Corporate Governance and Backdating of Executive Stock Options

Transcription

1 Corporate Governance and Backdating of Executive Stock Options Daniel W. Collins a, Guojin Gong b, Haidan Li c,* a Tippie College of Business, University of Iowa, Iowa City, IA 52242, USA b Smeal College of Business, Pennsylvania State University, University Park, PA 16802, USA c Leavey School of Business, Santa Clara University, Santa Clara, CA 95053, USA August 2008 Abstract This paper investigates whether weak corporate governance is a contributing factor to the incidence of backdating executive stock option awards. Based on a sample of S&P 1500 firms that exhibit evidence of backdating, we find that firms with weaker governance structures that allow CEOs to exercise greater power over the board and its compensation committee are more likely to engage in CEO option backdating. Moreover, the tendency to backdate is stronger when stock options are more important in CEO compensation and when directors receive option grants on the same date as the CEO. We also find interlocking boards among backdating firms are associated with a higher incidence of backdating. Finally, we find that CEOs of backdating firms receive a significantly higher level of total compensation than their counterparts in non-backdating firms after controlling for economic determinants of executive pay, and that the predicted excess compensation arising from the board and ownership structure variables has a more negative association with future firm performance for backdating firms relative to non-backdating firms. The evidence is consistent with backdating firms having greater agency problems that negatively affect shareholder value. JEL classification: G30; J33 Keywords: Corporate governance; Executive compensation; Stock option grants; Backdating We thank workshop participants at the Georgia State University, Santa Clara University, University of Cincinnati, University of Iowa, University of Technology in Sydney, the 2007 Contemporary Accounting Research Conference, and Robert Bushman (discussant), Doug DeJong, Cristi Gleason, Bruce Johnson, Ryan LaFond, Shivaram Rajgopal (Associate Editor), Sonja Rego and two anonymous referees for useful comments on earlier versions of the paper. * Corresponding author. Tel.: ; fax: addresses: daniel-collins@uiowa.edu (D.W. Collins), gug3@psu.edu (G. Gong), hli4@scu.edu (H. Li).

2 Corporate Governance and Backdating of Executive Stock Options 1. Introduction Backdating of stock option grants refers to the practice of using hindsight to select a date in the past on which the stock price was particularly low to be the option grant date. Because stock options typically have an exercise price that is set to the market price of the stock on the grant date, backdating allows executives to receive in-the-money options thereby enhancing the value of their option grants. As of January 2007, over two hundred companies have come under federal investigations by the Securities and Exchange Commission (SEC), the Justice Department, or inquiries from their own boards over possible backdating practices. 1 Announcements of option-backdating investigations have prompted share price declines, stock downgrades, and for some companies, financial statement restatements and replacements of board members and senior executives. 2 The revelation that some companies backdated executive stock options raises concerns about the effectiveness of corporate governance in setting executive pay. For example, The Wall Street Journal (WSJ) recently reported that the board of UnitedHealth, one of the alleged backdating firms, allowed its former CEO, William McGuire, to choose the day of his own option grants, which resulted in several large option awards dated at the years single lowest closing price (Bandler and Forelle, 2006). In addition, questions have been raised about the independence of UnitedHealth s board and compensation committee (Forelle and Bandler, 2006a). 3 Arthur Levitt, former chairman of the SEC, has referred to 1 For the list of firms under backdating investigations as reported by The Wall Street Journal, see Also see Glass Lewis & Co. Yellow Card Brief Alert, January 3, There are accounting and tax consequences associated with backdating because retroactively dating options to achieve a low exercise price is equivalent to issuing in-the-money options. Consequently, companies may have to restate their stock option expense and pay additional withholding taxes and penalties on the value of the in-themoney options deemed compensation to employees. 3 For example, the head of the compensation committee, a money manager and friend of Mr. McGuire, had managed money for him and had accepted investments from Mr. McGuire in his own business. Moreover, Mr. McGuire and the company had made generous contributions to charities supported by other directors (Bandler and Forelle, 2006). 1

3 backdating as... the ultimate in greed. It is stealing, in effect. It is ripping off shareholders in an unconscionable way (Forelle and Bandler, 2006b). 4 In this study we examine whether weaknesses in corporate governance are related to the incidence of executive stock option backdating. We expect backdating firms to have weaker governance structures that give rise to greater managerial power over the boards and compensation committees, relative to firms that do not backdate executive stock option grants. Our study provides direct evidence on the managerial power theory proposed by Bebchuk and Fried (2004) in explaining the practice of executive compensation. Under this theory, managerial power arises because boards and compensation committees do not function independently with respect to the contracting process with CEOs. As a result, executives can exert influence over their own pay including retroactively timing their option grants. While managerial power by itself does not necessarily imply suboptimal contracting, the use of managerial power for self-serving purposes by CEOs can hurt shareholder value (Core et al. 1999). Backdating provides another interesting setting to examine this issue. To examine whether backdating is linked to weak governance structures, we use a sample of S&P 1500 companies that are likely to have backdated CEO stock options during the period from 1998 to We classify a CEO option grant as backdated if the grant date stock price falls in the lowest decile of the stock price distribution over a 240-day window surrounding the option grant date. The idea underlying our method is that backdating allows managers to select a grant date in the past with a particularly low stock price. We then analyze corporate governance features for the backdating sample relative to a control sample consisting of CEO stock option grants not classified as backdated. Corporate governance is a complex and multi-faceted construct. Our goal is to develop a parsimonious model that focuses on a set of governance variables that a priori are most likely to capture 4 Although most people condemned the practice of backdating, a small group of people hold a different view. For example, Holman Jenkins, a member of the editorial board of the WSJ, defends backdating as an innocuous and even sensible practice (Jenkins, 2006). SEC Commissioner Paul Atkins argues that option grants are the result of a board s business judgment and that A board, by issuing options at an opportune time, maximizes the effect of those options (Atkins, 2006). However, he also emphasizes that backdated options are legal only when they are properly reported. In this study, we focus on the illegal practice of backdating that is not properly accounted for and disclosed. 2

4 CEO power and influence over the board that allows the backdating behavior to take place. We first examine a set of governance structure variables to capture the level of CEO power and influence over the board and the compensation committee, including: (1) the proportion of inside directors on the board; (2) the proportion of gray outside directors on the board; (3) the proportion of outside directors appointed by the incumbent CEO; (4) whether the CEO serves as chairman of the board; (5) whether an inside director serves on the compensation committee; and (6) CEO tenure. Consistent with the managerial power view of backdating, we conjecture that board and compensation committee structures that give rise to greater CEO power and influence over the boards are more likely to exhibit evidence of backdating. Accordingly, we expect firms that have boards with a greater proportion of inside directors and gray outside directors, a higher percentage of outside directors appointed during the tenure of the incumbent CEO, where the CEO serves as chairman of the board, and with compensation committees that have inside directors are more likely to backdate CEO option grants. Moreover, we predict a positive relation between CEO tenure and backdating because CEOs with longer tenure are likely to have accumulated greater power over directors and thus are more likely to influence the timing of option awards. It has recently been suggested that interlocking boards are at least partially responsible for spreading the backdating practice across firms (The Corporate Library Report, 2006; Bizjak et al., 2006). We thus investigate the impact of interlocking boards on backdating. We conjecture that the presence of a board member serving on the board of another backdating firm increases the likelihood of backdating. In addition to board and compensation committee variables, we examine the effect of ownership structure and incentives for backdating. Because we expect better monitoring to limit opportunistic management behavior, we predict that firms with stronger monitoring by institutional investors, a large outside shareholder (blockholder) serving on the compensation committee, and firms audited by dominant audit suppliers will exhibit less evidence of backdating. We also conjecture that the likelihood of backdating is positively related to the importance of stock options in CEO compensation since the potential gains from backdating increase as CEOs receive larger stock option grants. Finally, since directors of many firms also receive stock options and can benefit from option timing manipulation, we 3

5 examine whether the likelihood of backdating increases with the importance of stock options in director pay, and whether the tendency to backdate CEO grants is stronger when CEOs and directors receive options on the same date. This latter prediction is consistent with board members, in addition to the management, engaging in opportunistic behavior. Consistent with the managerial power view of backdating, we find considerable evidence that firms with governance structures where the CEO exercises greater power over the board are more likely to engage in option backdating. Specifically, we find that backdating firms have a higher proportion of inside and gray directors on the board, a higher proportion of outside directors appointed by the incumbent CEO, and a higher incidence of the CEO serving as chairman of the board, relative to a control sample of non-backdating firms. We also find that the presence of a board member serving on the board of another backdating firm increases the likelihood of backdating. Consistent with strong outside monitoring deterring opportunistic managerial behavior, we find that backdating is less likely when there is an outside blockholder on the compensation committee. Regarding the incentives for backdating, we find that the likelihood of backdating is higher when stock options are more important in CEO compensation and when directors receive option grants on the same date as the CEO. The evidence suggests that the tendency to backdate is stronger when the potential gains from backdating are greater for CEOs and when directors share in the benefits of backdating. Finally, we find a number of firm characteristics are related to backdating. Firms audited by one of the Big 4 audit firms exhibit a lower incidence of backdating while firms with greater return volatility and firms in high technology industries exhibit greater evidence of backdating. In an attempt to allay concerns that correlated omitted variables may be driving our results, we conduct a series of supplemental cross-sectional tests to provide additional evidence that board structure and ownership structure variables that allow CEO power and influence over the board are important determinants of backdating. We first compare firms with multiple occurrences of backdating versus single occurrence of backdating during our sample period and conjecture that the multiple-occurrence backdating firms will exhibit weaker governance structures. Consistent with our predictions, we find that 4

6 multiple-occurrence backdating firms exhibit greater evidence of CEO power over the board relative to single-occurrence backdating firms. Moreover, we find that CEOs and directors of firms with multiple occurrences of backdating receive a higher portion of their total compensation in the form of option grants. These results suggest that board structure and incentive variables are important determinants of the intensity of backdating as measured by the number of backdating occurrences. We next investigate whether governance features that proxy for CEO power and influence over the board are more prevalent among firms that failed to comply with the two-day reporting requirement under Section 403 of the Sarbanes-Oxley Act (SOX). We find that firms with greater CEO power and influence over the board are more likely to violate the SOX 403 two-day reporting requirement thereby providing a greater opportunity for backdating. We also examine a group of firms that do not backdate CEO options but exhibit evidence of backdating non-ceo executive option grants. We expect that CEOs with relatively more power over the board will act in self-serving ways to increase their own compensation. We thus conjecture that the board and ownership structure variables that we use to proxy for CEO power and influence will be more important in explaining the backdating of the CEO s own options relative to explaining the backdating of non-ceo executives option grants. Again, we find evidence consistent with this cross-sectional prediction. Finally, we investigate whether there is greater evidence of CEO excess compensation and rent extraction among backdating firms relative to non-backdating firms. Specifically, we investigate whether CEOs who receive backdated option grants are more likely to receive greater total compensation beyond the level determined by firm-specific economic determinants of executive pay, and whether the predicted component of compensation arising from the board and ownership structure variables that proxy for CEO power and influence over the board (i.e., predicted excess compensation) has a more negative association with future firm performance for backdating firms. We find that CEOs of backdating firms receive a significantly higher level of total compensation relative to their counterparts in non-backdating firms that 5

7 averages about $1.056 million after controlling for economic determinants of pay. 5 In addition, we find that the predicted excess compensation for backdating firms is more negatively associated with future firm performance measured as return on assets and annual stock returns for the subsequent year or averaged over the subsequent three years. These findings are consistent with the notion that firms that backdate CEO options have greater agency problems that negatively affect shareholder value. Taken together, the results are consistent with the view that weaker corporate governance structures that give rise to greater managerial power over the boards, interlocking boards among backdating firms, greater importance of stock options in CEO compensation, and directors sharing in the benefits of backdating lead to a higher incidence of backdating executive stock options. Moreover, we provide evidence that relative to CEOs of non-backdating firms, CEOs of backdating firms exhibit greater evidence of overcompensation that is more negatively related to future performance, which is consistent with CEOs exercising power to extract rents from shareholders. Although our focus is on backdating, our findings are also relevant to the broader debate on executive compensation. We add to this literature by providing new evidence that is supportive of the managerial power theory in explaining executive compensation practices (Bebchuk and Fried, 2004). Our finding that the likelihood of backdating is higher when directors share in the benefits also raises concerns about potential agency problems between directors and shareholders. Several concurrent papers investigate the relation between backdating and various aspects of corporate governance (Bebchuk et al., 2006a and 2006b, Bizjak et al. 2006). 6 We add to these studies by investigating a more comprehensive set of corporate governance mechanisms and ownership structure variables and also include a number of variables to capture the incentives to backdate, which are not examined in these studies. More importantly, none of these studies investigate whether backdating firms exhibit greater evidence of managerial rent extraction that adversely affects shareholder value. We 5 Note that the actual excess compensation could be higher for CEOs of backdating firms as our estimate does not include the stealth compensation CEOs receive through backdating. 6 We provide a more detailed discussion of these papers in Section

8 address this issue by estimating the relation between predicted excess compensation for CEOs and future firm performance. Our study provides direct evidence that backdating firms experience greater managerial rent-seeking problems, an important finding that is not available in any of the concurrent studies. In the next section we discuss related research. Section 3 discusses our corporate governance measures and control variables. Section 4 describes the sample construction procedure. Section 5 presents empirical results on the relation between corporate governance variables and the incidence of backdating, discusses endogeneity concerns and presents a series of cross-sectional tests designed to mitigate concerns that correlated omitted variables may be driving our results. Section 6 summarizes our findings and concludes. 2. Research on corporate governance, CEO compensation and backdating 2.1. Corporate governance and CEO compensation There is a long-standing debate on whether executive compensation can be better explained by incentive compatible optimal contracting or by managerial rent-seeking behavior. Under the optimal contracting theory, boards and compensation committees design executive compensation arrangements to reduce the agency problem between managers and shareholders in ways that enhance shareholder value. Consistent with the incentive alignment view, Core and Guay (1999) show that firms award equity grants in a manner that is consistent with agency and contracting theories. In addition, Hanlon et al. (2003) find that executive stock option grants are positively related to future firm operating performance. Accordingly, they conclude that executive stock option grants are driven by economic determinants that are aligned with shareholder interests and not by poor governance quality that allows rent-seeking managerial behavior. In recent years, the enormous size of compensation packages to some executives coupled with an ever-growing list of accounting scandals have triggered intense criticisms about board governance and executive compensation practices. Bebchuk and Fried (2004) argue that executive compensation 7

9 practices are often the product of managerial power that allows rent extraction from shareholders. CEOs have power to influence board decisions in a variety of ways, including: CEOs are typically involved in the director selection process; CEOs can use their firm s resources or their personal influence to benefit directors both inside and outside the firm; when setting CEO pay, compensation committees often rely on compensation consultants who are hired by the CEOs; CEOs or other senior officers may serve on the compensation committee (e.g., Yermack, 1997; Anabtawi, 2004; Bebchuk and Fried, 2004). In addition, some social and psychological factors can affect the effectiveness of the board and the compensation committee. For example, some boards have a tendency not to question CEO pay because board culture promotes collegiality and discourages conflict (Jensen, 1993). Bebchuk and Fried (2004) argue that because the board and the compensation committee do not function independently of the CEO in setting CEO compensation, CEOs can exert influence over their own pay, leading to executive pay that is either too high or that does not provide appropriate levels of incentives to enhance shareholder value. Consistent with the managerial power view of executive compensation, Core et al. (1999) find that CEOs of firms with weaker corporate governance (as proxied by board characteristics and ownership structure variables) receive greater compensation after controlling for economic determinants of executive pay, and that the excess compensation is inversely related to future firm performance. However, inconsistent with this view, Anderson and Bizjak (2003) find little evidence that lack of independence on the compensation committee affects executive pay. Recent empirical evidence also suggests that executive stock options encourage earnings management and other executive opportunistic behavior (such as discretionary disclosures) aimed at increasing the value of options (e.g., Aboody and Kasznik, 2000; Baker et al., 2003; Bergstresser and Philippon, 2006; Burns and Kedia, 2006; Cheng and Warfield, 2005). In this paper, we investigate another way in which option grants may invite opportunistic managerial behavior, i.e., the backdating of executive stock options. 8

10 2.2. CEO influence over option grant date stock prices The literature on opportunistic timing manipulation of executive stock options begins with Yermack (1997). Yermack examines a sample of 620 CEO option awards from 1992 to 1994 for Fortune 500 companies and documents positive abnormal returns following the option grant dates. Yermack interprets the evidence as suggesting that executives manipulate the timing of stock option awards such that they receive option grants before good news announcements, which is often referred to as spring loading in the literature. Aboody and Kasznik (2000) focus on a sample of scheduled option awards and, consistent with Yermack (1997), find positive abnormal returns following the grant dates. 7 They conclude that for firms that issue stock options on a fixed schedule, executives manipulate the timing of value-relevant information disclosures around the fixed grant dates to enhance the value of their option awards. Subsequent studies, including Chauvin and Shenoy (2001), Lie (2005), Collins et al. (2005a and 2005b), Heron and Lie (2006a), and Narayanan and Seyhun (2006), find significantly negative abnormal returns before option grants and positive abnormal returns after the grants. The latter three studies also find that the return reversal pattern around option grant dates becomes weaker, but is still present, in the period after the Sarbanes-Oxley Act of 2002 (SOX) that requires firms to report option grants within two business days following the grant date. Lie (2005) is the first paper to suggest that backdating contributes to the return reversal pattern around the grant dates. Heron and Lie (2006a) go further and argue that backdating explains most, if not all, of the pattern in abnormal returns around option grants. Several concurrent studies examine the prevalence of backdating in practice and report that a significant number of executive and director stock options are likely to have been backdated (Heron and Lie, 2006b; Bebchuk et al., 2006a and 2006b). Our study contributes to the literature that investigates the relation between opportunistic timing or backdating of executive stock option grants and various aspects of corporate governance. Yermack 7 Aboody and Kasznik (2000) define scheduled option awards as awards that occur within a one-week window around the one-year anniversary of the prior year s award. 9

11 (1997) reports that abnormal returns after the grant date are higher when the CEO has greater influence over the compensation committee. Our study differs from Yermack s in several ways. First, Yermack (1997) focuses on the opportunistic timing of option grants before anticipated good news announcements, while our focus is on backdating. Moreover, we examine a larger sample of firms over a longer period of time when stock option compensation is more widely used and backdating appears to have been more prevalent. Finally, we examine a broader set of board structure, ownership and executive compensation variables than those examined by Yermack. Two concurrent studies examine the link between backdating and board characteristics. Bebchuk et al. (2006a) find that CEOs are more likely to receive lucky grants when the board does not have a majority of outside directors and the CEO has longer tenure. 8 Bizjak et al. (2006) show that the likelihood of backdating is higher when the company has directors sitting on the board of another company that has awarded backdated options to its executives. We examine a more comprehensive set of board and ownership structure variables than either of these two concurrent studies and we introduce a number of variables to capture the incentives to backdate. Moreover, we extend these studies by examining board and ownership structure characteristics of: (1) multiple-occurrence versus singleoccurrence backdating firms; (2) firms that complied versus firms that did not comply with the two-day SOX Section 403 reporting requirements of executive option grants; and (3) firms that backdated CEO options versus firms that backdated non-ceo executive options. Thus, through these supplemental tests we are able to provide a more complete picture of the governance features and managerial incentives that contribute to backdating. Finally, we provide important new evidence that backdating firms have greater agency problems that negatively affect shareholder value. Our findings regarding directors incentives to backdate CEO options are also related to recent studies by Bebchuk et al. (2006b) and Byard and Li (2005). Bebchuk et al. (2006b) examine the backdating of director stock options and find that directors are more likely to receive backdated grants 8 Bebchuk et al. (2006a) define lucky grants as grants awarded to executives at the lowest price of the month. We employ a different approach to identify grants that are likely to have been backdated. See footnote 14 for more discussion. 10

12 when the CEO also receives options on the same date. This result suggests that backdating of director options is more likely when executives and directors options are linked. Byard and Li (2005) find a positive relation between the importance of stock options in director compensation and the extent of return reversal around CEO option grant dates. We extend the analysis in Bebchuk et al. and Byard and Li by examining whether the likelihood of backdating CEO option grants is greater if directors receive options on the same date as the CEO. 9 Our study also adds to the broader literature on governance characteristics and corporate scandals. Several studies investigate the relation between corporate governance and the incidence of accounting restatements or the SEC Accounting and Auditing Enforcement Release actions for alleged accounting violations (Beasley, 1996; Dechow et al., 1996; Abbott et al., 2003; Agrawal and Chadha, 2005; Baber et al., 2006). These studies find mixed results regarding whether weak corporate governance is linked to accounting scandals. In contrast, we find strong evidence that weak corporate governance is at least partially responsible for the backdating scandal. 3. Variable measurement 3.1. Board and committee attributes To evaluate the influence of governance structures on the timing manipulation of option grants, we focus on the board and the compensation committee due to their direct involvement with, and oversight responsibility for, executive compensation. The first four variables measure CEO influence over the board, including: (1) the proportion of inside directors on the board (INSIDEDIR); (2) the proportion of gray outside directors on the board (GRAYDIR); 10 (3) the proportion of outside directors 9 Byard and Li (2005) claim that most firms grant options to CEOs and directors on the same date, and examine whether directors have greater incentives to opportunistically time option grants when options are more important in director compensation. In other words, CEOs and directors receiving options on the same date is an assumption underlying their research design. In contrast, we directly measure whether CEOs and directors receive options on the same date and include it as an independent variable to explain the likelihood of backdating. 10 The Investor Responsibility Research Center (IRRC) database defines an outside director as gray or affiliated if he/she is a former employee; is an employee of a significant service provider, supplier or customer; is a recipient of 11

13 who are appointed by the incumbent CEO (CEOHIREDIR); 11 and (4) whether the CEO serves as chairman of the board (CEOCHR). We posit that inside directors, gray outside directors, and outside directors appointed by CEOs are less independent of CEOs and, therefore, are less effective monitors and are more likely to be influenced by CEOs. Moreover, CEOs who serve as chairman of boards have greater power over board members. Thus, consistent with the managerial power theory, we expect these board attributes to be positively associated with the incidence of backdating. In addition to the board attributes outlined above, we examine the compensation committee independence. We code a dummy variable, INSIDEDIR_COMP, equal to 1 if the firm has an inside director sitting on the compensation committee, and zero otherwise. We expect that CEOs have greater ability to influence their own pay, including backdating their option awards, if they or other insiders serve on the compensation committee. Moreover, we expect CEOs that have longer tenure to be more entrenched and to have greater power over the board and its committees. Accordingly, we predict a positive relation between CEO tenure (TENURE) and the incidence of backdating. Recently, the Corporate Library, an independent research firm that provides data and analysis of corporate governance issues, has claimed that interlocking boards may be responsible for spreading the backdating practice across firms (see also Bizjak et al., 2006). Thus, we consider whether interlocking boards among backdating firms contribute to the incidence of backdating. We define a dummy variable that equals 1 if the firm has at least one board member who also serves on the board of another firm that exhibits evidence of backdating for the same year, and 0 otherwise (INTERLOCK_BKDATE). We expect the presence of director(s) linked to another backdating firm increases the likelihood that a firm will backdate. charitable funds; is considered as an interlocking director (i.e., a director and executive of the company who sits on a board of another company that has an executive and director who also sit on the original company s board); or is a family member of an executive officer. 11 An outside director is assumed to have been appointed by the CEO if he/she joined the board after the incumbent CEO took office (Core et al., 1999). 12

14 3.2. Ownership structure Jensen (1993) and Shleifer and Vishny (1997) argue that blockholders and institutional investors that hold large equity positions in a company are important to a well-functioning governance system because they have the financial interest and independence to monitor firm management and policies in an unbiased way, and the voting power to put pressure on management if they observe self-serving behavior. We code a dummy variable, BLKHOLD_COMP, equal to 1 if there is an outside director sitting on the compensation committee who owns at least 5% of shares outstanding, and 0 otherwise. We measure institutional ownership, INSTOWN, as the percentage of shares held by institutional shareholders as reported in SEC 13-F filings. If better monitoring reduces self-serving managerial behavior, we expect backdating to be less likely when there is an outside blockholder that serves on the compensation committee and when the firm has greater institutional ownership. The effects of CEO ownership, CEOOWN, on the likelihood of backdating are ambiguous. On the one hand, higher levels of CEO ownership may improve the incentive alignment between the CEOs and shareholders, making it less likely that backdating will occur. On the other hand, high CEO ownership may increase management s entrenchment and limit the board s ability to deter CEOs selfserving behavior. We thus make no prediction regarding the relation between CEO ownership and the likelihood of backdating Incentives to backdate We expect the larger the option-based compensation relative to total compensation for CEOs and directors, the greater their incentives to backdate option awards. Furthermore, when directors receive their stock options concurrently with CEOs, they directly benefit from the timing manipulation of CEO option grants and therefore may have greater incentive to backdate (or have less incentive to constrain the practice). Thus, we expect backdating is more likely when directors receive options on the same date as CEOs. We measure the importance of CEO (director) option compensation as the Black-Scholes value of 13

15 stock option grants as a percentage of total compensation (CEOGRANT and DIRGRANT). 12 SAMEDAY is a dummy variable coded 1 if at least one director receives option grants within five days of a CEO grant Control variables We control for several firm characteristics that are likely to affect the probability of backdating. Firm size (MVE) is a common control variable that captures a variety of factors, including the general monitoring environment. Small firms may face resource constraints in implementing effective monitoring mechanisms and also receive limited attention from the public. Heron and Lie (2006b) find that smaller firms are more likely to backdate stock option awards. Stock return volatility (VOLATILITY) is an important factor in valuing stock option awards. Based on evidence in Heron and Lie (2006b), we expect a positive correlation between backdating and stock return volatility as greater return volatility implies greater potential gains from backdating stock options. The news media has frequently claimed that the backdating practice is more prevalent in high technology firms where stock options are heavily used in compensating executives. We thus control for high technology industry classification (HighTech) in the multivariate analysis. Following Heron and Lie (2006b), we also control for auditor type (BIG4). We expect firms audited by dominant audit suppliers to be less likely to backdate since these audit firms are likely to use more sophisticated audit procedures to detect backdating and they face greater reputation and litigation costs if one of their clients is caught backdating. The variable names, definitions, and data sources used in our analyses are summarized in the Appendix. 12 The value of options granted to a director and director total compensation are not available in ExecuComp and require estimation. We calculate the fair value of director options as the number of options granted to a director times the fair value per option, where the fair value per option granted to a director is proxied by the average fair value per option granted to the CEO. Director total compensation includes cash retainer, meeting fee, stock and option grants. 14

16 4. The sample We collect CEO stock option grant data from Thomson Financial Insider Trading database and Standard & Poor s ExecuComp database. The Insider Trading database provides data on insider trading activities reported on SEC forms 3, 4, 5 and 144, and the ExecuComp database provides data on executive compensation based on proxy statements for S&P 1500 companies. Our sample period ranges from 1998 through 2004 since this is the time frame for which corporate governance data are available from the Investor Responsibility Research Center (IRRC) database. Although we utilize the Insider Trading database that covers a large set of companies, our final sample consists only of firms in the S&P 1500 index because IRRC only collects corporate governance data for the S&P 1500 companies. Below we discuss our sample construction process as detailed in Table 1. [INSERT TABLE 1 HERE] We start with 29,609 CEO stock option grants from the Insider Trading database or ExecuComp from 1998 to 2004, eliminating multiple grants that occur on the same date (so that there is only one grant for a given date and firm combination). 13 We exclude 3,797 grants due to missing CRSP stock price data over the 240-day window around option grant dates. Among the remaining 25,812 CEO stock options, we classify 2,658 grants as backdated and 23,154 grants as non-backdated. We classify a CEO option grant as backdated if the stock price at the grant date ranks in the bottom decile of the firm s stock price distribution over a 240-day window around the option grant date (i.e., from 120 days before to 120 days 13 We use Insider Trading database as the primary source of CEO option awards in our sample (about 84% of our sample). We require option award data in the Insider Trading database to have a cleanse indicator of R ( data verified through the cleansing process ), H ( cleansed with a very high level of confidence ), or C ( a record added to nonderivative table or derivative table in order to correspond with a record on the opposing table ). Since CEOs sometimes identify themselves as Chairman or President in their SEC filings, we collect option grants to CEO, President, and Chairman of the Board. We then add CEO stock option awards from the Execucomp database whenever the corresponding firm-year option grant information is not available from the Insider Trading database. Since ExecuComp does not report option grant dates, we infer option grant dates based on option expiration dates in combination with information about fiscal years and the assumption that the maturities of options are in whole years (Yermack, 1997; Aboody and Kasznik, 2000; Lie, 2005). Our results are qualitatively the same if we exclude option awards obtained from ExecuComp. 15

17 after). 14 CEO option awards that have grant date stock prices that do not fall in the bottom decile of the firm s 240-day stock price distribution are defined as non-backdated option grants. Note that this method of identifying backdating is subject to errors as the board s compensation committee may grant options to executives on dates with relatively low stock prices by chance. If such grants are not the result of CEO influence over the board and its committees, then including these observations in the backdating sample works against the predicted relation between governance characteristics and backdating under the managerial power theory. We convert the 25,812 CEO stock option awards into 19,246 firm-year observations because the governance structure variables and other control variables are updated annually. We define backdated firm-years as firm-years that have at least one CEO stock option award with a grant date price ranked in the bottom decile of the firm s stock price distribution over a 240-day window around the option award date. Our control sample consists of firm-years that have no such grants. We further require firms to have available corporate governance variables from IRRC, CEO stock option compensation from ExecuComp, institutional ownership from 13-F filings, and relevant accounting variables from Compustat to compute the explanatory and control variables used in our analysis. These restrictions reduce our sample to 6,250 firm-year observations from 1998 to 2004, comprised of 771 firm-years with at least one backdated CEO stock option grant and 5,479 firm-years with no backdated CEO stock option grants. We further exclude 87 backdating firm-years that are classified as scheduled (as defined below). 15 Thus, 14 In sensibility analysis, we identify samples of backdating firms using alternative criteria proposed by Bebchuk et al. (2006a) or Heron and Lie (2006b), as well as a sample of firms currently under backdating investigation by the SEC, the Justice Department, and/or their own boards as reported by Glass Lewis & Co. Yellow Card Brief Alert. Results based on these alternative backdating samples are consistent with backdating firms having weaker governance structures that allow greater CEO power and influence over the board. Results are available from the authors by request. 15 We exclude scheduled option grants from our backdating sample because, a priori, it is unlikely that grants that are made on roughly the same date as the prior year are being backdated. Thus, these observations would likely be misclassified if we retained them in the backdating sample. Conversely, we retain scheduled grants in our nonbackdating sample because for these observations it is highly unlikely that they have been backdated. Retaining these observations in the non-backdating sample increases the power of our tests by minimizing the classification error for this sample and increasing the sample size. When we exclude the 1,008 scheduled grants from the nonbackdating sample, the coefficient estimates (untabulated) for the logistic model are qualitatively similar to those 16

18 our final sample has 6,163 firm-years, including 684 backdating firm-years and 5,479 non-backdating firm-years. Table 2 reports summary statistics for our sample. As shown in Panel A, the proportion of backdated CEO stock option awards increases from 11% in 1998 to 13% in 2001, and then declines to 6% in Panel B reports a similar pattern for the firm-year level sample. The proportion of firms that have granted at least one backdated CEO stock option award increases from 11% in 1998 to 18% in 2000, and then declines to 7% in Panel C reports the distribution of scheduled and unscheduled CEO stock option awards for our firm-year level backdating and control samples. Following Heron and Lie (2006b), we define an option award as scheduled if it is dated within one day of the one-year anniversary of a prior grant, and unscheduled otherwise. We then define unscheduled firm-years as firm-years that have at least one unscheduled option grant. The opportunity to backdate stock option awards is limited or eliminated when the grants are scheduled at the same time each year. Consistent with our expectation, Panel C shows that a significantly higher proportion of unscheduled firm-years are classified as backdated (14%) relative to scheduled firm-years (7%). In our subsequent analyses, we exclude the 87 scheduled firm-years (193 scheduled option grants) that are classified as backdated. These observations, although associated with relatively low grant date stock prices, are less likely to have arisen from backdating. [INSERT TABLE 2 HERE] 5. Corporate governance and backdating of CEO stock option awards 5.1. Descriptive statistics and univariate results Table 3 reports descriptive statistics and the results of univariate tests that statistically assess the differences in our test variables between the backdating and control samples. Summary statistics for the continuous variables include the mean, standard deviation, first quartile, median, and third quartile. For reported in Table 4 below, but the statistical significance for some of the variables is marginally lower because of the decreased sample size. 17

19 the dummy variables, we present the mean values that represent the proportion of backdating or control samples that possess the indicated characteristics. [INSERT TABLE 3 HERE] In general, the results are consistent with the managerial power theory that predicts a relation between weak corporate governance and the incidence of backdating. Relative to the control sample (i.e., firm-years that have no backdated CEO stock option awards), we find that the backdating sample has a higher proportion of inside directors on the board and a higher proportion of outside directors hired by the incumbent CEOs. In addition, CEOs in the backdating sample on average have longer tenure than CEOs in the control sample (the median difference, however, is not statistically significant). Finally, consistent with the Corporate Library report, firms from the backdating sample are more likely to have directors that serve on the board of another backdating firm. For the ownership structure variables and incentives for backdating, Table 3 reveals that backdating firms are less likely to have an outside blockholder on the compensation committee. However, there is no difference between the backdating and non-backdating sample in the level of institutional ownership. CEOs in the backdating sample have greater stock ownership and receive a higher proportion of their total compensation from stock options compared to CEOs in the control sample. Directors stock option compensation is also significantly higher for the backdating sample relative to the control sample. In addition, the incidence of concurrent grants (i.e., granting options to CEOs and directors at approximately the same time) is significantly more frequent in the backdating sample relative to the control sample. 16 The evidence with respect to the incentive variables is consistent with our conjecture that backdating is more likely when the potential gains from backdating are greater for both CEOs and directors. Also consistent with findings in prior studies (Heron and Lie 2006b), firms in the backdating sample are smaller and have higher return volatility than firms in the control sample (although the mean 16 Table 3 indicates that about 40% of our sample firms grant options to CEOs and directors at approximately the same time. Thus, our evidence does not support the claim in Byard and Li (2005) that most firms grant options to CEOs and directors on the same date. 18

20 difference in firm size is not statistically significant). Consistent with claims from the financial press, a higher proportion of the backdating sample comes from high technology industries and backdating firms are more likely to be audited by non-big4 auditors. Table 3, Panel B presents pair-wise correlations of governance and control variables for the sample, with the upper right (lower left) hand portion of the table presenting Pearson product-moment (Spearman rank order) correlations. As shown, most of the correlations between governance attributes are below 0.30, suggesting that the variables we consider capture different aspects of firms governance structure. One exception is the high Pearson (Spearman) correlation of 0.67 (0.70) between CEO tenure (TENURE) and the proportion of outside directors appointed after the CEO came into office (CEOHIREDIR), which is expected Logistic regression results on corporate governance and backdating We estimate the following logistic model to examine the joint effects of board and compensation committee attributes, the firm s ownership structure, the incentives to backdate, and other firm characteristics on the likelihood of backdating: Prob(BACKDATE it =1) = f (a 0 + b 1 INSIDEDIR it + b 2 GRAYDIR it + b 3 CEOHIREDIR it + b 4 CEOCHR it + b 5 INSIDEDIR_COMP it + b 6 Log(TENURE) it + B 7 INTERLOCK_BKDATE it + b 8 BLKHOLD_COMP it + b 9 INSTOWN it + b 10 CEOOWN it + b 11 CEOGRANT it + b 12 DIRGRANT it + b 13 SAMEDAY it +b 14 Log(MVE) it-1 + b 15 VOLATILITY it-1 + b 16 HighTech + b 17 BIG4 + e i ) (1) where BACKDATE equals 1 for firm-years with at least one backdated unscheduled CEO stock option award, and 0 for firm-years that do not have backdated CEO stock option awards. All the other variables are as defined in Section 3 and the Appendix. Table 4 presents estimation results for the logistic model specified in equation (1). Because a firm can enter the sample multiple times, within-firm auto-correlation of error terms is likely. Accordingly, we employ the generalized linear model method to estimate equation (1) to correct for time 19

21 dependent errors within firms (Liang and Zeger, 1986). 17 As shown, the likelihood of backdating option awards is significantly positively related to the percentage of inside directors on the board (coefficient = 1.541, p-value = 0.000), the percentage of outside gray directors on the board (coefficient = 0.474, p- value = 0.065), and the percentage of outside directors hired by the incumbent CEO (coefficient = 0.299, p-value = 0.100). The likelihood of backdating also increases when the CEO serves as chairman of the board (coefficient = 0.132, p-value = 0.091). These findings suggest that greater CEO influence over the board as captured by the lack of independence of board members increases the likelihood of backdating. In addition, the presence of directors linked with another backdating firm significantly increases the likelihood of backdating (coefficient = 0.242, p-value = 0.004), consistent with the findings in Bizjak et al. (2006). Overall, these results suggest that backdating is linked to corporate governance features that capture CEO power and influence over the board. 18 [INSERT TABLE 4 HERE] Among the ownership structure variables, we find that backdating is negatively related to the presence of an outside blockholder on the compensation committee (coefficient = , p-value = 0.075), consistent with blockholders playing an important monitoring role in the firm s governance structure, particularly with respect to executive compensation. However, contrary to the managerial power view, we find that institutional ownership has no effect on the likelihood of backdating. We do find a significant positive coefficient on CEO ownership (coefficient = 2.281, p-value = 0.001), consistent with the notion that higher ownership increases CEOs entrenchment and ability to influence their own pay through option backdating. Turning to incentive variables, the coefficient on CEOGRANT is significantly positive (coefficient = 0.271, p-value = 0.074), suggesting that the likelihood of backdating CEO option awards 17 Our inferences remain the same based on standard logistic regressions. 18 The negative (albeit insignificant) coefficients on INSIDEDIR_COMP and Log(TENURE) are due to high correlations with other governance attributes. For example, Log(TENURE) would have a positive coefficient if we remove CEOHIREDIR, and INSIDEDIR_COMP would have a positive coefficient if we remove INSIDEDIR from the model. 20