Guilty until Proven Innocent: The Economic Consequences of the Initiation and the

Outcome of Internal Investigations of Option Backdating

Discussion

CAPANA Conference

July 2010

V-shaped Return Pattern

Progression of the Literature

• V-shaped returns pattern around stock option grants (Yermack, 1997)

• Attributed to timing of stock option grants via opportunistic voluntary disclosures (Aboody and Kasznik, 2000; Chauvin and Shenoy, 2001)

• Based on sample of “unscheduled” option grants: V-shaped pattern attributed to option backdating (i.e., options granted ex post on a day when price was low) – Lie (2005) and Heron and Lie (2007)

Backdating Investigations

• Firms lost around 8% of market cap over announcement window (Narayanan et al., 2006)

• Potential benefits to executives were miniscule ($600k per firm)• Puzzle: Challenges the agency problems (or managerial

opportunism) motivation for backdating• Gao and Mahmudi (2008): alternative motivation – efficient

contracting hypothesis:– Use subsequent minus prior CARS over a 10-day window around

option grants as proxy for backdating.

– Find: Better corporate governance associated with more backdating; backdating associated negatively with CEO’s cash compensation and positively with executive pay-performance sensitivity.

– Conclude: backdating reduces compensation cost and increases managerial incentives.

Li, Elayan and Meyer (2009)

• Also examines motivations for backdating, using a sample of firms with internal investigations of backdating

• Proxy = alleged back-dating• Examine alternative motivations: managerial

opportunism versus economic benefits (employee retention, incentives, and morale)

Market Reaction Test

Interesting Results:

• Negative returns on announcement of initiation of investigation

• More negative for intentional backdating firms (-5.2% versus -1.6%)

• Announcement of outcome of investigation:– Insignificant return for intentional backdating firms– Significant positive returns for unintentional and no-

backdating firms

Motivations for Backdating

• Managerial Opportunism variables:– FV of options to total compensation of top 5 executives– % shares & options owned by top 5 executives

• Economic Benefits variables (employee retention and morale):– Pay-performance sensitivity (PPS) of option grants– % of options granted to non-executive employees

• Findings:– Managerial incentives, weak corporate governance, internal

control deficiencies, PPS of options, % of options to non-executives associated with higher likelihood of backdating

• Find support for both managerial opportunism and economic benefits motivations

Comments

• Interpretation of on average results• Is managerial opportunism more associated with

intentional backdating firms and economic benefits with unintentional or no backdating firms?

• Useful to examine motivations based on the outcome of the investigation

Comments (continued)

• Univariate results (Table 2) suggest no difference between intentional and unintentional/no backdating firms in relation to variables proxying for either of the two motivations – problematic!

• Suggestions: – Consider corporate governance and internal control weakness

as indirect proxies of managerial opportunism– Improve proxies capturing both motivations –

• Currently-used proxies may simply be capturing the reward and incentive structures of option-granting firms

• Refine proxies by estimating “abnormal” measures or industry-adjusted measures (e.g., abnormal option compensation as a % of total compensation, similar to Core and Guay, JAE 1999)

Reasons for negative market response to announcement of investigation

• Variables:– Managerial opportunism variables– Economic benefits variables– Media bias (% of articles on backdating)– Investigation outcome uncertainty (resignation/termination of

management, number of lawsuits filed, self-initiated investigation vs. SEC/DOJ initiated, financial leverage

• Find: No relation between CAR and managerial opportunism and economic benefits variables; weak corporate governance, high outcome uncertainty, and high media coverage associated with more negative CARs.

Comments

• Strong corporate governance associated with higher returns – does not seem like the market is changing its beliefs about firms with strong corporate governance as hypothesized by authors??

• Why is the market response not consistent with managerial opportunism and economic benefits motivations?

– Univariate analysis (Table 4) suggests that the market has the ability to predict the outcome of the investigation – but outcomes are unable to differentiate motivations (Table 2), hence it is not surprising that motivations do not explain the market reaction!

• Suggestions:– Need to obtain better proxies capturing managerial opportunism and

economic benefits– Include control firms in the market reaction analysis – may be outcomes

can better differentiate motivations relative to control firms?– Or, Include control for self-selection of backdating (inverse Mills ratio

from first-stage regression?)

Additional Comments

• May be interesting to see what variables drive the market reaction on the investigation outcome announcement??– Is the return reversal for unintentional/no backdating

firms stronger when the initial reaction was caused by media hype?

– Is there really a media “bias”? Or, are intentional backdating firms correctly given more negative publicity?

Concluding Remarks

• Interesting paper• New insights using investigation outcomes• Definitely worth reading

Thank You!