May 22, 2006
More on the Options Scandal
Posted by Gordon Smith

Last week I blogged about the options scandal. Today the W$J reports the results of its own study, finding five additional companies with "highly improbable patterns of options grants." The big question is whether the options were backdated:

The five companies are noteworthy for nearly always awarding top executives option grants dated just ahead of a sharp rise in the company's share price. The dates also were often at the bottom of steep dips in the share price. The statistical analysis doesn't prove any wrongdoing. It is possible that the sharp rises after grants result from luck, a sense of market timing or some other factor. But the repeated grants before sharp stock gains raise the question of whether the grants were actually awarded later, then backdated to the more favorable time, or otherwise gamed.

Erik Lie at Iowa has been at the forefront of the study of backdating. His 2005 article "On the Timing of CEO Stock Option Awards" is here. He concludes, "Unless executives possess an extraordinary ability to forecast the future marketwide movements that drive these predicted returns, the results suggest that at least some of the awards are timed retroactively."

Professor Lie furthers his study of backdating in a paper with Randall Heron that is forthcoming article in the Journal of Financial Economics. SSRN has the paper here. They conclude, "most of the abnormal return pattern around option grants is attributable to backdating of option grant dates."

Are we on the front end of a tsunami? Erik Lie thinks we might be (from the W$J article linked above):

Mr. Lie, who wrote a watershed academic paper suggesting that options backdating could be pandemic, believes that scores more companies could come under the microscope. His data on thousands of option grants show that, on average, shares perform far better than normal in the periods after option dates. The aberration is so large, Mr. Lie says, that backdating or some other means of grant timing "must be widespread."

Lots of others are writing about backdating, including Paul Caron, Steve Bainbridge, and Geoff Manne. Geoff does the most thorough job exploring possible market explanations for the observed price effects, though these seem unlikely to be right in light of Erik Lie's work.

What should be done? Heron and Lie observe, "We find that this return pattern is much weaker since August 29, 2002, when the SEC requirement that option grants must be reported within two business days took effect." Steve suggests that the SEC or shareholder advocates take the reform one step further, requiring same day electronic disclosure of option grants. I like the idea. Simple and (likely) effective.

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