What Drives Executive Stock Option Backdating?

• Author: Betty H.T. Wu,Chris Veld
• Published date: 01 September 2014
• Date: 01 September 2014
• DOI: http://doi.org/10.1111/jbfa.12077

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 41(7) & (8), 1042–1070, September/October 2014, 0306-686X

doi: 10.1111/jbfa.12077

What Drives Executive Stock Option

Backdating?

CHRIS VELD AND BETTY H.T. WU∗

Abstract: We study motives for executive stock option backdating, the practice of changing

the grant dates of current options to dates in the past using hindsight. We find that smaller,

younger and less profitable firms tend to be more heavily involved in backdating. These results

are consistent with the retention hypothesis. In line with the incentive hypothesis, we find that

backdating occurs more for options that are out-of-the-money. Wederive some evidence for the

agency hypothesis, in the sense that backdating companies have a larger percentage of inside

directors. However, contrary to this hypothesis, we conclude that backdating firms have better

protection for minority shareholders compared to firms that do not backdate.

Keywords: executive compensation, stock option grants, backdating, corporate governance

1. INTRODUCTION

In December 2006, shareholders of the Apple Company were relieved to find that the

iconic chief executive, Steve Jobs, was largely exonerated from blame in the backdating

of employee stock options of the company. Option backdating is the practice of using

hindsight to change the grant dates of current options to dates in the past. Because of

accounting conventions and tax considerations, employee stock options are generally

granted at-the-money, i.e., the exercise price is set equal to the market price. If options

are backdated, in fact the exercise price is lowered by choosing a date in the past

∗The first author is at Monash University, Caulfield Campus, Melbourne, Australia. The second author is at

University of Glasgow Adam Smith Business School, Glasgow, UK. The authors would like to thank Steven

Young, Associate Editor,and an anonymous referee for very insightful comments that significantly improved

the paper.We are indebted to Riccardo Calcagno, Enrico Perotti, Ludovic Phalippou and Zacharias Sautner

for constructive comments and advice. We also thank participants at the 2013 British Accounting and

Finance Association (the Scottish Area Group) Annual Conference, the 2012 Capital Markets Conference,

the 2011 NTU International Conference on Economics, Finance and Accounting, the 2009 Financial

Management Association Annual European Conference, the 2009 Midwest Financial Association Annual

Meeting, the Final Conference of European Corporate Governance Training Network, the 2008 Doctoral

Session of European Finance Association Annual Meeting and seminar participants in the University of

Glasgow, the Korea University Business School, the Yonsei School of Business, the SKK GSB, the Finance

Group at University of Amsterdam, and the Tinbergen Institute for useful comments and suggestions. We

thank Annie H.L. Wu for assistance in the earlier version of the paper. Lastly, Betty Wu is grateful to the

European Corporate Governance Training Network for financial support. (Paper received October, 2011,

revised version accepted March, 2014)

Address for correspondence: Betty Wu, Adam Smith Business School, Glasgow G12 8QQ, Scotland, United

Kingdom.

e-mail: Betty.Wu@glasgow.ac.uk.

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WHAT DRIVES EXECUTIVE STOCK OPTION BACKDATING? 1043

with a lower stock price. This practice is not illegal in itself, as long as it is revealed to

shareholders, but it can be controversial as the Apple case shows.

Yermack (1997), the precursor of the literature on option backdating, identified

a pattern of abnormal stock price returns around executive stock option grants in

the sense that there were abnormally high returns immediately after these options

were granted. Other than pure luck and/or the ability to forecast stock prices, firms’

timing of option grants or firm-related announcements, or “springloading”, is the

most likely explanation for these abnormal returns. Several subsequent studies (for

example, Aboody and Kasznik, 2000; Chauvin and Shenoy, 2001; Lie, 2005; Heron and

Lie, 2007) further show that stock returns are abnormally low before the grant dates.1

Lie (2005) and Heron and Lie (2007) argue that the stock options in question are

more probably backdated and that the firms are unlikely to be timing grants and/or

backdating information flow to the market. In other words, with hindsight, the grant

dates of current options are changed to dates with lower strike prices.

Heron and Lie (2009) estimate that 13.6% of all top executive (CEO) option grants

from 1996 to 2005 are backdated or otherwise manipulated. This estimate is 18.9% for

unscheduled at-the-money grants, but it has decreased significantly since the passage

of the Sarbanes-Oxley Act of 2002 (SOX).2At the firm level, 29.2% of their firms are

estimated to have backdated grants, though not all grants have been backdated.

Firms often argue that option backdating is essential to restore incentives and to

retain talented executives. Both arguments are backed up by empirical research: for

example, Fang (2010) finds evidence for the retention explanation, and the research

of Gao and Mahmudi (2011) supports the incentive hypothesis. However, others

have argued that by resetting existing option grants to a date with a favorable price,

executives are in fact rewarded for poor performance, which can be viewed as an

example of managerial entrenchment or rent-seeking. Studies by, for example, Collins

et al. (2009) and Bizjak et al. (2009) relate option backdating to inferior corporate

governance, also known as the agency hypothesis. The anticipation of possible option

backdating is detrimental to managerial incentives, i.e., executives profit from upside

risk (when options become in-the-money) while enjoying protection from downside

risk (when out-of-the-money options are backdated). The empirical findings of studies

that test the agency hypothesis go in different directions: Collins et al. (2009) find that

option backdating results from weak governance, whereas Bizjak et al. (2009) do not

find such a relation.

Despite the fact that there are a number of empirical studies on the causes of

backdating, there is no conclusive evidence as of yet. For example, the literature is

divided on whether or not option backdating is associated with weak governance. In

addition, the empirical research tends to be fragmented with different studies focusing

on different aspects of the cause for backdating. The goal of this paper, therefore,

is to compare the competing explanations for backdating, i.e., incentive alignment,

retention and agency considerations. By combining proxies for all three different

1 The combination of low abnormal returns before the backdating and high abnormal returns after is often

referred to as the “V”-shape for option backdating.

2 On August 29, 2002, this Act was passed to address issues such as independent auditors, corporate

governance, internal control assessment and financial disclosure. Among others, firms are required to

report their executive stock option grants within 2 business days to the Securities and Exchange Commission

(SEC), which makes this information available to the public within 1 day. Previously,reports of such grants

were not due until 45 days after the firm’s fiscal year end and were to be announced to the shareholders in

the proxy statement for the following year’s annual meeting.

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