Santa Clara University

The Ripple Effect

How a Company’s Forecast Can Impact Competitors

Timing matters. When a publicly traded business uses stock options as a significant part of its executive compensation structure, the date of the option (and hence the base value of the stock) can make a big difference in what it’s worth to the executives and board members who get it.

In a number of widely publicized recent cases, companies have attempted to sweeten executive pay by backdating options, setting a base date in the past when the stock value was relatively low, thus magnifying the value of subsequent gains.

“Backdating was the new corporate scandal when we started looking into it in 2007,” says Haidan Li, Assistant Professor of Accounting at the Leavey School of Business. “It was in the news every day, and we wanted to see what was causing it to be so widespread, and whether there was any connection to corporate governance.”

The result of the research done by Li and her colleagues — Daniel W. Collins of the University of Iowa and Guojin Gong of Pennsylvania State University — is a paper titled “Corporate Governance and the Backdating of Executive Stock Options.” It has been accepted for publication by Contemporary Accounting Research, one of the leading journals in the field.

Although backdating is within the law when promptly reported, companies that do it don’t always comply with the reporting rules. This has led to securities investigations resulting in share price declines, stock downgrades, restatement of financial statements, and in some instances, replacement of board members and senior executives.

With so much at stake, Li and her colleagues looked into the connections between governance structure and backdating incidence. Based on a sampling of S&P 1500 firms that showed evidence of backdating, they reached several key conclusions:

• Companies that allow CEOs more power over the board and compensation committee are more likely to engage in backdating. These firms tend to have more inside and affiliated directors on the board, more directors appointed by the incumbent CEO, and are more likely to have the CEO serving as chair of the board.
• The tendency to engage in backdating is stronger when stock options make up a larger part of the CEO compensation package.
• It also appears that backdating is more likely when directors of the corporation receive stock option grants on the same date as the CEO. “That finding really surprised me,” Li says.

Moreover, Li and her colleagues found that annual pay of CEOs who received backdated options is significantly higher (more than a million dollars a year on average) than for CEOs in similar companies that don’t backdate, and that the excess compensation hurts shareholder value.

Silicon Valley is prominently involved in the backdating controversy because the practice is so common here, Li says.

“It happens a lot in high-tech companies,” she says, “because options are more commonly used in the compensation package and stock prices tend to be more volatile, which allows more room to backdate to a lower starting stock price.”