Profiles in Leadership - UW-Milwaukee

Faculty Research
Can Large Stock Option Grants Lead to
Fraudulent Financial Reporting?
By: Richard L. Priem, The Robert L. & Sally S. Manegold Professor of Management and Strategic Planning and Faculty
Director, M&I Marshall & Ilsley Center for Business Ethics
Accurate fi nancial reporting by
listed fi rms is essential for viable
equity markets. Yet recently,
scandals at fi rms such as Enron Corp.
and WorldCom Inc. have highlighted the
serious consequences of fraudulent
fi nancial reporting, not only for the
companies involved and their employees,
but also for their communities and society
at large. Fraudulent fi nancial reporting
by top managers clearly erodes shareholder
value: it is estimated to have contributed
to trillions of dollars in losses for U.S.
pension plans and 401(k) savings plans
from 2000 to 2002, according to a 2002
report published in the New York Times.
These losses are caused primarily by a
few “bad apples” at the top. Most CEOs
and top managers are honest and
hard-working; they do their very best to
maximize shareholder returns and to
simultaneously provide clear benefi ts for
their customers, employees, and
communities. Unfortunately, intense
media attention given to scandal-plagued
companies and their CEOs tends to
tarnish the reputation of the entire
business community.
The umbrella term “corporate governance”
includes forces and mechanisms
that may limit the ability of “bad apple”
CEOs to engage in unethical or illegal
behaviors. According to Michael Jensen
of Harvard University, these forces
include: legal and regulatory systems,
now reinforced by the Sarbanes-Oxley
legislation; external control mechanisms
such as capital markets that allow poorly
run companies to be taken over;
14 OUTLOOK
Richard L. Priem
competition in product and factor
markets; and various internal control
systems headed by boards of directors.
These internal control systems include
the board’s various monitoring activities
plus the setting of executive compensation.
Since the 1980s, much attention has been
paid to the granting of executive stock
options as a potentially highly effective
method of corporate governance. The
rationale is that CEOs and other top
managers with large stock-option grants
will maintain a laser-like focus on
improving their companies’ stock prices
rather than going off-track in pursuing
other, sometimes self-serving goals. And
because stock price appreciation is the
shareholders’ goal as well, this aligns the
interests of a company’s managers with
those of its shareholders. Lucian Bebcuk
of Harvard argues that companies are
following this logic, and that is one
reason why CEO pay from stock option
grants has soared.
Several colleagues and I became curious
as to whether really large stock option
grants might at times have the perverse
and unintended effect of motivating “bad
apple” CEOs to infl ate their fi rms’
fi nancial results in order to ensure a high
stock price when they exercise their
options. If this occurs, those CEOs would
be trading near-term personal benefi t for
longer-term stockholder loss. We decided
to examine these issues in a research
project, which was subsequently published
in the Academic of Management Journal
(49: 483-500, 2006). My co-investigators
were Joe O’Connor, a Lubar School Ph.D.
graduate who is currently on the faculty
of the University of Texas at El Paso, Joe
Coombs of Texas A&M University, and
another former Ph.D. student of mine,
Matt Gilley of Oklahoma State University.
We conducted our study by fi rst reviewing
a database covering 550 newspapers
articles that appeared from 2001 to 2004
that contained variations of the word
“restate,” indicating possible restatement
of fi nancial results. We considered only
restatements downward that were not the
result of changes in accounting principles
or various non-fi nancial matters. This
produced about 300 restatements per
year. But because we wanted to make
sure that the restatements resulted from