M.P. Narayanan and H. Nejat Seyhun
Playing Dating Games with Stock Options
Managers not only backdate, but forward-date, as well, Ross School research shows.
ANN ARBOR, Mich.—While the fallout from corporate accounting scandals has curtailed backdating of stock options, it is still prevalent. In fact, executives also influence their compensation by engaging in another kind of dating game—forward-dating, say researchers at the University of Michigan's Stephen M. Ross School of Business.
When backdating, executives report to the Securities and Exchange Commission that they received options from their corporate board on a date prior to the actual time the board decision was made—if the stock price was rising before the board decision date.
But if the stock price was falling prior to the board's decision, backdating is clearly unprofitable, since the price may end up even lower after the grant date, the researchers say. The lower the stock price on the reported grant date, the greater the payoff.
"In this case, managers may wait to see how the stock price behaves afterwards," says H. Nejat Seyhun, U-M professor of finance. "If it continues to fall, they may designate a date in the future as the grant date, trading off the benefit from even lower exercise prices against the risk of getting caught. We term this form of the dating game as forward-dating."
Seyhun and colleague M.P. Narayanan examined more than 638,000 option grants from Aug. 29, 2002—when the Sarbanes-Oxley Act became effective—until the end of 2004. A provision within the law requires executive stock option grants to be reported within two business days after the grants.
The researchers found that nearly a quarter of executives still report their options late in spite of potential legal sanctions. About 10 percent report more than a month late.
Consistent with backdating, Seyhun and Narayanan found that post-grant date returns and stock-return reversals around the grant date are positively correlated with reporting lags.
Moreover, even among executives who report promptly within the two-day window, large negative returns prior to the grant day increases the probability of having a reporting lag of two days, the study shows.
"Specifically, we find that when stock returns are negative prior to the grant date, post-grant date returns tend to be positive and managers are more likely to report in the maximum allowed two days," said Narayanan, professor of finance at the Ross School.
According to the study, executives have complied more closely with SOX requirements over time. The average reporting lag has declined from nearly 18 days in 2002 to just over eight days in 2004.
The magnitude of gains for large grants from backdating can be significant, the researchers say. By reporting 30 days late, a manager receiving a grant of 1 million shares of a typical company’s stock can increase the value of his or her option compensation by about 8 percent.
"By conservative estimates, this is equivalent to a windfall of $1.2 million," Narayanan said.
Seyhun and Narayanan also found that dating games are more likely to be played by smaller firms, when grants are large or unscheduled, and when senior executives are the recipients.
Managers in the transportation and energy industries report most promptly, while those in public utilities and consumer services are the biggest late reporters. Dating games, however, are most prevalent in the technology sector, which accounts for nearly half of all option awards.
To mitigate backdating and forward-dating, the two-day reporting requirement should be strictly enforced and firms should be required to grant options only on previously scheduled dates, such as the fiscal year-end.
"Our findings lend credence to the view that executive compensation-setting is not an arms-length transaction between the board and the manager and that senior managers have the power to influence their own compensation," Seyhun said. "Discovery of dating games is likely to lead to sudden loss of confidence in the firm's management team and lead to potential legal problems for both the firm and the executives involved.
"It is imperative, therefore, to improve corporate governance by putting in place effective checks and balances to prevent these dating games."
For more information on the researchers and their work, visit http://sitemaker.umich.edu/optionsdating.
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