Backdating Executive Option Grants - Nanyang Technological ...

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