Backdating Executive Option Grants - Nanyang Technological ...

Backdating Executive Option Grants - Nanyang Technological ...

Backdating Executive Stock Option Grants: Is It All Agency?Huasheng GaoNanyang Business SchoolNanyang Technological UniversityS3-B1A-06, 50 Nanyang Avenue, Singapore, 639798(65) Mahmudi ∗Price College of BusinessUniversity of Oklahoma307 Brooks Street, Norman, OK 73019405.819.0702hamed@ou.eduThis version: February 2013 First version: November 2007Abstract: It is widely documented that managers tend to backdate their stock option grants sothat a past date on which the stock price was particularly low is picked to be the grantdate. Using a simple model of incentive contracting as a guide, we examine empirically whethersome aspects of this practice may be an optimal response of firms to distortions in theinstitutional environment, in particular tax law and accounting rules. Some of our findingssuggest, in fact, that firms may be attempting to efficiently lower the exercise price of theexecutive options in order to lower compensation cost for risk averse and poorly diversifiedexecutives, and in the presence of restrictive accounting and tax rules, backdating may be amechanism to achieve this objective. Using data on corporate governance and executivecompensation, we find the following evidence consistent with our theory of efficient contracting:(i) backdating is often associated with good corporate governance; (ii) backdating is oftenassociated with better ex-post incentive structures; (iii) backdating is often associated with loweroverall managerial compensation; (iv) after the Sarbanes-Oxley Act (SOX) of 2002 whichgreatly constraints firms from backdating, firms that were involved in more backdating in thepre-SOX period have greater increase in CEO pay. These empirical results suggest that themanagerial agency problems previously cited as an explanation for option backdating may beonly part of the story underlying this complex and wide-spread practice.JEL Classification: G32; J33Keywords: Backdating; Executive Compensation; Efficient Contracting∗ We thank Alexander Dyck, Kai Li, Alan Kraus, Michael Lemmon (WFA discussant), Hernan Ortiz-Molina, RalphWinter, Laurence Booth, Craig Doidge, Jan Mahrt-Smith, Adlai Fisher, Ambrus Kecskes, Feng Zhang, ZhongzhiSong, Yuan Gao, Konstantinos Zachariadis, and seminar participants at the University of British Columbia,University of Toronto, Shanghai Advanced Institute of Finance, the 2008 WFA meeting, the 2008 EFA meeting andthe 2008 FMA meeting for insightful discussions. All errors are ours. This paper was previously circulated under thetitle “Backdating Executive Stock Option Grants: An Agency Problem or just Efficient Contracting?”

The goal of backdating, it becomes clearer than ever, was to motivate employees at thelowest possible cost to shareholders. This was done by granting stock options that, at the date ofissue, were "in the money".1. IntroductionHolman W. Jenkins, Jr., The Wall Street Journal, December 16, 2009, A25There has been an active debate in the executive compensation literature between theefficient contracting view and the managerial power view. The former argues that the board ofdirectors optimally designs compensation contracts to align managers’ interests with those ofshareholders, while the latter argues that powerful managers can influence the terms of their owncompensation and that the compensation practice is largely inefficient (see Weisbach (2007) andLarcker et al. (2011) for a review). The recent events regarding executive option backdatingprovide a setting to examine these viewpoints.The conventional wisdom is that backdating provides a powerful example of the weaknessesin corporate governance in the United States. For example, Arthur Levitt, former chairman ofSEC, states “Backdating is ripping off shareholders in an unconscionable way,” (Forelle andBandler (2006)). Bebchuk et al. (2010) also suggest that executive option backdating is the resultof an agency problem whereby managers manipulate their compensation terms for their ownbenefits at the expense of shareholders. Moreover, there is evidence that option backdating iswidespread, as Heron and Lie (2009), who brought backdating to public attention, find that thisproblem afflicts 29.2% of US corporations.In this paper, first, we examine the backdating evidence and, surprisingly, find thatgovernance is at best a partial explanation. If backdating is a consequence of powerful managersmanipulating their option grants at the expense of the shareholders, we should expect that weakercorporate governance predicts backdating. While it is true that worse governance predicts1

ackdating for some measures of governance, this is not what we find more generally.Specifically, for the larger sample better governance predicts more backdating, particularly whenwe use more general measures of governance and the full sample of backdaters. 1 This relation iseven stronger for riskier firms, for the period prior to the Sarbanes-Oxley Act (SOX), for longertenureCEOs, for larger option grants, and for the case when other top executives receive optiongrants along with the CEO. 2Since the governance explanation is at best a partial rationale for the patterns we observe inthe data, we consider alternative explanations for backdating and conduct tests to examine theirpower in explaining the evidence. The dominant alternative to the managerial power view toexplain compensation setting is efficient contracting. Here, we build on the work of Hall andMurphy and consider a context in which shareholders design option compensation to incentivizemanagers. Like Hall and Murphy (2000, 2002), the theory demonstrates that the optimal strikeprice for an option grant is usually lower than the grant-date stock price for an under-diversifiedand risk-averse CEO. The challenge with such a policy is the tax and accounting disadvantages.Under current tax rules, CEOs can benefit from a lower tax rate aligned with a capital gain andcan defer the tax to the time of exercising the option grant. Generally, if all rules are compliedwith, the recipient of an option grant pays taxes on his entire option profit at the lower tax rateapplicable to long-term capital gains. To qualify for the lower tax bracket, the option must begranted at or out of the money. Backdating sidesteps such issues, while of course raising legaland ethical quandaries, a topic we discuss at much greater length later. 31 We also conduct robustness tests on our backdating and governance measures following studies such as Heron andLie (2009), Bizjak et al. (2009), Collins et al. (2009), and Bebchuk et al. (2010). Our results are robust to thesealternative measures.2 Recent studies, such as Collins et al. (2009) and Bebchuk et al. (2010) argue that backdating is associated withpoor corporate governance.3 See Walker (2007) and Fleischer (2007) for a detailed discussion on the tax/accounting issues for executive optioncompensation.2

This view helps to reconcile the broader evidence of a (weak) positive association betweengovernance and backdating, but by itself is weak evidence. Luckily, this explanation suggestsfurther tests that help to differentiate between the efficient contracting and the managerial powerviews. A natural implication of the managerial power view is that managers would benefitfinancially from backdating, getting higher total compensation. The contracting view suggeststhe alternative: Backdating is associated with better alignment of shareholder-manager interestand reduces compensation level for executives.First, we examine the relation between backdating and managerial incentive portfolio. Ourempirical results highlight a positive association between backdating and the pay-performancesensitivity in executive pay. This evidence is consistent with the view that option backdatingcould be part of efficient contracting which helps to strengthen managerial incentive.We then examine the relation between the level of the CEO pay and his backdating behavior.Supporting the efficient contracting view, we find that backdating is negatively related with theCEO’s total compensation and his cash compensation. This evidence suggests that the board ofdirectors simultaneously grants less cash payment to CEOs when backdating activities areongoing. Of further importance is the finding that the total compensation cost is actually reducedin the presence of option backdating, which does not support the view that backdating makesshareholders overpay. To provide further evidence that backdating of stock option is conductedto lower the compensation cost, we examine the change in CEO pay around the implementationof SOX in 2002. Since SOX greatly constraints firms from backdating, we expect that firmsincrease their CEO pay after backdating is no longer viable. Consistent with our expectation, wefind that firms involved in more backdating in the pre-SOX period have greater increase in CEOpay compared to firms involved in less backdating in the pre-SOX period.Although it is plausible to describe backdating as managers exerting influence over their own3

pay by retroactively timing their option grants, this explanation has certain drawbacks. It treatsthe compensation packages as being exogenously determined: Once the packages are set,managers then backdate their option grants to increase the value of their option pay at the cost ofshareholders. However, investors can adjust the whole compensation contract when anticipatingoption backdating. In other words, the managerial power explanation does not fully depict theequilibrium of a model in which option backdating results from managers’ manipulation of stockoption grants.It is widely documented that firms’ stock returns are abnormally negative before executiveoption grants and abnormally positive afterward (see e.g., Yermack (1997), Aboody and Kasznik(2000), Chauvin and Shenoy (2001), and Lie (2005)). Backdating, that is, picking a past date onwhich the stock price traded particularly low to be the grant date, is believed to contribute to thisstock price pattern (see, e.g., Heron and Lie (2007)). On a different path, Bizjak et al. (2009)document how the practice of backdating employee stock options spreads across firms throughtime. They show that board connections are one mechanism that facilitates the spread of thepractice of backdating stock options.Our paper does not propose to deemphasize the self-interested behavior of some CEOs inmanipulating the terms of their compensation contracts. However, efficient contracting motives,in which the managerial incentive is higher and total costs of compensation are lowered, can helpus understand the documented empirical results, which are otherwise difficult to explain. Wesuggest that attributing backdating solely to agency problems is not necessarily the entire storyand that backdating activity can also be justified as a form of efficient contracting from aneconomic perspective.It is worth noting that this paper is not intended to question the legality issues of backdating.But it explains backdating from the perspective of its efficiency to solve the executive4

compensation problem. Our definition of efficiency is from a purely economical perspective: Anillegal behavior can be economically efficient if the ex-ante expected cost of getting caught islower than the expected benefit. Our empirical findings imply that under existing tax/accountingrules at the time, an informed board could take advantage of the grey areas of the tax law andbackdate the CEO’s option grants while adjusting the other terms of his compensation.Interestingly, practitioners and financial media have begun to change their opinions aboutbackdating from being purely an agency problem. For example, in the Wall Street Journal (WSJ),Jenkins (2009, A25) states that “most backdating cases amount to companies trying to behaverationally amid irrational accounting rules, rather than the media's standard trope of businessmena-lyin' and a-stealin'.” On the academic side, more evidence on the efficiency perspective ofbackdating is also found, including mitigating the investment timing problem (Dierker andHemmer (2010)) and attracting valuable employee (Fang and Whidbee (2010)). 4The remainder of this article proceeds as follows. In Section 2, we describe the data sourceand sample selection. Section 3 illustrates the empirical results on the relation between corporategovernance and backdating activities. Section 4 presents the model and Section 5 tests themodel’s implications empirically. Finally, Section 6 concludes.2. Variable Construction and Sample SelectionWe first seek to explore the power of governance to explain patterns in backdating in USfirms. To do so we need to define what we (and others) consider backdating and to introduce thevarious measures of governance we explore.2.1. Measures of Option BackdatingFollowing Heron and Lie (2009), we infer the backdating activities from the stock price4 Overall, while our study is in many ways complementary to Dierker and Hemmer (2010) and Fang and Whidbee(2010), it captures a different source of efficiency as we provide an explanation based on CEO’s risk aversion,under-diversification, and the existing tax law.5

movement surrounding the option grant dates. In the absence of backdating or other types ofgrant date manipulation, the stock return distribution before grant dates should be largely similarto the distribution after the grant dates, as suggested by Heron and Lie (2009). For this reason,the difference between the stock returns for a certain number of days after grants and the returnsof the same number of days before grants should be centered at zero. However, if the grants havebeen backdated or otherwise manipulated, the difference will be positive. Following this logic,we estimate the extent of option backdating as follows:Backdate[t] = AR[1, t] − AR[−t, −1]where AR[1,t] is the cumulative stock returns (AR) from day 1 to day t after the grant day (day0), and AR[-t,-1] is AR from day -t to day -1 relative to the grant day. 5An alternative approach to measure the degree of ex ante backdating is to focus on the mostegregious examples of backdating. This is the approach taken by Bebchuk et al. (2010) andCollins et al. (2009) who define backdating as a dummy variable that equals one if the grant-datestock price is in the bottom decile of the firm’s stock price distribution around option grants. Ourpreference is for the Heron and Lie (2009) measure as it is a continuous measure and capturesthe broad possible extent of backdating behavior. The continuous measurement allows us a morerobust empirical investigation by including grants that have had strike prices lower than thegrant-date stock price, but have not been issued with strike prices within the bottom decile of thestock price distributions around the grants. Furthermore, as we shall show in Section 4, in anefficient contracting setting with endogenous strike price, variables, such as executive riskpreference and personal wealth, determine the optimal strike price and this strike price does notnecessarily equal a firm’s bottom-decile stock price. Therefore, using a continuous measure5 As a robustness check, we also delete observations with negative values of our backdating variables because thoseobservations may be less indicative of backdating. Our results are insensitive to this alternative method. We also usecumulative abnormal returns using the market model based on CRSP value-weighted index returns instead of rawstock returns. The results are the same (untabulated).6

allows us to capture potential optimal strike prices in a wide range of time around the grantdates. 62.2. Measures of Corporate GovernanceTo explore whether governance helps to explain patterns in backdating, we use severalmeasures of corporate governance. One variable to capture weak firm governance is the degreeof managerial entrenchment due to the number of anti-takeover provisions in a firm’s charter andin the legal code of the state in which the firm is incorporated (the so-called G-index of Gomperset al. (2003), and the closely related E-index of Bebchuk et al. (2009)). Takeover protectionprovisions have a significant impact on firm decision-making since the market for corporatecontrol is viewed as a strong external force for disciplining management. Second, we focus ourattention on various attributes of the board of directors that are supposed to overseecompensation setting, specifically focusing on board size and board independence. Boardefficacy plays a crucial role in making decisions related to executive compensation packages.Finally, we also look at ownership as an indicator of governance. Large shareholders withincentives to monitor management improve the firm’s operations from within by taking steps toprotect their own investments in the face of potential managerial agency conflicts. Our studyfocuses on these measures to provide insight into the effects of both internal and externalgovernance on backdating activities.G-index. Our first measure is the Gompers et al. (2003) corporate governance index, G-index, which measures the number of anti-takeover provisions in a firm’s charter and in the legalcode of the state in which the firm is incorporated. The authors document that anti-takeoverprovisions, an indicator of poor corporate governance, decrease firm value. The Investor6 Alternatively, we also follow Bebchuk et al.’s (2010) method to define backdating as a dummy, which equals oneif the grant-date price is within the lowest deciles of grant-month stock price, and zero otherwise. Our results aresimilar.7

Responsibility Research Center (IRRC) assembles and reports the data for the index about everytwo years (1990, 1993, 1995, 1998, 2000, 2002, and 2004), and the index varies between 0 and24. Note that current literature has extensively used this as a general measure of shareholderrights (see, e.g., Cremers and Nair (2005) and Davila and Penalva (2006)).E-index. As a second measure, we replace the G-index with the entrenchment indexdeveloped in Bebchuk et al. (2009). This index is based on the same IRRC data but uses only sixof the provisions in the firm’s chapter. Bebchuk et al. (2009) show that out of the 24 provisions,these six have the greatest impact on firm value. Following Bebchuk et al. (2009), we denote theentrenchment index as E-index. The E-index ranges between 0 and 6; higher values indicateweaker shareholder rights or more entrenched management.BoardSize. We use the size of the board of directors to measure its effectiveness. Assuggested by Jensen (1993), the cost of poorer communication and decision-making associatedwith larger groups will make a larger board less efficient. Yermack (1996) documents a clearinverse relation between firms’ market valuation and the size of their boards of directors. Hisresult suggests that a smaller board is usually more efficient in monitoring CEOs.Board Independence. Starting with Weisbach (1998), many papers have found boardsdominated by independent directors to be more likely to make decisions that are in the interestsof shareholders. We measure the board independence as the fraction of independent directors onthe board. Based on the IRRC, independent directors include retired executives of other firms,academics, private investors, and executives of unaffiliated firms.Institutional Ownership. As documented by existing literature, institutional shareholdersmaintain a strong monitoring role on managers. When institutional investors have larger amountsat stake in firms, they tend to have stronger incentives to devote resources to monitoring. Inparticular, Hartzell and Starks (2003) show that institutional ownership has a strong influence on8

corporate compensation policies. We measure institutional influence as the proportion of thefirm’s shares owned by the top five institutional investors. 7Of the above five governance measures, G-index and E-index measure external governance,while the other three measure internal governance.2.3. Measures of CEO IncentiveBased on existing empirical studies, we use two variables to proxy the CEO’s incentive pay.Pay-Performance Sensitivity (PPS). Following Jensen and Murphy (1990), PPS is thedollar value of the CEO’s wealth change for a $1,000 change in shareholders’ value. Althoughmanagers can receive pay-performance incentives from a variety of sources, the majority are dueto ownership of stock and stock options (Jensen and Murphy (1990)). Similar to Aggarwal andSamwick (2003) and Core and Guay (1999), we compute this sensitivity as the dollar valuechange of stock and options held by a CEO to a $1,000 shareholder return.For common stock, PPS is simply the fraction of the firm that the executive owns. PPS foroptions is the fraction of the firm’s stock on which the options are written multiplied by theoptions’ delta. We use the method developed by Core and Guay (2002) to estimate option deltas.Their method avoids the cost and difficulty of collecting option data from various proxystatements since it requires information from only the most recent proxy statements. Moreimportant, the authors show that their estimates are effectively unbiased and 99% correlated withthe measures obtained if the parameters of a CEO’s option portfolio were completely known. 8Option-Grant Sensitivity (OGS). This sensitivity measures the dollar value change in aCEO’s option grant per $1,000 change in shareholder value. Following Yermack (1995) and7 As robustness check, we also measure institutional influence using the stock ownership by all the institutionalinvestors in the firm or using the Herfindahl index of institutional ownership concentration. Our results are notsensitive to these alternative measures.8 We also use Core and Guay’s (1999) method to measure pay-performance sensitivity as the CEO’s wealth changefor 1% shareholder return; our results are qualitatively similar.9

Hartzell and Starks (2003), we first calculate the delta of every option grant, and then multiplythe delta by the number of options granted and divided by the number of shares outstanding atthe beginning of the year. Finally, we multiply this number by 1000, which gives the sensitivityof the dollar value of option grants for per $1,000 change in shareholder wealth. Analyzing OGSindependently is important because stock options have replaced base salaries as the single largestcomponent of compensation (Murphy (1999)). Thus, if backdating is influential then we expect itto be quite prominent in this component of pay.2.4. Control VariablesWe use various control variables in the regression analysis. We measure firm size as thenatural logarithm of the firm sales, book value of equity as the sum of the common equity valueand deferred tax, and market value of equity as common shares outstanding times fiscal yearclosing price. To control for firm growth opportunities, we compute market-to-book (M/B) as theratio of market value of total assets over the book value of total assets, where the market value oftotal assets is obtained as the book value of total assets minus the book value of equity plusmarket value of equity. Return on assets (ROA) is measured as the ratio of operation incomebefore depreciation over total assets. We compute Leverage as the ratio of long-term debt andcurrent debt over total assets. To measure the firm risk, we use stock return standard deviationbased on the firm’s monthly returns over a five-year period. We also include the firm’s annualstock return to control for the stock performance. We measure GrantSize as the number ofoptions in each option grant deflated by the firm’s total shares outstanding. The dummyOtherExecutive equals one if one of the firm’s top five non-CEO executives also receives optiongrants on the CEO’s option grant date plus/minus one day, and zero otherwise.10

2.5. Data SourcesWe obtain our sample of stock option grants to CEOs from the Thomson Financial InsiderFiling database. This database captures insider transactions reported on SEC Forms 3, 4, 5, and144. Like Heron and Lie (2007), we include only observations with a cleanse indicator of R(“data verified through the cleansing process”), H (“cleansed with a very high level ofconfidence”), or C (“a record added to non-derivative table or derivative table in order tocorrespond with a record on the opposing table”).Following Heron and Lie (2007), an option is regarded to be issued at the money if theexercise price is equal or “close enough” to the stock price on the grant date. We take thetransaction date provided by Thomson Financial as the grant date if it is a trading day and theclosest prior trading date in CRSP in other cases. A “close enough” price is defined as a price thatis within 1% of the strike price. We exclude all grants not issued at the money, following Lie(2005) and Heron and Lie (2007). Consistent with prior research, more than 80% of the optiongrants are issued at the money.The existing literature generally separates scheduled grants from other ones, since it isunlikely that firms manipulate scheduled grants. Like Lie (2005), we define a grant as scheduledif it is issued on the same date plus/minus one day in the preceding year. Scheduled grants areeliminated from further analysis.We further require that our sample firms have available accounting data in Compustat,executive compensation data in ExecuComp, board data from the IRRC, and institutionalownership data from Thomson Financial. We obtain the G-index from Andrew Metrick’s websiteand E-index from Lucian Bebchuk’s website. 9 Our final sample consists of 8,486 unique option9 Andrew Metrick’s website is; Lucian Bebchuk’s website is

grants, 6,513 unique firm-year observations, and 1,971 unique firms from 1995 to 2005.Except for the backdating variables, all the variables are measured at the end of each fiscalyear. G-index and E-index are taken from the closest previous update. All of the dollar variablesare measured in 2000-constant dollars. To ensure that data outliers do not drive our results, wewinsorize all continuous variables at the 1 st and 99 th percentiles.2.6. Summary StatisticsTable 1 reports the distribution of CEO stock option grants across time. The number ofoption grants is increasing during our sample period. The accumulative stock return after thegrant date is, on average, higher than that before the grant date, as indicated by our backdatingvariables. Consistent with Heron and Lie (2007), the degree of backdating becomes less obviousafter 2002 due to SOX, because SOX requires that option grants must be reported within twobusiness days. Table 1 also shows that backdating is economically important. For instance, theaverage difference in accumulative stock returns for the 50-day period before and after the grantdate (Backdate50) is about 4.08 percentage points for our full sample.Figure 1 displays the average cumulative stock returns around the receipt of stock optiongrants by CEOs. Consistent with Lie (2005) and Heron and Lie (2007), the stock prices start todecline slightly more than a month before the award date. Nevertheless, there is a sharpturnaround of the price movement on the dates immediately after the grants; the prices increase.The price increase is more dramatic during the first few days after the awards; however, itcontinues to rise in the following 50 days after the awards.Our measure of backdating is the difference between post-grant and pre-grant stock returns.It is possible that this measure largely captures the firm’s volatility. We therefore explicitlyexamine the correlation between our backdating variables and firm stock volatility and find their12

correlation coefficients pretty small in magnitude. For example, the correlation coefficientsbetween Backdate50 and ReturnStd and that between Backdate50 and ReturnStd 2 are only 0.12and 0.11, respectively. This result suggests that our backdating variables are not indications ofvolatility.Table 2 shows the characteristics of our sample firms. The median value of a CEO’s totalannual compensation (ExecuComp Item TDC1) is $3,184,000 and the median cash pay is$1,173,000. The variable PPS has a mean of $21.6 per $1,000 shareholder return and a medianof $6.5; this number is quite similar to that reported by Hall and Liebman (1998). 10 The averageOGS in our sample is $0.63 per $1,000, with a median of $0.32, implying that option grants playan important role in aligning managers’ interests with those of their shareholders. The medianfirm has a G-index value of nine, E-index value of two, and nine directors sitting on the boardwith 70% of them being independent directors. Institutional investors are holding a sizeableamount of equity, with a median Top5holding of 25%. A median option grant includes 0.06% ofthe firm’s total shares outstanding, and 55% of our sample grants coincide with the option grantsto top five non-CEO executives. The median firm is quite large; its annual sales volume is$1,206 million. The sample firms are performing well, with a median M/B of 1.55, ROA of 13%,and yearly stock return of 10%. The firms are moderately levered with the median leverage ratioof 21%.3. Does Governance Explain Option Backdating?Are firms with stronger governance associated with less backdating? The empirical answer,revealed in Figure 2 and explored more rigorously in regressions in Table 3, is no. Figure 2provides a visual indication of the challenge for a governance explanation by providing splits ofthe data across the various governance measures described above. For example, Panel A of10 The pay-performance sensitivity reported in Hall and Liebman (1998) is $25 at the mean and $5.29 at the median.13

Figure 2 displays the average cumulative stock returns around the date of CEO option grants forsub-samples based on sample median for the G-index. Strikingly in the figure there is apparentlyfar more backdating in the low G-index firms, where low G-index indicates better governance.The negative trend of stock price before the award date and the positive trend afterward are moreevident for the sub-sample with a lower G-index. This difference between the two sub-samples ismore significant during the 20 days before to 20 days after the awards. Panel B of Figure 2shows the same relation between corporate governance and backdating when using E-index asthe governance proxy. Given that the G-index and E-index focus on external governancemechanisms, we next turn to measures of internal corporate governance: board characteristicsand ownership by institutional investors. Panel C of Figure 2 displays the average cumulativestock returns around the CEOs’ option grants for sub-samples based on BoardSize using thesample median BoardSize value as the cutoff. The negative trend of stock price before the awarddate and the positive trend afterward are more significant for the sub-sample with a smallerBoardSize. This difference is persistent between the two sub-samples during the entire samplefrom 50 days before to 50 days after the awards. Since a small board is usually considered moreefficient than a big one, this figure also shows that better governance is associated with morebackdating.Panel D of Figure 2 displays the stock price movement around the CEO’s option grant datesfor sub-samples made using the sample median Top5holding value as the cutoff. The negativetrend of stock price before the award date is not noticeably different from the two sub-samples;however, the positive trend after the award date is slightly steeper for the sub-sample of highTop5holding. This figure suggests that firms under stronger shareholder control backdate slightlymore.The only exception to this surprisingly negative relationship between governance measures14

and backdating is provided in Panel E of Figure 2 where we use the sample median of Boardindependence to measure corporate governance. The “V” shape trend in stock returns is morepronounced in the sub-sample with low board independence, indicating that firms with fewerindependent directors are backdating more. The result in Panel E is different from those in PanelsA–D. We address this difference in more detail when we investigate the relationship betweenbackdating and governance in multivariate regressions.While interesting, these simple univariate relationships could be confounded for by otherdifferences across the firms when they are broken into groups. To test for the power ofgovernance to explain backdating we ran a series of regressions of governance on backdating,this time employing a wide range of control variables. Specifically, we estimate the followingmodel:Backdate = a + a Governance + a FirmSize + a ReturnStd + a ROAit 0 1 it−1 2 it−1 3 it−1 4 it−1+ a M / B + a Leverage + a StockReturn + a PostSOX5 it−1 6 it−1 7 it−1 8it+ a Tenure + a GrantSize + a OtherExecutive + IndustryDummy + ε9 it 10 it 11it itwhere i indexes firms and t indexes year. To control for industry variation in the backdatingactivities, we include the Fama-French 48 industry dummies in each regression. We also includethe dummy PostSOX, which takes the value of one if the option grant is given after September 1,2002, and zero otherwise. Throughout the entire empirical test, p-values are computed based onrobust standard errors clustered at the firm level. Finding a positive coefficient for a1would beconsistent with our prior result from Figure 2 that stronger corporate governance is associatedwith more backdating. For brevity, we only report the regression results based on Backdate50;using other four backdating variables, Backdate10 to Backdate40, provides the same results.In Column (1) of Table 3, we regress Backdate50 on G-index as well as the controls. Thecoefficient on G-index is -0.004 and is statistically significant at the 1% level. A one-standard-15

deviation decrease in G-index is associated with an increase in Backdate50 of approximately 1.1percentage points, given that the sample median of Backdate50 equals 1.47%. The result is clear:Better-governed firms conduct more backdating.We use E-index as an alternative measure for corporate governance in Column (2) of Table3 and find a positive relation between corporate governance and option backdating. Theregression result highlights that the coefficient of E-index is -0.008 and is significant at the 1%level. The economic interpretation is that as E-index decreases by one standard deviation,Backdate50 will increase by 1.03 percentage points.Using Ln(BoardSize) as the proxy for the board effectiveness, Column (3) shows asignificantly negative relation between the size of the board and backdating behavior. Thecoefficient of Ln(BoardSize) is -0.032 and is significant at the 5% level. As a small value ofBoardSize implies high board effectiveness, the column also suggests that option backdating ismore prevalent when the board is more effective.To examine further the robustness of our results to the alternative governance proxies, wereplace Ln(BoardSize) with Top5holding in Column (4). The coefficient on Top5holding is notsignificantly different from zero, which does not support the view that CEOs in firms with strongshareholder control are less likely to backdate.In Column (5), we use Board independence to measure corporate governance. Surprisingly,we find a negative coefficient on it, which indicates that backdating is less likely to occur whenmore independent directors are on the board. One possible reason why the result in Column (5) isdifferent from those in Columns (1)–(4) is that an outsider-controlled board does not necessarilyimply better governance. Harris and Raviv (2008) predict that shareholders can sometimes bebetter off with an insider-controlled board when it is difficult for outsiders to acquire informationabout the firm’s operation. Supporting Harris and Raviv’s (2008) model, Duchin et al. (2010)16

find that when the cost of acquiring information is high, firm performance worsens after outsidedirectors are added to the board.To further investigate whether Harris and Raviv’s theory can explain the negative relationbetween board independence and backdating, we use M/B ratio, R&D expense, Hightechindicator, and dispersion of analyst forecasts as four proxies for information asymmetry betweeninsiders and outsiders, 11 and interact them with board independence in Table 4. We find that thecoefficients on the four interaction terms are all negative and significant, indicating that thenegative association between board independence and backdating is more pronounced when thecost of information acquisition is high (i.e. when having outside directors on the board is lessbeneficial to shareholders). Overall, the results from Table 3 and Table 4 show that strongcorporate governance is usually associated with more backdating, which does not support theview that backdating is due to powerful managers manipulating stock option grants at the cost ofshareholders.To better understand how corporate governance influences backdating, we investigate someother interaction terms in Table 5 by focusing on the G-index. We choose to focus on G-indexbecause G-index is quite stable over time (Gompers et al. (2003)) and thus the negative relationbetween G-index and backdating is less likely to be driven by the possibility that firms adoptimproved governance as a response to backdating. In Column (1), we interact corporategovernance with stock return volatility; the interaction G-index×ReturnStd has a significantlynegative coefficient and the variable ReturnStd has a positive coefficient. This result indicatesthat firms with higher stock volatility are doing more backdating and, notably, strong governance11 Existing literature suggests that firms with high M/B ratio, firms with high R&D expense, firms in the high-techindustry, and firms with great dispersion in analyst forecasts have more information asymmetry between insidersand outsiders (see for example, Barclay and Smith (1995), Opler et al. (1999), Harris and Raviv (2008), and Duchinet al. (2010)).17

strengthens this relation. Heron and Lie (2009) also find that firms with more volatile stock domore backdating. They interpret this fact as evidence of managerial power explanation, since theCEO can gain more from backdating if the stock is volatile. But their interpretation isinconsistent with the result that the positive association between volatility and backdating ismore evident for better-governed firms.In Column (2), we examine the interactions among SOX, backdating, and corporategovernance. Consistent with existing literature, the coefficient of PostSOX is negative andsignificant, indicating that SOX has greatly curbed backdating. Furthermore, the coefficient ofG-index×PostSOX is significantly positive, which implies that the positive relation betweengovernance and backdating becomes weaker after the SOX implementation.We interact G-index with CEO tenure in Column (3). The Tenure variable itself has asignificantly positive coefficient, indicating that longer-tenure CEOs are backdating more.Bebchuk et al. (2010) interpret this result as that entrenched CEOs are more likely to manipulatetheir compensation terms via backdating. However, this interpretation is not consistent with thesignificantly negative coefficient of G-index×Tenure, because this coefficient suggests that therelation that longer-tenure CEOs backdate more is more evident when the firm has strongergovernance.In Columns (4)–(5), we interact G-index with GrantSize and OtherExecutive, respectively.We find that CEOs are backdating more when they are receiving larger option grants and whenother top executives are receiving option grants on a similar date. However, the above relationsare stronger for better-governed firms.To formally examine the endogeneity concern that firms that struggle with backdating adoptimproved governance as a response (Collins et al. (2009)), in Figure 3 we plot sample splits18

ased on the median value of Backdate50, and track the firm’s G-index from three years prior tothe option grant to three years afterward. We find that, despite a slight upwards trend, the G-index is largely stable in both sub-samples and the patterns of G-index are almost parallel acrossthe two types of firms. Thus, there is no evidence that firms change their G-index in response toexecutive backdating.Overall, our empirical analysis does not support the view that poor corporate governancedrives backdating option grants. Surprisingly, better-governed firms are at least as likely toengage in backdating and in some of our tests better governance predicts backdating activities.This is a puzzle for the managerial power explanation. If this is insufficient, what else might begoing on? In the next section, we propose a theory to explain the rather puzzling resultspresented above.4. What Explanations are Consistent with a Positive Relationshipbetween Governance and Backdating?The data suggest a need for an explanation that shows a positive relationship betweengovernance and backdating. What theory provides such a rationale? One candidate is thedominant alternative to managerial power explanations for compensation setting: efficientcontracting. Does efficient contracting suggest such a relationship?4.1. Optimality of In-the-Money OptionsIn a standard principal-agent model, shareholders choose an optimal compensation packagefor the manager for maximizing stock price. The optimal pay structure, consisting of some basesalary and stock-based income, balances the manager’s incentive and risk. Building on the workof Hall and Murphy (2000, 2002) who previously explored the optimality of various optionarrangements, we show that allowing managers to receive a low-strike-price option reduces therisk posited on risk-averse and under-diversified managers, and therefore, saves shareholders the19

expense of compensating them for bearing risk, while holding managerial incentive constant.Like Lambert et al. (1991) and Hall and Murphy (2000, 2002), we distinguish the values ofthe option grants between executives and shareholders. The shareholders’ opportunity cost equalsthe gain that shareholders could have achieved by selling the options to outside investors,derived by Black-Scholes (BS) valuation model. However, the manager usually cannot trade orsell his options in the market. He is also less diversified than outside investors. Therefore, themanager values his option grants less than outside investors would.We measure the option value to executives by the amount of riskless cash compensation theexecutives would exchange for the option. We assume that the CEO has non-firm-related wealthw, holds s shares of the firm’s stock, and is awarded n options to buy n shares of stock at theexercise price k in T years. 12 We also assume that w is invested at the risk-free rate of r f and therealized stock price at T is P T . The CEO’s wealth at T is given by:W=w(1+ r f ) T + s P T +n max(0, P T – k)If he receives cash V instead of the option grant and invests the cash in risk-free assets, then hiswealth would be:W V = (V + w)(1+ r f ) T + s P TWe solve Equation (1), listed below, for the certainty equivalent of cash V for the CEO to beindifferent between the two choices, using numerical methods.v∫ U ( W ) f ( PT) dPT= ∫U( W ) f ( PT) dPT(1)12 Following Hall and Murphy (2000, 2002), we do not explicitly model restricted stocks in the compensationpackage. This is because in the model, restricted stock is a particular type of options with a strike price of zero.Moreover, if we allow the CEO to receive m shares of restricted stock together with n shares of options, theparameter s will be replaced with (s+m) in the simulation. Given that a CEO’s existing ownership is usually muchlarger than his annual equity grant (Core, Guay and Thomas (2005) and Jensen and Murphy (1990)), s≈(s+m) andthe model’s implication will be largely the same.20

1−ρWU (.) = is the CEO’s utility function. We assume constant relative risk aversion ρ and1 − ρ ,that the stock price follows a geometric Brownian Motion with volatility σ and drift m =rf+β r −r) where β is the firm’s systematic risk and r m is the return on the market portfolio.(m fThe simulations are derived assuming no dividends, σ = 0.30, β = 1, r f = 6 percent and r m– r f = 6.5 percent, following Hall and Murphy (2000).We define ‘‘incentives’’ as the change in the certainty-equivalent option value for each $1change in the stock price. 13 We imagine a two-stage process for deriving the optimal contract.The first stage minimizes compensation cost for an arbitrary incentive level, while the secondstage solves for the optimal incentive level that maximizes firm value, given the results of thefirst stage. The second stage requires information on the production function linking executiveactions to stock prices and the disutility function for those actions. While the second stage isbeyond the scope of our paper, we focus on the first stage by calculating the strike price thatminimizes the cost of the option grants for a given level of executive incentive. Without loss ofgenerality we assume a one-to-one correspondence between the action level taken by the CEOand his incentive level. Extending Hall and Murphy (2000, 2002), we solve Equation (2) to findthe exercise price that minimizes the company’s cost of granting options, while holding CEOincentive constant.Min k nC (2)s.t.∂V = CONST∂P13 For example, suppose that the certainty-equivalent option value is V1 when stock price at time T is P1, andsuppose that the certainty-equivalent value will be V2 when P1 increases to P1+1. In this case, the incentive in ourmodel is simply computed as V2 minus V1, which measures the sensitivity of executives’ option value to the stockprice.21

where∂V∂Pis the CEO incentive, n is the number of options, and C is estimated cost of issuingoptions calculated by the BS model.In Figure 4, we assume that the CEO has initial wealth of $5,000,000 and 66% of his wealthis invested in the company stock, while varying incentive levels. The relative risk aversion isassumed to be two and the options are assumed to be held for ten years. The incentive isinterpreted as the change in the certainty equivalent values of n options for each $1 change in thestock price. The grant-date stock price is normalized to be $100. Shareholders are aimed toprovide managers with a certain incentive level. Without loss of generality, we set four differentlevels for incentive: $1,000, $2,000, $3,000, and $5,000. 14 The four lines in Figure 4 correspondto the four incentive levels, respectively.As illustrated in Figure 4, the minimum BS cost is usually achieved when the strike price isset to be less than the grant-date price. For example, the minimum cost to the shareholders toachieve the executive incentive level of $3,000 is to issue option grants with the strike price of75% of the grant-date price.The simulation results for a different range of model parameters are reported in Table 6. Therelative risk aversion coefficient is assumed to be either two or three. The CEO incentive levelchanges from $1,000 to $5,000. The proportion of the CEO’s wealth invested in the firm isassumed to be either 33%, 50%, or 66%. For a wide range of model parameter values, theoptimal strike price is lower than the grant-date price. This phenomenon is more evident for themanager who is more risk-averse and more under-diversified. For the same level of managerialincentive, shareholders can save compensation costs by optimally setting the strike price. Thepercentage of cost savings, relative to setting the strike price to the grant-date price of $100,14 These incentive levels are interpreted as if stock price at year T=10 increases by $1 dollar, the CEO’s certaintyequivalent value will increase by $1,000, $2,000, $3,000, and $5,000, respectively.22

varies from 0.25 percentage points to 25 percentage points. Out-of-money options becomeoptimal only when we assume a low level of risk aversion and a low level of CEO underdiversification.Poor diversification makes the CEO vulnerable to unfavorable outcomes. Fromthe executives’ perspective, options issued in the money will be usually less risky, because theyhave a high probability of ultimately being in the money. This intuition is quite consistent withthat advanced in Hall and Murphy (2002).4.2. Tax/Accounting IssuesThere exists a fundamental difference in the taxation of at-the-money versus in-the-moneyoptions. If the option’s strike price is greater than or equals the grant-date stock price, then theexecutive who receives the option grant pays taxes on his option profit at the lower tax rateapplicable to long-term capital gains. 15 The options recipient can also benefit from deferring thetax to the time of the option exercise. In short, unlike in-the-money options, at-the-moneyoptions qualify for this lower tax rate. By avoiding the tax disadvantages associated with in-themoney options, the board can achieve the low cost of issuing options at the optimal strike price:Issuing at-the-money options which are backdated to a “proper” date. The “proper” date refers tothe one when the daily stock price approximately equals the optimal strike price.Prior to 2005, the Generally Accepted Accounting Principles (GAAP) provided that thedifference between the exercise price and the firm’s grant-date stock price was only expense thathad to be recognized by companies with respect to options issued on a fixed number of shares at15 The recipients of option grants awarded at-the-money pay taxes on the profit from “incentive stock options” atfavorable long-term capital gains rates. The incentive stock option grants sometimes make up as low as 10% of theoutstanding options to top executives. However, given the size of executives’ entire option grants and the differencebetween the tax rates, the magnitude of the tax difference of the entire option profit is still quite sizable.23

a fixed exercise price. 16Thus, the grant of an at-the-money option resulted in zero recognizedexpense for financial reporting purposes. On the other hand, an option that was granted in themoney would result in a negative charge to earnings. This created an accounting bias for theshareholders in favour of at-the-money options. Therefore, issuing “at-the-money” options viabackdating could be an effective way to minimize the cost of compensation without sufferingany tax or accounting drawbacks.For example, taking the case of $5,000 incentive level in Figure 4, the shareholders’ BSvalue would be minimized if the options are issued at the strike price of $70 (70% of the grantdatestock price). Therefore, shareholders could backdate the option grants to a date with thestock price of around 70% of the grant-date price and issue “at-the-money” stock options. Thus,shareholders would bear the least cost possible for providing the required incentive level to theCEO; at the same time, favourable tax and accounting treatments can be achieved as the optionsare granted “at-the-money.” In summary, by backdating options to the optimal strike price,shareholders can effectively save on compensation cost. 17If option backdating is a consequence of efficient contracting, we should not expect thatbackdating is driven by poor corporate governance. In contrast, to the extent that better-governedfirms are more likely to provide efficient compensation contracts (Core et al. (1999)), firms withstrong corporate governance are expected to do more backdating. Although we do not havecorporate governance explicitly in the model, our theory naturally implies this prediction.Therefore, the proposed theory is consistent with our empirical findings reported in Section 3.16 Prior to SFAS 123(R), most firms used the intrinsic-value method to expense for executive stock options becauseSFAS 123 allowed firms to choose either the fair-value based method or the intrinsic-value method to account forthe options. Under the intrinsic-value method, firms could escape recording an expense associated with options ifthey granted a fixed number of options with a fixed exercise price set at or above the market price of the underlyingstock on the grant date.17 Broadly consistent with our argument, Dhaliwal et al. (2010) show that backdating of CEO options on exercisedate is driven by tax-saving motivation. Cicero (2009) suggests that backdating option exercise might beadvantageous for both the CEO and shareholders at the expense of the tax payers.24

4.3. Legality Concerns on BackdatingBecause our purpose is to understand the efficiency aspect of backdating, we have notincluded any costs associated with backdating in the model. These costs may reflect the expenseof legal issues and accounting restatements if the backdating activity is caught. It is alsoimportant to note that, ex-post if detected, backdating is associated with costs beyond thoseimposed by the Justice Department and the SEC. These incremental costs include thereputational costs, the derivative law suits and the class action suits. 18 Considering theses costs(which are difficult to calibrate in the model), backdating can be either efficient or valuedestroying.Backdating options would only be optimal when the savings due to efficientcontracting outweighs the expected cost of backdating.Given that backdating causes some legality dispute, will the board take such a risk as toengage in backdating? The answer can be “yes.” Suppose that a board has two alternativecompensation packages to executives. 19 Both packages lead to the same incentives, but one isless costly for the shareholders if the board takes advantage of the grey areas of tax/accountingrules. In such a situation, it is likely for the directors to take this advantage and choose thecompensation scheme, which imposes less cost on the shareholders. This seems reasonableparticularly prior to SOX, when not all board members knew the details of the tax/accountingrules regarding executive option grants well. Without being perfectly informed of thetax/accounting details and possible consequences, a board may engage in backdating andsimultaneously adjust the other terms of CEO pay to save on the total cost of compensation.Moreover, Armstrong and Larcker (2009) argue that executives and directors may overlook thelegal and ethical issues of backdating due to social influence. Executives and directors believe18 See Carow et al. (2009) and Bernile and Jarrell (2009).19 We are assuming that the board is acting in the interest of shareholders.25

that most other firms are backdating and this implies that it must be a legitimate activity (i.e.,“everybody else is doing backdating, so it must be legitimate”).Prior to the implementation of SOX in 2002, there had not been any court conviction relatedto backdating. Furthermore, the first time backdating was reported in the media was February2005. 20 This evidence is consistent with the assumption that there could be board members whowere not accurately informed about the legal consequences of their actions. This suggests that thelegality concern on backdating was not severe prior to August 29, 2002. Therefore, prior to SOX,given the low ex ante probability of getting caught, the board/shareholders are more likely totake advantage of the grey area of tax/accounting law and take part in the backdating activities.Column (2) of Table 5 also supports this implication, in which the interaction term, G-index×PostSOX, has a significantly positive coefficient. As suggested by this empirical result, therelation that better-governed firms backdate more is stronger before SOX.To better understand the ex post legal consequences of backdating, we conduct anextensive search on all backdating cases that were under investigation from three differentsources. First, Glass-Lewis Co. records 257 companies that have announced internal reviews,SEC inquiries, or Justice Department subpoenas related to their historical stock-option grants. 21Second, in September 2007, WSJ lists 145 companies as being investigated by SEC and/or theJustice Department in connection with the option backdating scandal. 22 Third, the SEC website“Spotlight on Stock Options Backdating” publishes SEC enforcement actions related tobackdating. 23 We consolidate all the data, and end up with 260 backdating investigations.20 The first article was “Test of good corporate citizenship” by Mark Hulbert, published in Market Watch onFebruary 18, 2005.21 See Glass-Lewis Co. report ( See WSJ daily updated tables ( See SEC’s website, (

As described in the Appendix, by December 31, 2012, 25 out of the 260 cases (9.6%) arestill under investigation, 183 cases (70.4%) are settled with firms restating their option expensebut without explicit punitive actions taken to the executives, 24 and 52 cases (20%) are settledwith firms restating their option expense and explicit punitive actions taken to the executives. 25Among these 52 cases, all the executives investigated paid some penalties, in 46 cases executivesare fired, in 26 cases executives are also banned from being public firm officers/directors for upto five years, and in 6 cases executives are put in jail. 26Although the ex post penalty onexecutives inferred from the 52 cases above is severe, Heron and Lie (2009) estimate that 13.6%of all option grants to top executives during the period 1996–2005 were backdated and 29.2% offirms manipulated grants to top executives at some point between 1996 and 2005. Given howwide spread backdating was, the number of firms that experienced some sort of legalconsequence seem to be very small (i.e., the ex ante probability of being caught and penalizedseems small). 274.4. Empirical ImplicationThe efficient contracting view thus does provide an explanation that predicts a positiverelationship between governance and backdating. This evidence alone though is far from24 This number is only growing. For example, in the recent case of Broadcom all criminal charges againstBroadcom’s co-founders Henry Samueli and Henry T. Nicholas III, and also the company's former chief financialofficer (CFO) William J. Ruehle were dismissed by U.S. District Judge Cormac J. Carney (See Jenkins 2009). Thisanecdotal evidence indicates that the legal system has also started to treat backdating charges with more caution,highlighted in the not-guilty verdict of Broadcom’s executives.25 We only account for the explicit punitive actions because we can clearly attribute them to the backdating cases.However, it is possible that the firms punish their executives in an implicit way (such as not renewing contracts andnot giving them directorship after retirement).26 These punitive actions are not mutually exclusive and some executives may be subject to more than one type ofpunishments.27 The settlements from many backdating suits are confidential, and it is possible the public does not even know thatthere has been a suit/settlement. Thus, the reported number of backdating investigations may be smaller than thenumber in reality. (We thank the anonymous referee for providing this comment.)27

convincing as we set out to find a theory to explain this fact. Luckily, there are auxiliary testsflowing from this theory that differentiate between the managerial power and the efficientcontracting perspectives. We turn our attention to these now.As advanced in the theory, a certain in-the-money option is optimal because it caneffectively reduce the cost posted on risk-averse and under-diversified managers. Given that theeffect of risk-aversion and under-diversification is usually more evident in riskier firms, loweringstrike price via backdating is therefore more vital for executives in those companies. This view isalso consistent with the empirical result in Column (1) of Table 5, which highlights thesignificantly negative coefficient of G-index×ReturnStd. This coefficient suggests that bettergovernedfirms backdate more in response to high stock return volatility.Under-diversification is one of the driving forces behind the optimality of granting in-themoneyoptions. The benefit of backdating options will be higher for more under-diversifiedCEOs. Although the degree of diversification in the CEO’s portfolio is not directly observable inthe data, longer-tenure CEOs are more likely to be poorly diversified. This could be due to thehigh level of human capital and firm-specific wealth locked within the manager’s firm. Theabove argument is consistent with the empirical results in Column (3) of Table 5, in which theterm G-index×Tenure displays a significantly negative coefficient. This coefficient implies thatbetter-governed companies backdate more when their CEOs have longer tenure.If backdating can reduce compensation cost for shareholders, then this saving will be moresizeable for larger CEO grant size. Supporting this view, the empirical result in Column (4) ofTable 5 shows a negative coefficient for G-index×GrantSize, indicating that better-governedfirms backdate more for larger option grants.If backdating reduces shareholders’ cost for compensating the CEO, it can also lower costs for28

compensating non-CEO top executives, leading to a more dramatic reduction in compensationcost within the firm. In Column (5) of Table 5, the significant and negative coefficient of G-index×OtherExecutive implies that better-governed firms backdate more when other top executivesare also receiving options along with the CEO.As summarized in Table 7, both managerial power view and efficient contracting view givesome similar predictions on backdating behavior but different interpretations. Incorporatinginteractions with corporate governance can help to differentiate these explanations, and theresults are generally supporting the efficient contracting view.It is also worth noting that Bebchuk et al. (2010) and Collins et al. (2009), wheninvestigating the relation between backdating and corporate governance, mainly use variables,such as “CEO is Chairman” for corporate governance. These measures essentially reflect theseniority of the CEO over the company’s board of directors, but are less applicable as a measureof governance in the setting of backdating (although it could be proper to use them asgovernance proxies in studying other corporate policies). When the CEOs are also the chair ofthe boards, they typically also have large equity stakes and human capital in the firms and/orhave worked in the companies for a long time (thus, allowing them a position of seniority). Inother words, these CEOs are more likely to be under-diversified than other CEOs. As shown inour model, the benefit of backdating for poorly-diversified CEOs is greater than for those whoare relatively well-diversified. Therefore, it is consistent with the efficient contracting view toobserve that high-seniority CEOs experience more backdating. In other words, the result thatCEOs who are also chairs are more likely to backdate could be consistent with both themanagerial power view and the efficient contracting explanation.In contrast, there is no good reason to believe that CEOs in firms with a low G-index aremore under-diversified. To test our theory further, we further investigate two empirical29

predictions generated directly from our model, as described below.Prediction 1: Option backdating is associated with higher executive incentives.Prediction 2: Option backdating is associated with lower level of executive compensation.Both predictions arise directly from our simulation results and are consistent with theefficient contracting view of executive compensation. On the contrary, the managerial powerview suggests no clear relation between backdating and executive incentives and would predict apositive relation between backdating and executive compensation level, as backdating impliespowerful CEOs manipulating their compensation terms for their own benefits.5. Empirical Results5.1. Option Backdating and Incentive PayIn this section, we investigate the association between option backdating and incentive pay.As predicted by the theory, option backdating helps to provide stronger pay-performancesensitivity for managers. To examine this relation empirically, we apply the following pooledOLS regression model:Incentive it = b 0 + b 1 Backdate50 it + b 2 Firmsize it−1 + b 3 ReturnStd it−1 + b 4 ROA it−1+ b 5 M/B it−1 + b 6 Leverage it−1 + b 7 StockReturn it−1 + b 8 Tenure it−1+ IndustryDummy + YearDummy + ε itAccording to Prediction 1, we expect the b 1 coefficient to be positive.Table 8 highlights the notion that backdating is significantly positively associated withexecutive incentive pay. The dependent variable in Column (1) is PPS, which measures howclosely the CEO’s wealth is tied to the shareholder value. The independent variables includeBackdate50 as well as control variables. The Backdate50 variable has a coefficient of 6.59,30

which is significant at the 1% level. This result indicates that when Backdate50 increases by onestandard deviation (26.11%), PPS will increase by $1.72 per $1,000 shareholder return relative tothe sample median of $6.5.The coefficients of other control variables are generally consistent with existing empiricalstudies. In particular, we find that PPS tends to be higher for firms of small size, good operatingperformance, and long-tenure CEO.A CEO with a high PPS typically has high stock ownership of his own firm, which mayimply managerial entrenchment. For this reason, the positive association between PPS andbackdating variables could also be explained by the fact that managers with strong entrenchmentwill backdate more. To examine this possibility, we further use OGS as an alternative measure ofexecutive incentive in Column (2) of Table 8. Recall that this measure reflects the incentiveprovided in the CEO’s new option grants. Therefore, OGS is not related with managerialentrenchment. While PPS reflects the incentive from the CEO’s existing portfolio, OGSmeasures the incentives from the CEO’s newly granted options.Notably, our PPS and OGS variables are constructed based on reported grant-date stockprices. They may underestimate the actual managerial incentive if options are backdated becausethe delta of options is increasing in grant-date prices. In cases where options are backdated,reported grant-date prices tend to be lower than the actual prices, and thus, the actual PPS andOGS will be even higher than the values we are using. In other words, the current PPS and OGSvariables may cause biases against finding a positive relation between backdating and incentive.If we had adjusted those two incentive variables from the backdating biases , we would obtain aneven stronger positive relation between incentive and backdating. 2828 In the model, we define executive incentive as sensitivity of the certainty-equivalent option value to stock price,which is different from our empirical measures, PPS or OGS. The reason for this difference is that it is impossible to31

Column (2) shows that backdating is important in enhancing executive incentive throughoption grants. The coefficient on Backdate50 is around 0.15 and significant at the 1% level. Theeconomic implication of this coefficient is that an increase in Backdate50 by one standarddeviation is associated with an increase in OGS by $0.039 per $1,000 shareholder return,compared to the sample median of $0.32. This column also shows that OGS is positivelyassociated with the firm’s stock performance and ROA, and negatively related to firm size. Insummary, the results in Table 8 provide evidence supporting the prediction that backdating isassociated with better alignment of manager-shareholder interests.5.2. Option Backdating and the Level of CEO PayOur tests on the relation between backdating and the level of CEO pay are based on thefollowing equation using pooled OLS regression models:Ln(Pay) it = c 0 + c 1 Backdate50 it + c 2 Firmsize it−1 + c 3 ReturnStd it−1 + c 4 ROA it−1+ c 5 M/B it−1 + c 6 Leverage it−1 + c 7 StockReturn it−1 + c 8 Tenure it−1+ IndustryDummy + YearDummy + ε itThe dependent variable is the level of the CEO’s compensation. The key independentvariable is Backdate50. Estimating negative coefficients for c 1 would be consistent with theprediction that backdating reduces compensation cost for shareholders.Table 9 highlights a negative relation between backdating and CEO pay level. Column (1) ofTable 9 reports the regression result of using the CEO’s cash compensation as the dependentvariable. The coefficient on Backdate50 is -0.095 and is significant at the 1% level. It impliesestimate the executive incentive in the model empirically, as variables, such as managers’ risk preference andpersonal wealth, are unknown.32

that when Backdate50 increases by one standard deviation, the level of Cashpay will decrease byabout 2.48%. Consistent with prior literature, our results also show that a CEO tends to receivehigher cash pay when the firm size is big, when the firm has high growth opportunities, when thefirm has good stock performance, and when the CEO has long tenure. Overall, this resultsuggests that shareholders give the CEO less cash compensation when the CEO is backdating.This result is clearly consistent with the theory.In Column (2), we use ExecComp Item TDC1 to measure the CEO’s total compensation andregress Ln(TDC1) on Backdate50, as well as a set of controls which could possibly influence therelationship between backdating and cost of compensation. The coefficient on Backdate50 is-0.136 and significant at the 1% level, implying that a one-standard-deviation increase inBackdate50 is associated with 3.55% reduction in the CEO’s total pay.Item TDC1 from ExecuComp includes the BS value of option grants using the reportedgrant-date price. In cases where options are backdated, Item TDC1 will underestimate the optioncosts to the shareholders and cause a bias towards finding a negative relation between backdatingand the pay level. To address this possibility, we use Item TDC2 to measure Totalpay in Column(3). Item TDC2 is the same as TDC1 except it replaces the value of options granted with thevalue of options exercised during the year. Unlike TDC1, TDC2 measures the ex post pay leveland reflects the benefit that an executive may have received from backdating options (Kaplanand Rauh (2010)). The mean and median of TDC2 in our sample are $5,063,000 and $2,017,000,respectively.Consistent with Column (2), Column (3) reveals a strong negative relation betweenbackdating and the total pay level (TDC2). The coefficient on Backdate50 has a coefficient of-0.136 and this coefficient is significant at the 1% level. This result indicates that a one-standarddeviationincrease in Backdate50 is associated with 3.55% decrease in the total pay level.33

In the presence of backdating, the actual grant-date stock price tends to be higher than thereported one, leading to underestimation of the Black-Scholes value of option grants. To addressthis concern, we calculate backdating_blkvalue, which is the BS value of the grants assumingthat the actual grant-date price equals the maximum stock price of the grant month. To calculatebackdating_blkvalue we use the annual estimates for the firm’s volatility and dividend yield asfound in ExecuComp (Items BS_VOLATILITY and BS_YIELD), as well as the annual risk-freerates used by ExecuComp. Other information about option grants, like expiration date (ItemEXDATE) and strike price (Item EXPRIC) is also collected from ExecuComp. We then computeNewTDC1 as adjusting TDC1 by replacing the BS value of options reported in ExecuComp (ItemOPTION_AWARDS_BLK_VALUE) with backdating_blkvalue. Essentially, we are inflating thereported grant-date price to the monthly maximum stock price while holding constant other BSparameters as reported in ExecuComp. 29 The adjustment on the “moneyness” of the optionsenables us to correct the total pay calculations of the backdated options by simply making themin the money. Clearly, our NewTDC1 variable biases us against finding a negative relationbetween backdating and total pay level. The mean and median of NewTDC1 in our sample are$5,963,000 and $3,072,000, respectively.The sample and regression specification in Column (4) are the same as those in previousthree columns, except that we use Ln(NewTDC1) as the dependent variable. The coefficient ofBackdate50 is -0.184 and significant at the 1% level. The economic interpretation is thatNewTDC1 will decrease by 4.80% when Backdate50 increases by one standard deviation. Theconclusion from Table 9 is straightforward: Based on various measures for the CEO pay level,shareholders pay less to the CEO when backdating occurs. This empirical evidence supports our29 Alternatively, we replaced the reported grant date price with the maximum stock price within “two” months afterthe grant, while holding constant other BS parameters as reported in the ExecuComp. The results remainedunchanged.34

theory.There could be an alternative explanation for this result: CEOs who are underpaid are morelikely to backdate to extract additional perks. To examine this possibility, we flag the CEOs whohave been CEOs for a long period of time, have high ownership, or are the firms’ founders, andinteract these indicators with Backdate50 in Table 10. On one hand, long-tenure CEOs, highownershipCEOs, and founder CEOs are less likely to be underpaid because they usually havestronger control and power in the firms. For this reason, if underpaid CEOs try to cheat viabackdating, then the negative relation between backdating and CEO pay should be weaker forthese CEOs. On the other hand, these CEOs usually have large financial stakes and humancapital in their own firms, which likely makes them more under-diversified. If the negativerelation between backdating and CEO pay is due to backdating reducing risk for underdiversifiedCEOs, then this relation should be stronger for long-tenure CEOs, high-ownershipCEOs, and founder CEOs.In Columns (1) and (2) of Table 10, we define a long-tenure (high-ownership) CEO as theone whose tenure (ownership) is above the sample median, and zero otherwise. The coefficientson Backdate50× Long tenure and Backdate50× High ownership are all negative and significantat the 5% level. In Column (3), we obtain the founder information from Capital IQ and interactthe Founder CEO indicator with Backdate50. The coefficient on the interaction term is negativeand significant at the 1% level. Overall, Table 10 indicates that the negative association betweenbackdating and CEO pay is stronger for long-tenure, high-ownership, and founder CEOs (whoare more likely to be under-diversified, but less likely to be “underpaid”). These results are notconsistent with the view that underpaid CEOs are more likely to backdate to extract rents.To provide further evidence that backdating is part of optimal contracting that lowers theoverall compensation costs, we then examine whether the abandonment of backdating after 200235

leads firms that backdated to increase CEO compensation, more so than firms that did notbackdate. 30In Column (1) of Table 11, we focus on the sample of firms with the same CEOduring 2001-2003 period and the examine the growth of CEO compensation from 2001 to 2003as the dependent variable (Ln(CEO pay at Year 2003) – Ln (CEO pay at Year 2001)). Our keyindependent variable is Backdate50 in year 2001. The coefficient on Backdate50 is positive andsignificant at the 5% level, indicating that after backdating is abandoned in 2002, firms thatbackdated more in the pre-SOX period increase CEO compensation more dramatically. Wefurther examine the CEO pay changes over the 2000-2004 period in Column (2) and the CEOpay changes over the 1999-2005 period in Column (3), and we find similar results. Overall, afterbackdating is abandoned due to SOX in 2002, there is a greater growth of CEO compensation inthe firms that previously backdated more, as compared to the firms that previously backdatedless.6. ConclusionWe employ option backdating as a case to examine the efficient contracting view and themanagerial power view of executive compensation. Our paper provides explanation andempirical evidence to illustrate the consistency between the efficient contracting view and optionbackdating activities, under the existing tax/accounting law.We first document a rather surprising result that firms with strong corporate governance areassociated with more backdating. This relation is more evident: (1) when the firm has a morevolatile stock return, (2) when the grant is made before SOX, (3) when the CEO has longertenure, (4) when the option grant is bigger, and (5) when other non-CEO top executives are30 We thank the editor (Ivo Welch) for providing this suggestion.36

eceiving option grants on similar dates. We then provide a theory to justify these findings.Under the framework of efficient contracting, our theory suggests that backdating is aneffective way to increase managerial incentive and lower compensation cost by reducing risk forrisk-averse and under-diversified managers. The driving force behind the theory is that whenmanagers are risk-averse and under-diversified, the optimal strike price for option grants isusually below the grant-date stock price. While directly issuing in-the-money options causes taxand accounting disadvantages, backdating is a possible way to achieve the optimal strike pricewithout losing the tax and accounting benefits of issuing at-the-money options.The model also generates new predictions that backdating is associated with higher CEOincentives but lower CEO pay levels. We then investigate these predictions empirically and findsupporting evidence. We also find that after backdating is largely abandoned by SOX in 2002,CEO compensation is increased more in the firms that previously backdated more, relative to thefirms that previously backdated less.Suggesting that managerial rent seeking may not be the solo explanation for backdating, ourpaper provides evidence that backdating could also be consistent with efficient contracting. Weunderstand the legality concerns associated with the backdating behavior; however, our paperdemonstrates its efficiency from the economic perspective. Our results are broadly consistentwith Larcker et al. (2011), which show that existing compensation choices are the results ofvalue-maximizing contracts between shareholders and managements.A few studies find negative stock price reaction to the disclosure of backdating transactions(Carow et al. (2009), Bernile and Jarrell (2009), and Narayanan et al. (2007)). These resultssuggest that backdating is costly ex post if detected by the SEC, but it does not contradict ourview that backdating is a form of efficient contracting ex ante. The firm will backdate its CEO’soption grants when the expected benefit outweighs the expected cost. Even if backdating37

destroys firm value ex post when it causes legal investigations, it can still be efficient from the exante perspective. Considering that 29.2% of all US public firms are engaged in option backdatingduring 1996-2005 (Heron and Lie (2009)) and that only a handful of companies are investigatedby SEC and/or the Justice Department in connection with the option backdating, the ex anteprobability of “getting caught” is virtually zero.It is worth mentioning that we do not differentiate between backdating and other option grant“manipulations” that will create similar stock price patterns (such as timing of option grantaround corporate announcements). In this paper, we focus on identifying the underlying motivesof backdating rather than differentiating it from other forms of manipulations. From theperspective of our explanation on backdating, backdating and strategic timing of option grantsare identical in the sense that both approaches can effectively give CEOs option grants at a lowerstrike price and avoid the tax and accounting disadvantages of in-the-money options.It would also be interesting to examine empirically the magnitude of tax saving forexecutives via backdating. However, to do so we would need to know what the grant-date stockprice would be if the option grants were not backdated. This kind of data is currently unavailable,but we would like to suggest this investigation for future research.38

Appendix. Consequence of Investigated Backdating CasesThis table reports the consequence of 260 investigated backdating cases, collected from Glass-Lewis Co., the WSJbackdating list and the SEC website “Spotlight on Stock Options Backdating.”Case status as of December 31, 2012 Number of cases As a percentage of 260Case is still under investigation. (A) 25 9.6%Case is closed and no explicit punitive actionsare taken to the executives investigated. (B)Case is closed and explicit punitive actions aretaken to the executives investigated. (C)183 70.4%52 20.0%Conditional on (C)Executives are put in jail. 6 2.3%Executives are banned from being a public firmofficer/director for up to 5 years.26 10.0%Executives are fired. 46 17.7%Executives pay penalties. 52 20.0%39

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Table 1. Overview of the CEO Stock Option GrantsThe sample consists of 8,486 CEO option grants from 1995 to 2005. We obtain option grant data from the ThomsonFinancial Insider Filing database. We further require that our sample firms have available stock price data in CRSP,accounting data in Compustat, CEO compensation data in ExecuComp, institutional holding data in ThomsonFinancial, and data on the board of directors, G-index and E-index in the Investor Responsibility Research Center(IRRC). Backdate10 is defined as AR[1,10]-AR[-10,-1], where AR is the accumulative stock returns over thecorresponding event windows around the grant date (day 0). Analogous to Backdate10, Backdate20 = AR[1,20]-AR[-20,-1], Backdate30 = AR[1,30]-AR[-30,-1], Backdate40 = AR[1,40]-AR[-40,-1], and Backdate50 = AR[1,50] -AR[-50,-1].Panel A: Distribution of Option Grants across TimeYearNumber ofOptionGrantsAverageBackdate10AverageBackdate20AverageBackdate30AverageBackdate40AverageBackdate501995 157 1.65% 2.75% 3.84% 6.13% 1.65%1996 515 1.47% 2.04% 1.82% 2.48% 1.27%1997 719 2.15% 2.22% 2.27% 2.47% 1.56%1998 669 3.74% 4.37% 5.07% 4.84% 2.15%1999 763 2.75% 3.09% 3.38% 3.66% 1.77%2000 793 4.99% 7.63% 9.60% 10.45% 3.88%2001 953 6.51% 6.74% 6.75% 7.76% 4.87%2002 984 3.99% 4.05% 3.64% 3.73% 2.73%2003 1007 2.82% 3.50% 4.08% 4.13% 1.79%2004 1009 -0.03% 0.42% -0.12% -0.73% 0.33%2005 917 0.74% 1.16% 1.36% 1.58% 0.30%Full Sample 8486 2.11% 2.95% 3.55% 3.81% 4.08%Panel B: Summary Statistic on Option BackdatingMean Std 5 th Pct Median 95 th PctBackdate10 2.11% 11.63% -14.74% 0.82% 23.91%Backdate20 2.95% 16.37% -20.15% 1.07% 32.85%Backdate30 3.55% 20.25% -25.59% 1.26% 40.68%Backdate40 3.81% 23.14% -29.27% 1.29% 45.92%Backdate50 4.08% 26.11% -33.91% 1.47% 51.31%44

Table 2. Descriptive Statistics of Sample FirmsThe sample consists of 8,486 CEO option grants from 1995 to 2005. We obtain option grant data in the ThomsonFinancial Insider Filing database, stock price data in CRSP, accounting data in Compustat, CEO compensation datain ExecuComp, and institutional holding data from Thomson Financial. BoardSize, Board independence, G-indexand E-index are constructed from the Investor Responsibility Research Center (IRRC). Sales ($ millions) refer to theannual sales volume. ROA is the accounting return of assets, obtained as the ratio of operation income beforedepreciation to total assets. Leverage is the ratio of total debt over total assets. M/B is the ratio of market value oftotal assets over the book value of total assets, where the market value of total assets is obtained as the book value oftotal assets minus book value of equity plus market value of equity. ReturnStd is the stock return standard deviationbased on the monthly return of past five years. StockReturn is the annual stock return of the firm. Tenure is thenumber of years the CEO has been in office. Cashpay is the sum of a CEO’s yearly salary, bonus, payouts fromlong-term incentive plans, and all other compensation. Totalpay (ExecuComp Item TDC1) is the sum of a CEO’scashpay, the value of restricted stock granted, and the BS value of stock options granted. Both Cashpay and Totalpayare measured in thousands. Pay-performance sensitivity is calculated as the dollar value change of the stock andoptions held by a CEO per $1,000 shareholder return. Option-grant sensitivity is the dollar value change in a CEO’soption grants per $1,000 shareholder return. G-index is the “Governance Index” from Gompers et al. (2003). E-indexis the “Entrenchment Index” from Bebchuk et al. (2009). BoardSize is the number of directors sitting on the firm’sboard. Board independence is the fraction of independent directors on the board. Top5holding is the proportion ofthe firm’s common shares owned by the top five institutional investors. GrantSize is the number of options in eachoption grant deflated by the firm’s total shares outstanding. The dummy OtherExecutive takes the value of one ifother non-CEO executives also receive option grants at the CEO’s option grant date plus/minus one day, and zerootherwise. All of these variables are measured at each fiscal year-end. Both G-index and E-index are taken from theclosest previous updates. All the dollar-value variables are measured in 2000-constant dollars.Mean Std 5 th Pct Median 95 th PctSales 4869 12737 95 1206 21162ROA 13% 10% -2% 13% 29%Leverage 0.22 0.17 0.00 0.21 0.52M/B 2.11 1.57 0.97 1.55 5.28ReturnStd 0.13 0.07 0.06 0.11 0.28StockReturn 17% 54% -57% 10% 109%Tenure 7.5 6.7 1 5 21Totalpay 5923 8232 625 3184 20920Cashpay 1863 2157 336 1173 5600Pay-Performance Sensitivity 21.63 44.13 0.78 6.54 110.75Option-Grant Sensitivity 0.63 0.90 0 0.32 2.37G-index 9.2 2.7 5 9 14E-index 2.39 1.34 0 2 4BoardSize 9.7 2.9 6 9 15Board independence 67% 16% 37% 70% 90%Top5holding 25% 9% 11% 25% 41%GrantSize 0.18% 0.31% 0.001% 0.06% 0.78%OtherExecutive 0.55 0.49 0 1 145

Table 3. Backdating and Corporate GovernanceThe sample consists of 8,486 CEO option grants from 1995 to 2005. The dependent variable is Backdate50, definedas AR[1,50]-AR[-50,-1]. AR is the accumulative stock returns over the corresponding event windows around thegrant date (day 0). FirmSize is defined as the natural logarithm of yearly sales. Industry dummies are based on the48-industry classification of Fama and French (1997). Corresponding p-values from robust standard errors clusteredat the firm level are reported in brackets. The notation ***, ** and * denote statistical significance at the 1%, 5%and 10% level, respectively.(1) (2) (3) (4) (5)G-index -0.004***[0.002]E-index -0.008***[0.003]Ln(BoardSize) -0.032**[0.048]Top5holding -0.020[0.627]Board independence -0.074***[0.001]FirmSize -0.005 -0.006** -0.002 -0.007*** -0.003[0.125] [0.046] [0.596] [0.008] [0.336]ReturnStd 0.261*** 0.271*** 0.375*** 0.428*** 0.418***[0.005] [0.004] [0.000] [0.000] [0.000]ROA 0.094 0.094 0.002 0.040 0.004[0.139] [0.136] [0.972] [0.451] [0.940]M/B -0.003 -0.003 0.003 0.007* 0.006[0.580] [0.558] [0.442] [0.077] [0.112]Leverage -0.046* -0.046* 0.009 -0.028 0.024[0.062] [0.062] [0.715] [0.224] [0.326]StockReturn -0.009 -0.008 0.002 -0.004 0.003[0.452] [0.461] [0.871] [0.678] [0.733]PostSOX -0.033*** -0.032*** -0.035*** -0.046*** -0.033***[0.000] [0.000] [0.000] [0.000] [0.000]Tenure/10 0.006 0.006 0.008 0.010** 0.006[0.262] [0.271] [0.138] [0.036] [0.217]GrantSize 1.795* 1.792* 1.772* 2.038** 1.886*[0.090] [0.090] [0.074] [0.020] [0.070]OtherExecutive 0.036*** 0.036*** 0.035*** 0.042*** 0.038***[0.000] [0.000] [0.000] [0.000] [0.000]Industry Dummy Yes Yes Yes Yes YesConstant 0.056 0.066 0.040 0.088 0.017[0.457] [0.379] [0.621] [0.239] [0.815]Observations 5420 5420 5872 7468 5872Adjusted-R2 4% 4% 4% 5% 3%46

Table 4. Further Analysis on Backdating and Board IndependenceThe sample consists of 8,486 CEO option grants from 1995 to 2005. The dependent variable is Backdate50, definedas AR[1,50]-AR[-50,-1]. AR is the accumulative stock returns over the corresponding event windows around thegrant date (day 0). In Column (2), R&D is the firm’s R&D expense normalized by total asset. In Column (3), theHightech dummy follows Bebchuk et al. (2010) and flags the firms in the high-tech industry (SIC code 3570, 3571,3572, 3576, 3577, 3661, 3674, 4812, 4813, 5045, 5961, 7370, 7371, 7372, and 7373). In Column (4), dispersion ofanalyst forecast is the standard deviation of analyst’s annual earning forecasts. Industry dummies are based on the48-industry classification of Fama and French (1997). Corresponding p-values from robust standard errors clusteredat the firm level are reported in brackets. The notation ***, ** and * denote statistical significance at the 1%, 5%and 10% level, respectively.(1) (2) (3) (4)Board independence 0.030 -0.061*** -0.051** -0.064***[0.468] [0.010] [0.036] [0.006]Board independence × M/B -0.050***[0.002]Board independence × R&D -0.265**[0.034]Board independence × Hightech -0.172**[0.031]Board independence × Dispersion ofanalyst forecast-1.281*[0.072]R&D -0.016[0.569]Hightech 0.116**[0.018]Dispersion of analyst forecast 0.003*[0.064]FirmSize -0.003 -0.003 -0.003 -0.003[0.298] [0.232] [0.302] [0.305]ReturnStd 0.416*** 0.476*** 0.464*** 0.463***[0.000] [0.000] [0.000] [0.000]ROA 0.016 -0.051 0.022 -0.009[0.760] [0.363] [0.627] [0.869]M/B 0.038*** 0.009** 0.005 0.007**[0.001] [0.019] [0.116] [0.041]Leverage 0.027 0.017 0.016 0.028[0.273] [0.489] [0.471] [0.268]StockReturn 0.002 0.001 0.002 0.001[0.801] [0.916] [0.850] [0.957]PostSOX -0.032*** -0.034*** -0.032*** -0.034***[0.000] [0.000] [0.000] [0.000]Tenure/10 0.007 0.006 0.007 0.006[0.182] [0.219] [0.181] [0.219]GrantSize 1.900* 1.765* 2.171** 1.994*[0.068] [0.090] [0.035] [0.063]OtherExecutive 0.038*** 0.038*** 0.038*** 0.039***[0.000] [0.000] [0.000] [0.000]Industry dummy Yes Yes No YesConstant -0.043 0.027 0.031 -0.004[0.573] [0.715] [0.625] [0.962]Observations 5872 5872 5872 5771Adjusted-R2 3% 4% 3% 3%47

Table 5. The Interaction Effects between Backdating and Corporate GovernanceThe sample consists of 8,486 CEO option grants from 1995 to 2005. The dependent variable is Backdate50, definedas AR[1,50]-AR[-50,-1]. AR is the accumulative stock returns over the corresponding event windows around thegrant date (day 0). G-index is the “Governance Index” from Gompers et al. (2003), which proxies for the level ofshareholder rights. Industry dummies are based on the 48-industry classification of Fama and French (1997).Corresponding p-values from robust standard errors clustered at the firm level are reported in brackets. The notation***, ** and * denote statistical significance at the 1%, 5% and 10% level, respectively.(1) (2) (3) (4) (5)G-index -0.001 -0.008*** -0.001 -0.003** -0.002[0.812] [0.000] [0.975] [0.032] [0.175]G-index × ReturnStd -0.043*[0.078]G-index × PostSox 0.009***[0.001]G-index × (Tenure/10) -0.006***[0.003]G-index × GrantSize -0.468[0.196]G-index × OtherExecutive -0.006*[0.092]FirmSize -0.004 -0.005* -0.005* -0.004 -0.004[0.200] [0.083] [0.083] [0.163] [0.172]ReturnStd 0.692*** 0.268*** 0.267*** 0.313*** 0.311***[0.003] [0.000] [0.000] [0.000] [0.000]ROA 0.076 0.093** 0.096** 0.068 0.070[0.132] [0.048] [0.043] [0.178] [0.165]M/B 0.000 -0.003 -0.003 0.001 0.001[0.980] [0.378] [0.414] [0.880] [0.888]Leverage -0.039 -0.048** -0.048** -0.040 -0.040[0.105] [0.033] [0.035] [0.102] [0.100]StockReturn -0.006 -0.008 -0.008 -0.005 -0.006[0.548] [0.390] [0.361] [0.595] [0.552]PostSOX -0.038*** -0.113*** -0.033*** -0.039*** -0.039***[0.000] [0.000] [0.000] [0.000] [0.000]Tenure/10 0.007 0.006 0.056*** 0.007 0.006[0.171] [0.165] [0.002] [0.181] [0.185]GrantSize 1.943* 1.798* 1.793* 6.247* 1.685*[0.073] [0.075] [0.076] [0.083] [0.092]OtherExecutive 0.036*** 0.035*** 0.035*** 0.036*** 0.088***[0.000] [0.000] [0.000] [0.000] [0.005]Industry Dummy Yes Yes Yes Yes YesConstant -0.020 0.089 0.019 0.050 0.014[0.806] [0.215] [0.788] [0.489] [0.855]Observations 5420 5420 5420 5420 5420Adjusted-R2 4% 4% 4% 4% 5%48

Table 6. Summary of Simulation ResultsThe simulation results are calculated using various model parameters. The relative risk aversion coefficient is set tobe two or three. The CEO incentive level changes from $1,000 to $5,000. The proportion of CEO wealth invested inthe firm is assumed to be either 33%, 50%, or 66%. Cost Saving via Backdating (Column 7) is computed as(Column 6-Column 5) / Column 6.(1) (2) (3) (4) (5) (6) (7)BS Cost ofOptimalSetting theProportion ofStrike PriceIncentiveMinimum BS Strike PriceCEO Wealthas PercentageLevelCost to be thein the Firmof the GrantdatePriceGrant-datePriceRisk AversionCost SavingviaBackdating2 33% $2000 165% $169,920 $184,100 N/A2 50% $2000 130% $240,480 $243,620 N/A2 66% $1000 95% $157,500 $157,900 0.25%2 66% $2000 85% $317,800 $319,800 0.62%2 66% $3000 75% $480,060 $483,840 0.78%2 66% $5000 70% $806,660 $825,100 2.23%3 33% $1000 120% $135,800 $136,400 N/A3 33% $2000 100% $282,500 $282,500 03 50% $2000 70% $415,800 $439,700 5.5%3 66% $1000 40% $282,000 $334,800 16%3 66% $2000 35% $567,800 $715,000 20.6%3 66% $3000 30% $854,700 $1,150,000 25%49

Table 7. Explanations of Backdating, Managerial Power View vs. Efficient ContractingViewPositive relation betweenbackdating and volatilityNegative relation betweenbackdating and PostSOXManagerial Power ViewManagers can extract more benefits bybackdating volatile stock options.SOX prevents managers frombackdating.Efficient Contracting ViewThe benefit of reducing CEO risk viabackdating is greater for volatile stock.Shareholders/directors are more aware ofthe legality issue of backdating andconduct less backdating.Positive relation betweenbackdating and CEOtenureEntrenched managers have moreinfluence on their pay.The benefit of reducing CEO risk viabackdating is greater for underdiversifiedCEOs; long tenure reflectsunder-diversification.Positive relation betweenbackdating and GrantSizeManagers extract more benefits frombackdating when the option grant islarge.The benefit of reducing risk viabackdating is greater for large optiongrant.Positive relation betweenthe backdating behavior ofCEO and other topexecutivesNot only CEO but also other topexecutives are extracting perks viabackdating.Above relations are less evident in bettergovernedfirmsThe need for reducing risk viabackdating applies not only to CEO butalso to other executives.Above relations are more evident inbetter-governed firms50

Table 8. Backdating and Managerial IncentiveThe sample consists of 8,486 CEO option grants from 1995 to 2005. The dependent variable in Column (1) is PayperformanceSensitivity (PPS), where PPS is calculated as the dollar value change of the stock and options held by aCEO per $1,000 shareholder return. The dependent variable in Column (2) is Option-grant Sensitivity (OGS), whereOGS is computed as the dollar value change in a CEO’s option grants per $1,000 shareholder return. Backdate50 isdefined as AR[1,50]-AR[-50,-1], where AR is the accumulative stock returns over the corresponding event windowsaround the grant date (day 0). Industry dummies are based on the 48-industry classification of Fama and French(1997). Corresponding p-values from robust standard errors clustered at the firm level are reported in brackets. Thenotation ***, ** and * denote statistical significance at the 1%, 5% and 10% level, respectively.(1)PPS(2)OGSBackdate50 6.597*** 0.154***[0.001] [0.004]FirmSize -4.075*** -0.084***[0.000] [0.000]ReturnStd 48.879*** 0.425[0.003] [0.311]ROA 33.821*** 0.666***[0.001] [0.008]M/B 0.051 0.010[0.944] [0.608]Leverage -0.762 -0.078[0.908] [0.486]StockReturn 1.266 0.168***[0.338] [0.000]Tenure 2.359*** -0.000[0.000] [0.920]Year&Industry DummyYesYesConstant 86.811***[0.000]2.150***[0.000]Observations 7039 7222Adjusted-R2 21% 10%51

Table 9. Backdating and Level of CEO PayThe sample consists of 8,486 CEO option grants from 1995 to 2005. Cashpay is the sum of a CEO’s yearly salary,bonus, payouts from long-term incentive plans, and all other compensation. We measure a CEO’s total compensationlevel by using TDC1, TDC2 and NewTDC1. ExecuComp Item TDC1 is the sum of a CEO’s yearly salary, bonus,payouts from long-term incentive plans, the value of restricted stock granted, the BS value of stock options granted,and all other compensation. TDC2 is the same as TDC1 except it replaces the value of options granted with the valueof options exercised during the year. NewTDC1 is backdating-adjusted total pay, and is defined as follows. For theoption grants received by the CEO, we calculate backdating_blkvalue, the BS value of the grants, assuming that theactual grant-date price equals the maximum stock price during the grant month. To calculate backdating_blkvaluewe use the annual estimates of the firm’s volatility and dividend yield as found in ExecuComp (Items bs_volatilityand bs_yield), as well as the annual risk free rates used by ExecuComp. Option expiration date (Item EXDATE) andstrike price (Item EXPRIC) are also collected from ExecuComp. We then compute NewTDC1 as adjusting TDC1 byreplacing the BS value of option grants reported in ExecuComp (Item OPTION_AWARDS_BLK_VALUE) withbackdating_blkvalue. Ln() denotes the natural logarithm transform. Backdate50 is defined as AR[1,50]-AR[-50,-1],where AR is the accumulative stock returns over the corresponding event windows around the grant date (day 0).Industry dummies are based on the 48-industry classification of Fama and French (1997). Corresponding p-valuesfrom robust standard errors clustered at the firm level are reported in brackets. The notation ***, ** and * denotestatistical significance at the 1%, 5% and 10% level, respectively.(1)Ln(Cashpay)(2)Ln(TDC1)(3)Ln(TDC2)(4)Ln(NewTDC1)Backdate50 -0.095*** -0.136*** -0.136*** -0.184***[0.001] [0.001] [0.005] [0.000]FirmSize 0.318*** 0.423*** 0.394*** 0.423***[0.000] [0.000] [0.000] [0.000]ReturnStd -0.825*** 1.784*** -0.779* 1.541***[0.006] [0.000] [0.052] [0.000]ROA -0.077 -0.526** 0.144 -0.398*[0.654] [0.014] [0.545] [0.063]M/B 0.040*** 0.191*** 0.203*** 0.196***[0.000] [0.000] [0.000] [0.000]Leverage 0.115 0.037 0.012 0.021[0.178] [0.716] [0.921] [0.837]StockReturn 0.002*** 0.002*** 0.004*** 0.003***[0.000] [0.000] [0.000] [0.000]Tenure 0.006*** 0.003 0.017*** 0.004*[0.001] [0.202] [0.000] [0.083]Year&Industry DummyYes Yes Yes YesConstant 7.001***[0.000]5.174***[0.000]5.485***[0.000]5.125***[0.000]Observations 7989 7989 7989 7989Adjusted-R2 50% 47% 43% 47%52

Table 10. Interaction Effects between Backdating and Level of CEO PayThe sample consists of 8,486 CEO option grants from 1995 to 2005. The dependent variable is the natural logarithmof CEO total compensation, measured by ExecuComp Item TDC1. The dummy variable, Long tenure, takes thevalue of one if the CEO tenure is above the sample median, and zero otherwise. The dummy variable, Highownership, takes the value of one if the CEO ownership is above the sample median, and zero otherwise. Thedummy variable, Founder CEO, takes the value of one if the CEO is the firm’s founder, and zero otherwise.Backdate50 is defined as AR[1,50]-AR[-50,-1], where AR is the accumulative stock returns over the correspondingevent windows around the grant date (day 0). Industry dummies are based on the 48-industry classification of Famaand French (1997). Corresponding p-values from robust standard errors clustered at the firm level are reported inbrackets. The notation ***, ** and * denote statistical significance at the 1%, 5% and 10% level, respectively.(1)Ln(TDC1)(2)Ln(TDC1)(3)Ln(TDC1)Backdate50 -0.151*** -0.114** -0.164***[0.001] [0.047] [0.000]Backdate50 × Long tenure -0.139**[0.042]Backdate50 × High ownership -0.170**[0.031]Backdate50 × Founder CEO -0.282***[0.002]Long tenure 0.091***[0.000]High ownership 0.038[0.171]Founder CEO -0.016[0.593]FirmSize 0.428*** 0.428*** 0.424***[0.000] [0.000] [0.000]ReturnStd 1.593*** 1.573*** 1.586***[0.000] [0.000] [0.000]ROA -0.371*** -0.367** -0.360***[0.002] [0.041] [0.003]M/B 0.180*** 0.181*** 0.181***[0.000] [0.000] [0.000]Leverage 0.025 0.021 0.024[0.705] [0.816] [0.713]StockReturn 0.003*** 0.003*** 0.003***[0.000] [0.000] [0.000]Year&Industry DummyYes Yes YesConstant 5.003*** 5.012*** 5.111***[0.000] [0.000] [0.000]Observations 7989 7989 7989Adjusted-R2 47% 47% 47%53

Table 11. Backdating and CEO Pay Changes around SOXIn Column (1), the sample is the ExecuComp firms with no CEO changes from 2001-2003. The dependent variableis Ln(CEO pay at Year 2003) – Ln (CEO pay at Year 2001). In Column (2), the sample is the ExecuComp firmswith no CEO changes from 2000-2004. The dependent variable is Ln(average CEO pay in Years 2003 and 2004) –Ln(average CEO pay in Years 2000 and 2001). In Column (3), the sample is the ExecuComp firms with no CEOchanges from 1999-2005. The dependent variable is Ln(average CEO pay in Years 2003-2005) – Ln(average CEOpay in Years 1999-2001). CEO pay is measured by ExecuComp Item TDC1. Backdate50 is defined as AR[1,50]-AR[-50,-1], where AR is the accumulative stock returns over the corresponding event windows around the grantdate (day 0). ∆Firmsize is computed as Ln(sales in Year 2003) – Ln(sales in Year 2001) in Column (1), Ln(averagesales in Years 2003 and 2004) – Ln(average sales in Years 2000 and 2001) in Column (2), and Ln(average sales inYears 2003-2005) – Ln(average sales in Years 1999-2001) in Column (3), respectively. Accumulative stock return(ROA) is the firm’s accumulative stock return (ROA) in over 2001-2003 in Column (1), over 2000-2004 in Column(2), and over 1999-2005 in Column (3), respectively. ReturnStd is the standard deviation of monthly stock returnover the respective period in each column. Industry dummies are based on the 48-industry classification of Famaand French (1997). Corresponding p-values from robust standard errors clustered at the firm level are reported inbrackets. The notation ***, ** and * denote statistical significance at the 1%, 5% and 10% level, respectively.(1)CEO Pay Change2001-2003Backdate50 in year 2001 0.152**[0.027]Average backdate50 inyears 2000-2001(2)CEO Pay Change2000-20040.204**[0.028](3)CEO Pay Change1999-2005Average backdate50 in0.285**years 1999-2001[0.018]∆Firmsize 0.183** 0.204** 0.412***[0.027] [0.028] [0.000]Accumulative stock return 0.154*** 0.090*** 0.412***[0.000] [0.000] [0.000]Accumulative ROA 0.233*** 0.175** 0.005[0.008] [0.047] [0.950]ReturnStd -0.866*** -0.090*** -0.956***[0.000] [0.000] [0.000]Industry Dummy Yes Yes YesConstant 0.423[0.182]0.544*[0.092]-1.449***[0.001]Observations 944 706 461Adjusted-R2 25% 28% 33%54

8.0%7.0%6.0%5.0%Mean returns4.0%3.0%2.0%1.0%0.0%-50-1.0%-40 -30 -20 -10 0 10 20 30 40 50-2.0%-3.0%-4.0%-5.0%Trading days relative to award dateFigure 1. Stock Returns around Option Grant DatesThis figure displays the cumulative stock returns from 50 days before through 50 days after stock option grants toCEOs.55

Mean returns5.0%3.0%1.0%-1.0%A-50 -30 -10 10 30 50Mean returns5.0%B3.0%1.0%-50-1.0%-30 -10 10 30 50-3.0%-3.0%-5.0%Trading days relative to award date-5.0%Trading days relative to award dateLow G-indexHigh G-indexLow E-indexHigh E-index5.0%5.0%Mean returns3.0% C1.0%-1.0%-50 -30 -10 10 30 50Mean returns3.0% D1.0%-1.0%-50 -30 -10 10 30 50-3.0%-3.0%-5.0%Trading days relative to award date-5.0%Trading days relative to award dateSmall BoardLarge BoardLow Institutional OwnershipHigh Institutional Ownership7.0%5.0%EMean returns3.0%1.0%-1.0%-50 -30 -10 10 30 50-3.0%-5.0%Trading days relative to award dateLow Board IndependenceHigh Board IndependenceFigure 2. Stock Returns around Option Grant Dates, Sub-samples Sorted by DifferentGovernance MeasuresThis figure displays the cumulative stock returns from 50 days before through 50 days after stock option grants toCEOs. In Panel A, the full sample is divided to two sub-samples based on the median of the related G-index value.In Panel B, the full sample is divided to two sub-samples based on the median of the related E-index value. In PanelC, the full sample is divided to two sub-samples based on the median of the related board size. In Panel D, the fullsample is divided to two sub-samples based on the median of the related Top5holding. In Panel E, the full sample isdivided to two sub-samples based on the median of the related board independence.56

1211G-index10987-3 -2 -1 0 1 2 3Years relative to award dateBelow MedianAbove MedianFigure 3. G-index around BackdatingWe divide our sample based on the median of Backdate50 and plot the average G-index value from 3 years prior tothe option grants to 3 years afterward.57

$1,200,000$1,000,000Incentive $5000BS Option Cost$800,000$600,000$400,000Incentive $3000Incentive $2000$200,000Incentive $1000$05%15%25%35%45%55%65%75%85%95%105%115%125%135%145%155%165%175%185%195%Strike Price as % of Grant-date Stock PriceFigure 4. Simulation Results for Various Incentive LevelsThe figure assumes that executives own $5 million in initial wealth and that 66% of their wealth is invested in thefirms that employ them. The coefficient of relative risk aversion is assumed to be 2. We define “incentives” as thechange in the certainty-equivalent option value for each $1 change in the stock price. The four lines respond to theincentive levels of $1,000, $2,000, $3,000, and $5,000, respectively.58

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