The economic impact of backdating of executive stock options.

• Author: Narayanan, M.P.

This Article discusses the economic impact of legal, tax, disclosure, and incentive issues arising from the revelation of dating games with regard to executive option grant dates. It provides an estimate of the value loss incurred by shareholders of firms implicated in backdating and compares it to the potential gain that executives might have obtained through backdating. Using a sample of firms that have already been implicated in backdating, we find that the revelation of backdating results in an average loss to shareholders of about 7%. This translates to about $400 million per firm. By contrast, we estimate that the average potential gain from back dating to all executives in these firms is about $500,000 per firm annually. We suggest some remedies not only for backdating, but also for other dubious practices such as springloading.

TABLE OF CONTENTS INTRODUCTION I. AN OVERVIEW OF BACKDATING AND FORWARD-DATING II. ECONOMIC IMPACT OF BACKDATING A. Legal Issues 1. Violation of Federal Securities Laws 2. State Corporate Law Implications B. Tax Issues C. Financial Reporting and Disclosure Issues D. Incentive Issues III. EVIDENCE ON THE ECONOMIC IMPACT OF DATING GAMES A. Characteristics of Implicated Firms and Their Grants B. Stock Price Behavior of Implicated Firms Around Option Grant Dates C. Estimates of Stealth Compensation from Backdating D. Impact of Revelation of Backdating on Shareholder Value IV. REMEDIES CONCLUSION INTRODUCTION

The burgeoning compensation packages of top executives of U.S. companies have attracted considerable attention in the past few years. (1) Most of the public attention has centered on compensation levels (2) while academics have focused on the incentive effects of compensation. (3) Shareholder activists have argued for years that compensation levels are high because top executives have captured the compensation process and that it is no longer an arms-length transaction between the board and the top executives. (4) Although academics have been slower to consider this point of view, there has been a spate of research in recent years that provides evidence inconsistent with the arms-length model. (5)

In this Article, we discuss the implications of one form of executive capture of the compensation process, namely, the practice of backdating executive stock options. Evidence consistent with the practice of backdating was first identified in 2005 by Professor Lie (6) and by Professors Narayanan and Seyhun. (7) Although the media subsequently picked up the results of this research and started reporting on the practice, (8) it became a full-fledged scandal when the Wall Street Journal published a report on its front page suggesting that executives of six companies might have backdated their options. (9) Since then, there have been new revelations of backdating on a regular basis. As of this writing, over one hundred companies have been embroiled in backdating, with the Securities Exchange Commission ("SEC"), the Justice Department, the Internal Revenue Service ("IRS"), and several state attorneys general starting their own investigations. (10) It has also triggered questions about the role of auditors in checking this practice.

Backdating is only one form of dating game that executives can play. Backdating occurs when the executive (with or without the knowledge of the board) designates as the options grant date some date before the date on which the board in fact decided to grant options. (11) The executive does this to obtain options at a lower exercise price because the board-designated exercise price typically mirrors the stock price prevailing on the board-designated grant date. (12) Thus, backdating is only worthwhile if the stock price has been rising in the days before the board decision date. Although backdating has received the most attention, other dating games are also possible. For example, if the stock price has been falling before the board's decision date, executives can wait to see what the stock price does in the near future before designating a grant date (backdating is clearly pointless). If the stock price continues to fall, they can designate a future date as the grant date. We term this practice forward-dating. (13)

We argue in this Article that misdating of option grants has economic implications resulting from legal, tax, disclosure, and incentive issues, all of which are detrimental to shareholders. Specifically, we discuss four consequences of misdating that can adversely impact shareholder value. (1) Legal issues: There are legal consequences arising from backdating or forward-dating without complete disclosure. In addition, the ethical issues raised might have economic consequences as they undermine investors' confidence in top executives. (2) Tax issues: The tax treatment of in-the-money options is different than the tax treatment of at-the-money options with implications for both the company and its executives. (3) Corporate disclosure issues: Disclosure of misdating practices can lead to the restatement of earnings, as the camouflaged pay is recognized as a compensation expense. The reduced earnings can also result in a downward reassessment of shareholder value. (4) Incentive issues: Misdating amounts to stealth compensation. If this is done because executives have captured the compensation process, then the managers are being inefficiently compensated, resulting in incorrect incentives.

We discuss the economic impact of each of the above issues. We then measure the economic impact of dating games on a list of firms that have already been implicated or are under investigation for these practices. The list of firms is taken from a website maintained by the Wall Street Journal. (14) We find that firms on this list lost on average a market value of $389 million per firm during a window of twenty-one days around the first announcement that implicated a firm in backdating, either by the firm's own admission, or because the SEC or the Justice Department had commenced an investigation. (15) We compare this figure to the average gain executives of these firms might have achieved during 2000-2004 if they had backdated aggressively, i.e., backdated on every grant date that backdating would have been profitable. We find that executives would have benefited by $500,000 per firm per year at most by backdating during this period. (16) It appears that the potential benefit to executives from clandestine backdating is miniscule compared to the potential damage to shareholders.

We suggest some remedies to eliminate clandestine backdating and other types of stock price manipulation influencing executive compensation. It has been documented that the Sarbanes-Oxley Act of 2002 ("SOX") (17) has not been successful in fully eliminating clandestine backdating or other forms of manipulation such as springloading, where managers manipulate the timing of the release of information around the grant date. (18) Recently the SEC has voted to approve changes to reporting requirements that will eliminate the dating games. (19) We discuss remedies to eliminate springloading as well.

The Article is organized as follows. Part I provides an overview of the dating games, namely backdating and forward-dating. Part II discusses the four consequences of these dating games and their impact on shareholder value. Part III measures the impact on the shareholder value of a list of firms already implicated in dating games. Part IV suggests some remedies for limiting the manipulation of executive compensation. The Conclusion summarizes our findings and conclusions.

1. AN OVERVIEW OF BACKDATING AND FORWARD-DATING

   In this section we provide a brief description of two types of dating games, namely backdating and forward-dating, and the academic evidence consistent with their prevalence before and after the enactment of SOX. We conclude by describing the types of companies and executives that appear more likely to backdate and the option-granting procedures that appear to encourage backdating. Before we describe these games, it is important to note that neither backdating nor forward-dating by itself is illegal, as long as it is duly authorized by the board, fully disclosed, and reported in keeping with tax rules.

   Dating games are best explained using simple examples. Suppose an executive is awarded options on April 15 by the board of directors when the firm's stock price is $40. As is the practice with almost all awards, these options are awarded at-the-money, meaning that the exercise price is set equal to the stock price on the grant date, here $40. (20) If the stock price at the time of exercise exceeds the exercise price of $40, the payoff to this executive will be the difference between the stock price prevailing at the time of exercise and the exercise price of $40.

   Suppose the firm's stock price has been rising before the board decision date. The executive sees an opportunity to increase her compensation and declares that she received at-the-money options on March 15, when the stock price of $30 was below $40, and files a Form 4 report with the SEC stating that March 15 is the grant date. (21) This is backdating. This declaration automatically sets the exercise price equal to the stock price on March 15, or $30. What the board intended was that the executive receive options on April 15 with an exercise price of $40. What the executive declared was that she received at-the-money options with an exercise price of $30 on March 15. The payoff to this executive now equals the stock price at the time of exercise less the exercise price of $30 if the stock price ends up above $30 at the time of exercise. By obtaining options at a lower exercise price than the board intended, the executive received more compensation than intended by tampering with corporate documents. Also, because the board decision was really made on April 15, this executive received options that are $10 in-the-money...