The number of companies ensnared in the backdating scandal just keeps on growing. Yet at the same time, many in the business lobby continue to argue that stock options misdating is a victimless crime. Business Professor H. Nejat Seyhun begs to differ.
In a soon-to-be-published study, Seyhun and his colleagues at the University of Michigan’s Ross School of Business found that 48 companies linked to the backdating scandal lost an average of $510 million in market value – or 8% average loss – in the three weeks after disclosure of their involvement. By comparison, the executives involved gained at most a total of $600,000.
As the study notes: “It appears that the potential benefit to executives from clandestine backdating is miniscule compared to the potential damage to shareholders.”
The Securities Fraud Monitor spoke with Seyhun about the options scandal, his research and the implications for shareholders.
Securities Fraud Monitor:Your study analyzed the market value losses of 48 firms that have been accused of backdating practices. Do you think the findings apply to an even broader spectrum of Wall Street companies?
H. Nejat Seyhun: We have just updated that initial study to include [a total of] 88 firms that have been identified by The Wall Street Journal or otherwise linked to the scandal. The numbers did not change significantly, although the losses did fall slightly – from $500 million per firm to about $436 million per company. The corresponding gain for executives also fell from $600,000 to $500,000 per year. But qualitatively, our earlier results continue to hold. This scandal will eventually cost shareholders up to $100 billion.
SFM: We understand you and your colleagues were studying these backdating scams long before the regulators and the media caught onto it.
HNS: The stock price patterns around option grant dates were well known for a long time. David Yermack [of New York University] had done a lot of work in the mid 1990s. He showed stock prices were rising after the granting of options, and he attributed it to springloading. Then other researchers noticed that stock prices were falling before the grant date as well. That was called bullet-dodging.
We were not convinced that that was all that was going on, because we noticed that the companies whose stock price fell before the grant date were also the ones whose stock price bounced back after the grant date.
While we could believe that bullet-dodging and springloading could occur in different companies at different times, we just did not find it credible that the same firms could be experiencing both at the same date. It seemed too risky and we thought it would be impossible to pull off. The company would have to announce some bad news only to be followed a few days later by especially good news.
Then, in early 2004, my colleague M.P. Narayanan had lunch with an executive who said that they were actually backdating options in his own firm. Backdating could easily explain both the falling as well as the rising stock price patterns.
Our intuition was the following: if companies were backdating, and they had to report option grants immediately, then there would be built-in reporting lags. So if I get the option today and report it tomorrow, but pretend I got it six months ago, then there would be a built-in six-month delay.
We looked to see if these V-shaped patterns around the granting of the options were more pronounced the bigger the reporting delays. Data confirmed our hypothesis. The bigger the reporting lag, the bigger the V-shaped price reversals around the grant date. We finished our paper in January 2005 and sent it to an academic journal for publication consideration. Unfortunately for us, no one could believe that top-level corporate executives would do this. They thought our claims were outlandish.
SFM: How long did it take before people did start to believe?
HNS: We kept trying to publicize our findings. But it wasn’t until The Wall Street Journal wrote its backdating story, “Perfect Payday,” in March that people started paying attention.
SFM: Would you say your analysis provides backdating proof?
HNS: I wouldn’t say it’s proof, exactly. For proof that would stand up in court, you need to look at actual corporate documents to see when did the board meet and when did the person receive the option grant. Our research provides convincing statistical evidence. I would say it is highly persuasive statistical evidence, but it is still statistical evidence.
There’s always a chance that somebody may have reported their options grant late and then got lucky by getting the stock for a minimum price. But based on our research, we can make statements such as “there’s only a one-in-a million chance that these options grants were due to random events.”
SFM: You have also found strong evidence of other games executives play. Can you explain the difference between backdating and forward dating?
HNS: Backdating is when the board grants options on a certain date, but the grant date for the executive is then set back to a date when the stock was at a lower price. Since options are issued with an exercise price equal to the stock price on the grant date, that means the options are immediately “in the money.” What is happening here is a form of fraud. The top executive is basically changing the board’s intent and decision in order to increase his or her compensation.
Forward dating is another kind of game. If stock prices have been falling prior to the grant date, there is no point in backdating. This would only increase the exercise prices, and thus reduce the value of the options. However, executives can benefit by waiting to see if the stock prices will continue to fall. There is incentive to wait for a lower price.
If prices continue to fall, they can designate a date in the future (thus forward dating) with a lower stock price as the grant date. If prices immediately revert up, they can simply report the original date as the grant date with no loss of value. Forward dating is harder to detect because there may not be a built-in reporting delay anymore. [Sarbanes-Oxley requires options grants to be reported within two days.]
Let’s say I intend to play the forward dating game. Stock prices have fallen from $50 to $40 and I get the option award when the stock price is at $40. I decide to wait and not report the grants immediately to HR. If the price continues to fall to $30 and then goes up, I report the day it was $30 as the grant date. I get to earn an extra $10 per share from playing the forward dating game.
If, instead, the stock price goes up immediately to $41 and the day after that to $42, I simply report that I got the options two days ago when the stock price was $40. In this case, it looks like I was honest even though I had intended to play the forward dating game. No one will catch that. In the end, if prices fall, I win. If the prices go up, I don’t lose. This is a nice game
for me.
SFM: Is forward dating as prevalent as backdating?
HNS: We find very strong evidence for forward dating as well, but it’s more subtle and much more difficult to catch. It’s probably more egregious than backdating. An executive could always pin the blame on the HR department by saying: “Look, I told HR to process these grants, but they did not.” Or, “Gosh, I forgot to tell HR to process these.”
SFM: If forward dating is so egregious, how come we haven’t seen very much about it in the popular press?
HNS: I don’t think people understand what it is. We’re now yelling that there’s another game – the forward dating game – just like when we initially yelled about backdating. People didn’t pay attention then either. We’re going to continue to scream here.
SFM: Do you think the backdating scandal has gotten the attention it deserves?
HNS: I don’t really think so. Again, there’s a lot that people don’t understand. It’s shocking that The Wall Street Journal ran two or three stories defending backdating. [WSJ columnist] Holman Jenkins apologizes for corporate fraud that this is not a big deal, but he obviously missed the point. Somehow it didn’t register that this is a fraud going on. How can he or anyone else defend fraud?
What makes this illegal is that top-level management is tampering with corporate documents to the detriment of shareholders. It’s as if they added a zero to their paycheck.
SFM: Explain for us two other dating game terms: bullet-dodging and springloading.
HNS: Bullet-dodging refers to announcing the bad news before the granting of the options. With the bad news out, the stock price is reduced, allowing the executive to get the stock at a lowered price.
With springloading, you get the options first, then you announce the good news. These two practices are very close to insider trading. If the executive were to buy and sell shares on this news – rather than granting himself options – he would go to jail for the same act. Bullet-dodging and springloading shouldn’t be treated any differently than insider trading.
SFM: What does this scandal demonstrate about corporate America?
HNS: To me, one of the lessons of this debacle is just how much control the top management has over the board of directors. This really suggests that the top management is running the board – not the other way around. It suggests that the checks and balances of corporate governance are not there to protect shareholder interest.
SFM: So what are the possible fixes?
HNS: For starters, the chairman should be a separate person from the CEO. At companies where the CEO and the chairman are one and the same, it’s like the fox is guarding the chicken coop. Another way to encourage board independence is to make the votes of the board members secret, so none of the directors or the CEO knows how the other directors voted. Only the chairperson should know.
SFM: Should regulators be doing more to curb these abuses?
HNS: The SEC needs to address springloading and bullet-dodging. I applaud the new executive compensation changes the SEC implemented this summer. But they need to put some teeth into these changes. Sarbanes-Oxley is all good and fine. But nothing happens when Sarbanes-Oxley is ignored and somebody doesn’t file options grants in two days. There’s no penalty.
The SEC, for instance, could give shareholders private rights of action. So if somebody doesn’t report compensation in two days, investors can file a lawsuit. Or they could put in some explicit fines for each occurrence of non-compliance.