Academic journal article Quarterly Journal of Finance and Accounting

Corporate Governance Characteristics of Firms Backdating Stock Options

Academic journal article Quarterly Journal of Finance and Accounting

Corporate Governance Characteristics of Firms Backdating Stock Options

Article excerpt

Introduction

Stock options are intended to align the interests of managers with those of shareholders. For most option awards, the exercise price of the option is set equal to the closing price of the stock on the date of the grant. Backdating refers to the act of retrospectively and intentionally changing the original grant date of an option award to a date when the stock price of the firm was particularly low. [1] By opportunistically changing the option's grant date, management reduces the exercise price of the option, often to the lowest possible stock price of the year, and thus maximizes its compensation.

Studying the issue of backdating of options is important for several reasons. Executive compensation is always a topic of great interest to investors and regulators. Management compensation is perhaps the most important contracting device used by firms (Anderson and Bizjak, 2003). Pay packages that are established optimally can help avoid or reduce agency costs by aligning management's incentives with those of shareholders. Many institutional investors view top management compensation policy as a window to the overall quality of a company's corporate governance practices (Wood, 2004). Opportunistic managerial behavior with regard to compensation, for example the backdating of options, raises suspicions about management's integrity and the quality of the overall financial statements.

Our primary interest is in studying whether weak corporate governance systems facilitate opportunistic and potentially illegal backdating of stock options by management. Specifically, we identify backdating firms which are under investigation by the Securities and Exchange Commission and/or the Department of Justice and examine whether there are differences in the corporate governance mechanisms of the backdating firms and a group of control firms. Measuring the effectiveness of a firm's governance system is a difficult task. Our measures attempt to capture multiple dimensions of a corporate governance system including the effectiveness of a company's board of directors and its compensation committee, the quality of a firm's internal and external governance mechanisms, and the influence and power of the CEO.

Our study differs in several ways from prior studies. First, unlike prior studies, we investigate the role of compensation committees in option backdating. Compensation committees are responsible for the approval of option grants. The role of this committee in backdating has not been fully examined in the literature. [2] Second, we cover a more comprehensive set of board and CEO variables. Unlike prior studies that use corporate governance data from Investor Responsibility Research Center's (IRRC) databases (e.g., Collins et al., 2009), we hand collect data from proxy statements for our main tests. This enables us to include small backdating firms that are not covered by IRRC and also include variables not covered by IRRC, such as the number of board meetings and the presence of a CEO-founder. [3] Finally, we include proxies for the quality of internal controls based on the expectation that backdating will be associated with weak internal controls.

Consistent with our hypothesis, our results show that firms with weak boards are more likely to backdate stock options. We do not find, however, that compensation (or audit) committees play a significant role in preventing option backdating. Our results show that the probability of backdating increases for firms having CEOs who are young, are founders, have long tenure, and own smaller amounts of company stock. Finally, we find that there is a smaller likelihood of backdating when internal controls and external governance mechanisms are effective. [4]

Option Backdating

Stock option backdating practices have come under scrutiny following research showing that there were discrepancies between stated and actual grant dates of stock option grants made during the 1990s and early 2000s (McConnell et al. …

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