jarrell 2009). In addition, BD

firms constitute a large sample of firms charged with a specific type of misconduct. Using

a sample where there is a relatively homogeneous set of charges is useful because both

the corporate response to fraud charges and the firm’s ability to recover from the damage

may vary with the type of infraction.

Our empirical analysis uses a sample of 115 firms that are charged with BD

option grants and a matched sample of firms that are not targets of a BD investigation.

Consistent with earlier studies (Bernile and Jarrell 2009; Carow et al. 2009; Narayanan,

Schipani, and Seyhun 2007), we find a negative and statistically significant price reaction

to news of the BD charge. Following the revelation of BD, we find that the sample firms

experienced significant increases in board size, board independence, and chief executive

officer (CEO) turnover; a significant decline in duality; and significant increases in the

meeting frequency of the board and the compensation committee. Our findings suggest

that these firms made a concerted effort to address reputational problems by improving

oversight procedures in the wake of the BD scandal.

Several of the changes in board structure and activity are not restricted to firms

charged with BD but are also observed at the set of control firms. In particular, we

document significant increases in meeting frequencies for the board and the

compensation committee, as well as significant changes in duality and CEO turnover

at these firms. Our findings indicate that the revelation of option BD by some firms had a

spillover effect on monitoring and governance practices at not just those firms charged

with BD but also firms in related sectors that made significant use of option-based

compensation.

92 The Journal of Financial Research