A Case Study on the Violations of The Market Efficient Hypothesis

Transcription

1 ΟΙΚΟΝΟΜΙΚΟ ΠΑΝΕΠΙΣΤΗΜΙΟ ΑΘΗΝΩΝ ΤΜΗΜΑ ΟΙΚΟΝΟΜΙΚΗΣ ΕΠΙΣΤΗΜΗΣ ΜΕΤΑΠΤΥΧΙΑΚΟ ΠΡΟΓΡΑΜΜΑ ΣΠΟΥ ΩΝ ΚΑΤΕΥΘΥΝΣΗ ΕΦΑΡΜΟΣΜΕΝΗΣ ΟΙΚΟΝΟΜΙΚΗΣ & ΧΡΗΜΑΤΟΟΙΚΟΝΟΜΙΚΗΣ A Case Study on the Violations of The Market Efficient Hypothesis Χριστογιαννοπούλου Μαρία-Άννα ιατριβή υποβληθείσα προς µερική εκπλήρωση των απαραιτήτων προϋποθέσεων για την απόκτηση του Μεταπτυχιακού ιπλώµατος Ειδίκευσης Αθήνα Ιανουάριος

2 Εγκρίνουµε τη διατριβή της Χριστογιαννοπούλου Μαρίας-Άννας Υπεύθυνος Καθηγητής : Κόρδας Γρηγόριος Οικονοµικό Πανεπιστήµιο Αθηνών Εξεταστής Καθηγητής : Αρβανίτης Στυλιανός Οικονοµικό Πανεπιστήµιο Αθηνών Εξεταστής Καθηγητής : Σαπουντζόγλου Γεράσιµος Οικονοµικό Πανεπιστήµιο Αθηνών Ιανουάριος,

3 Αφιερωµένη στον Άγγελο και στο Χρήστο, που έδωσαν χρώµα και δύναµη στα όνειρά µου 3

4 TABLE OF CONTENTS Introduction The Efficient Market Hypothesis Problems in the Theory of Efficient Markets Securities and Exchange Commission Stock Options as Incentives to Top Managers Backdating Stock Options Essays which discovered and approved that backdating exists Good timing: CEO stock option awards and company news announcements CEO stock option awards and the timing of corporate voluntary disclosures Stock price decreases prior to executive stock option grants On the timing of CEO Stock Option Awards Introduction Opportunistic behavior around option awards and predicted price effects Sample Empirical results Abnormal returns around option awards Return patterns over time Predicted returns around option awards Conclusion Companies caught backdating Backdating, Market Efficient Hypothesis and Andrew Redleaf Conclusion

5 Introduction It is without doubt that the function of financial markets has a great impact on the modern way of life. In the recent years financial markets have risen continuously and this has caused investor s and researcher s interest. Investors try to achieve the best investment of their income in addition to make extra money for the future with the minimum risk. A crucial factor for that is their ability to predict future stock moves. A very common subject of economical researchers is the existence and the acceptance of the basic financial theories in this modern financial system. Many financial theories support the Efficient Market Hypothesis, according to which investors cannot acquire abnormal returns without undertaking the corresponding risk. This means in fact that investors cannot win the market. On the other hand, there are several studies which have shown that some events might have great influence on stock prices and also that investors can become able to earn abnormal returns by using the right strategy. The present essay is referred to the frame of this general controversy of the Market Efficient Hypothesis. We present a real case in which Andrew Redleaf gain money by using public information from Securities and Exchange Commission (SEC). He was informed that some companies backdate their stock options and his strategy was to buy bonds from those companies, denounce them at SEC for backdating and then demand immediate payment of his bond at par. The remainder of this essay proceeds as follows: 5

6 The first chapte reviews The Efficient Market Hypothesis and some issues that come in contradiction with the above theory. The second chapter analyzes the action of the Securities and Exchange Commission and the kind of information SEC decides to make public. The third chapter examines the CEOs motive given by shareholders. (Using stock options) The fourth chapter presents the notion of backdating stock options and the reason why this is a common practice by CEOs. The fifth chapter reports 5 essays which discovered and approved that backdating exists. The sixth chapter, based on real data by SEC, indicates several well known companies which caught backdating stock options. The seventh chapter explains how Andrew Redleaf managed to gain abnormal returns using public information. We explain that this arbitrage opportunity violates The Market Efficient Hypothesis. In conclusion the eighth chapter indicates that the market efficient hypothesis generally exists for average investors but there are many reasons to believe that big investors have many opportunities of free lunch, something that violates the Market Efficient Hypothesis. 6

7 1. The Efficient Market Hypothesis In the last three decades, a variety of research has been made, aiming to determine whether predictability in financial markets exists. Reason for this research is that the existence of predictability in the financial markets comes in opposition with the efficient market hypothesis, according to which investors cannot acquire abnormal returns without undertaking the corresponding risk. The efficient market hypothesis constitutes the base of modern financial theory. Investors determine the economic value of securities based on their forecasts about the future cash-flows that they expect to gain from these securities. Information is a major factor for investors in order to forecast accurately. Companies financial statements, possibilities of merges, potential changes in properties, new occasions of growth are information that help investors to make the right decisions and have accurate expectations. Therefore, information has a vital role in the assessment of securities. As soon as new information is spread through the market, investors will react by buying or by selling securities which are affected by that information. This strategy will cause readjustment in security prices. If the above readjustment is applied with precision and quickness, then the market can be called as efficient. So, one market is called efficient if it fully and correctly reflects all relevant information in the prevailing security prices with respect to some information set. Moreover, efficiency with respect to a certain information set implies that it is impossible to make economic profits by trading on the basis of this information. The security market is considered as effective when the market prices of securities are (approximately) the same with their real value, which is the present value of income that is expected from securities. When security market is efficient, then 7

8 securities prices in the market are considered to represent the best possible estimate of their real value. Some necessary assumptions must exist for market efficiency: The majority of investors activate themselves in the market aiming in maximizing their profits. Information knowledge is costless. Investors have homogenous expectations about companies prospects. Information diffusion is random. News are diachronically independent Investors react with precision and quickness to the news. E. Fama s study 1 placed the theoretical base for the efficient market issue and for the methodology used in order to test this efficiency. In this article Ε.Fama defined three forms of the efficient market hypothesis depending on the strength of the conditioning information set. I) Weak Form A weak form market assumes that security prices reject all the information which can be exported from the financial market. Market elements include the history of prices or returns, volume of transactions and any other information that refers to the market. If this form exists then it is impossible for investors to predict future changes at stock prices based on this information set. This means that past price 1 Fama s definition about efficiency markets was: a market where there are large numbers of rational, profit maximizers actively competing with each trying to predict future market values of individual securities and where important current information is almost freely available to all participants. In an efficient market on the average, competition will cause the full effects of new information on intrinsic values to be reflected instantaneously in actual prices. 8

9 information cannot be used to predict future moves. Weak form is similar with random walk theory (1960). II) Semi-strong Form A semi-strong form market assumes that security prices incorporate all public information. Public information includes market elements (weak form) and other public information such as dividend yields, economic and political facts, earnings reports etc. If this form exists then security prices will readjust rapidly as soon as new information is announced. Under those circumstances, it is impossible for investors to gain abnormal returns based on this information set. This happens because new information is already incorporated at security prices. So, in this form, publicly available information cannot be used to predict future moves. III) Strong Form A strong form market assumes that security prices incorporate all information, public and private. This information set includes all information known to any market participant. If this form exists then it is impossible for investors to predict future moves and gain abnormal returns. In other words, future price moves are completely unpredictable. In its Strong Form, the efficient market hypothesis strikes most people as unrealistic. Insider trading has certainly been known to make a lot of money to people who posses the inside information. On the other hand, few people would doubt the Weak Form of the efficient market hypothesis. If past price information had economically exploitable predictive power then everyone could gain profits. This cannot be an equilibrium situation, so even if such opportunities arise from time to time, they are quickly wiped out by the market. 9

10 Many studies arise over time in order to test the forms of efficient market. Random walk theory supports the Weak Form because every price change is random and we cannot predict future moves. Event studies try to test the Semi-strong Form and to analyze how prices react to new information, if we have under-reaction, overreaction, early reaction or delayed reaction. As far as the Strong Form is concerned, there is no evidence which supports that inside information are not economically exploitable Problems in the Theory of Efficient Markets Gradually researchers began to report evidence that appeared to contradict the theory. No theory can explain all the data with which it is confronted, especially when data is as abundant as stock prices. There is a large amount of abnormal facts that at least appears to contradict market efficiency such as: High returns from small companies in contrast with big companies. Seasonal patterns (e.g. higher returns on January and lower returns on Monday). The biggest part of daily return comes in the beginning and in the end of the day. Price under-reaction to earnings (slow readjustment). Value stocks have higher return in contrast with growth stocks. Moreover, reality gives us evidence that there are violations in the Market Efficient Hypothesis. At 2006 a corporate scandal was revealed, which strengthened those evidences. One investor managed to gain abnormal returns by using only public information. Andrew Redleaf made profits based on public information about stock options that CEOs take as a form of compensation. Such information is mandatory submitted to the S.E.C. (Securities and Exchange Commission) where everyone can reach that information. 10

11 2. Securities and Exchange Commission The Congress in order to support and protect investors instituted relative laws, among which those instituted in 1933 and 1934 declared the foundation of Securities and Exchange Commission. Congress, during the years of economical depression, passed the Securities Act of Often referred to as the "truth in securities" law, the Securities Act of 1933 has two basic objectives: Requirement that investors receive financial and other significant information concerning securities being offered for public sale; and Prohibit deceit, misrepresentations, and other fraud in the sale of securities. With the Securities Exchange Act of 1934, Congress created the Securities and Exchange Commission. The Act empowers the SEC with broad authority over all aspects of the securities industry. This includes the power to register, regulate, and oversee brokerage firms, transfer agents, and clearing agencies as well as U.S.A. s securities self regulatory organizations (SROs). The Act also identifies and prohibits certain types of conduct in the markets and provides the Commission with disciplinary powers over regulated entities and persons associated with them. The Act also empowers the SEC to require periodic reporting of information by companies with publicly traded securities. The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. As more and more first-time investors turn to the markets to help secure their futures SEC s investor protection mission is more compelling than ever. As U.S.A. s securities exchanges mature into global for-profit competitors, there is even greater need for sound market regulation. All of the SEC's actions must be taken with an eye toward promoting the capital formation that is necessary to sustain economic growth. 11

12 The world of investing is fascinating and complex. But unlike the banking world, where deposits are guaranteed by the federal government, stocks, bonds and other securities can lose value. There are no guarantees. That s the reason why investing is not speculation. By far the best way for investors to protect the money they put into the securities markets is to do research and ask questions. The laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it. To achieve this, the SEC requires public companies to disclose meaningful financial and other information to the public. This provides a common pool of knowledge for all investors to use to judge for themselves whether to buy, sell, or hold a particular security. Only through the steady flow of timely, comprehensive, and accurate information can people make sound investment decisions. The result of this information flow is a far more active, efficient, and transparent capital market that facilitates the capital formation so important to U.S.A. s economy. To insure that this objective is always being met, the SEC continually works with all major market participants, including especially the investors in securities markets, to listen to their concerns and to learn from their experience. The SEC oversees the key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds. Here the SEC is concerned primarily with promoting the disclosure of important market-related information, maintaining fair dealing, and protecting against fraud. Crucial to the SEC's effectiveness in each of these areas is its enforcement authority. Each year the SEC brings hundreds of civil enforcement actions against individuals and companies for violation of the securities laws. Typical infractions include insider 12

13 trading, accounting fraud, and providing false or misleading information about securities and the companies that issue them. SEC works closely with many other institutions, including Congress, other federal departments and agencies, self-regulatory organizations (e.g. the stock exchanges), state securities regulators, and various private sector organizations. Main responsibilities of the Commission are to: Interpret federal securities laws Issue new rules and amend existing rules Oversee the inspection of securities firms, brokers, investment advisers, and ratings agencies Oversee private regulatory organizations in the securities, accounting, and auditing fields Coordinate U.S. securities regulation with federal, state, and foreign authorities. Taking all the above under consideration, we can see why stock options and companies stock s are public information. 13

14 3. Stock Options as Incentives to Top Managers Plant and divisional managers are concerned about their own goals. Sometimes their interests conflict with those of the shareholders and that may lead to investment decisions that do not maximize shareholder s wealth. Managers will act in shareholders interests only if they have the right incentives. Although, there is no perfect system of incentives shareholders try to reduce the agency problem that causes agency costs. Agency cost is a type of internal cost that arises from an agent acting on behalf of a principal. Agency costs arise because of core problems such as conflicts of interest between shareholders and management. Shareholders wish for management to run the company in a way that increases shareholder value. But management may wish to grow the company in ways that maximize their personal power and wealth that may not be in the best interests of shareholders. Taking all the above under consideration, shareholders try to reduce agency cost in two ways: by monitoring the manager s effort and by giving them the right incentives to maximize value. Compensation plans must be designed to give managers high-powered incentives in order to maximize shareholder s wealth. The level of management compensation differs across countries. The United States has unusually high levels of executive pay in comparison with the European levels. Such high levels of executive pay undoubtedly encourage CEOs to work hard and offer an attractive reason to those who aspire to become CEOs. Another unusual feature in the United States is that the salary of CEOs forms a relatively small proportion of their total compensation. The balance is largely made up of bonuses tied to company profits and of long term incentives, such as stock options plans that allow the manager to buy the company s stock at a set price. 14

15 In the United States there has been a long term upward trend in the popularity of stock option plans. This has been partly encouraged by the way that stock options are treated for accounting and tax purposes. When companies calculate their income they are allowed to account for option grants in one of two ways. The first way is to deduct from income the fair market value of any options granted during the year. The second is to deduct any excess of the market value of the stock over the exercise price of the options. In this case, unless the exercise price is set below the market price when the options are granted, the company can boost its income by paying managers in the form of stock options rather than cash. Many investors have expressed concern that, if a company adopts this second method, a potentially major compensation expense will not show up in the company s income statement. Some major companies have therefore moved to the first method and deduct from income the fair value of any options granted. In that way, managers and investors may become more aware of the cost of their stock option programs. Stock options may also have a tax advantage. In the United States since 1994 compensation of more than $1 million paid to top executives is considered unreasonable and cannot be deducted as an expense for tax purposes. However, there is no such restriction on payments in the form of stock options. Thus, stock options may be relatively less expensive than a cash payment. The merits of tying manager s compensation to the value of the firm s stocks are undoubted. When the manager, who owns stock options, works hard to maximize firm value, he/she is helping both the firm s shareholders and his wealth. 15

16 Moreover, some difficulties arise when management compensation is being tied with stock prices. The accounting scandals at companies have led to worries that managers holding stocks or options may be tempted to manipulate their earnings and pump up the price of their shares 2. This situation forces us to analyze the backdating problem. 2 Managers must not take advantage of important inside information about the true state of the company s affairs. The Sarbanes-Oxley Act has attempted to address this problem by requiring that managers must pay back any profits from bonuses and stock sales obtained during the 12-month period following a financial report that is subsequently restated because of misconduct. 16

17 4. Backdating Stock Options Stock options are non-standardized calls that are issued as a private contract between the employer and employee. Over the course of employment, a company generally issues vested stock options to managers which are struck at a particular price, generally the company's current stock price. Depending on the vesting schedule and the maturity of the options, managers may elect to exercise the options at some point, obligating the company to sell managers its stock at whatever stock price was used as the strike price. At that point, managers may either sell the stock, or hold on to it in the hope of further price appreciation or hedge the stock position with listed calls and puts. Managers may also hedge stock options prior to exercise and avoid forfeiture of a major part of the options value back to the company. Stock Options are usually granted at-the-money i.e., the exercise price of the options is set to equal the market price of the underlying stock on the grant date. 17

18 Because the option value is higher if the exercise price is lower, executives prefer to be granted options when the stock price is at its lowest. Backdating allows executives to choose a past date when the market price was particularly low, thereby inflating the value of the options. An example illustrates the potential benefit of backdating to the recipient. If we point out a CEO option grant dated October The number of shares subject to option was 250,000 and the exercise price was $30 (the trough in the stock price graph above.) Given a year-end price of $85, the intrinsic value of the options at the end of the year was ($85-$30) x 250,000 = $13,750,000. In comparison, had the options been granted at the year-end price when the decision to grant to options actually might have been made, the year-end intrinsic value would have been zero. Backdating of stock option grants is not necessarily illegal if the following conditions hold: No documents have been forged. Backdating is clearly communicated to the company's shareholders. After all, it is the shareholders who effectively pay the inflated compensation that typically results from backdating stock options Backdating is properly reflected in earnings. For example, because backdating is used to choose a grant date with a lower price than on the actual decision date, the options are effectively in-the-money on the decision date, and the reported earnings should be reduced for the fiscal year of the grant 3. Because backdating is typically not reflected properly in 3 Under APB 25, the accounting rule that was in effect until 2005, firms did not have to expense options at all unless they were in-the-money. However, under the new FAS 123R, the expense is based on the fair market value on the grant date, such that even at-the- money options have to be expensed. 18

19 earnings, some companies that have recently admitted to backdating of options have restated earnings for past years. Backdating is properly reflected in taxes. The exercise price affects the basis that is used for estimating both the company's compensation expense for tax purposes and any capital gain for the option recipient. Thus, an artificially low exercise price might alter the tax payments for both the company and the option recipient. Further, at-the-money options are considered performance-based compensation, and can therefore be deducted for tax purposes even if executives are paid in excess of $1 million 4. However, if the options were effectively in-the-money on the decision date, they might not qualify for such tax deductions. Unfortunately, these conditions are rarely met, making backdating of grants illegal in most cases. In fact, it can be argued that if these conditions hold, there is little reason to backdating options, because the firm can simply grant in-the-money options instead. 4 Section 162(m) of the Internal Revenue Code 19

20 5. Essays which discovered and approved that backdating exists 5.1 Good timing: CEO stock option awards and company news announcements David Yermack (1997) was the first researcher to document some peculiar stock price patterns around stock option grants. At his article he analyzes the timing of CEO stock option awards, as a method of investigating corporate manager s influence over the terms of their own compensation. In a sample of 620 stock option awards to CEOs of Fortune 500 companies between 1992 and 1994, he found that the timing of awards has significant associations with contemporaneous movements in company stock prices. Stocks experience an average cumulative abnormal return of slightly more than 2% in the 50 trading days following CEO option awards, even though news of the awards is not disclosed until several months after a fiscal year ends. Analysis of corporate earnings announcements supports an interpretation that CEOs receive stock option awards shortly in advance of favourable corporate news. 5.2 CEO stock option awards and the timing of corporate voluntary disclosures Aboody D. and Kasznik R. (2000) investigate whether CEOs manage the timing of their voluntary disclosures around stock option awards. At their article they conjecture that CEOs manage investor s expectations around award dates by delaying good news and rushing forward bad news. For a sample of 2,039 CEO option awards by 572 firms with fixed award schedules, they document changes in share prices and analyst earnings forecasts around option awards that are consistent with their conjecture. They also provide more evidence based on management earnings forecasts issued prior to award dates. Their findings suggest that CEOs 20

21 make opportunistic voluntary disclosure decisions that maximize their stock option compensation. Taken together, their findings suggest that the abnormal returns around CEO stock option awards likely reflect two distinct sources of opportunistic behaviour: opportunistic timing of voluntary disclosures around award dates for firms with scheduled awards, and opportunistic timing of awards around news announcements for firms with unscheduled awards. 5.3 Stock price decreases prior to executive stock option grants Chauvin K. and Shenoy C. (2001) at their study examine abnormal stock price changes prior to executive stock option grants. Executives have the incentive and opportunity to manage the timing of their communications of inside information to the market during the period just prior to the date of their stock-option grant so as to reduce the exercise price of their options. Executives benefit from temporary stock price decreases before the grant date and by stock price increases after the grant date. Executive stock option grants create a unique opportunity for insiders to profit by manipulating the timing of information flowing to the market without engaging in insider trading. Using data on 783 stock-option grants to chief executive officers, they find a statistically significant abnormal decrease in stock prices during the 10-day period immediately preceding the grant date. 5.4 On the timing of CEO Stock Option Awards Furthermore, on modern bibliography Erik Lie made sedulous research about stock option awards. A detailed presentation of his reports, which discuss strong evidence about the backdating issue, follows. 21

22 A) On 2004 at his paper On the timing of CEO Stock Option Awards Erik Lie documents that the abnormal stock returns are negative before unscheduled executive option awards and positive afterward. The return pattern has intensified over time, suggesting that executives have gradually become more effective at timing awards to their advantage, and possibly explaining why the results in this study differ from those in past studies. Moreover, he documents that the predicted returns are abnormally low before the awards and abnormally high afterward. 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 Introduction Stock options are generally granted with a fixed exercise price equal to the stock price on the award date. If executives can influence the timing of a grant, they might therefore time it to occur (i) after an anticipated future stock price decrease, (ii) after a recent price decrease that they perceive to be unwarranted by fundamentals(in which case the price would gradually increase in the future), or (iii) before an anticipated stock price increase. In any of these cases, self-serving 22

23 behavior by executives should manifest itself in stock price decreases before stock option grants and/or stock price increases afterward. He gathers a sample of 5,977 CEO stock option awards from 1992 through 2002, 1,668 of which have sufficient information to be classified as unscheduled and 1,426 as scheduled. The stock return pattern for unscheduled awards is strong and striking. The average abnormal return during the 30 trading days leading up to the awards is 3%, most of which occurs during the 10 days immediately before the award. After the unscheduled awards, there is a sharp reversal; during the first 10 days afterward the average abnormal return is 2%, and it is almost another 2% during the next 20 days. He documents a similar pattern for scheduled awards. In particular, the abnormal stock return is roughly 1% during the 30 days before the scheduled awards and roughly 1% during the 30 days afterward. Erik Lie prefers to focus on the sample of unscheduled awards, because the main focus of his paper is the timing of awards rather than the timing of information releases around awards. Next, he examines whether the documented return trends arising from award timing have changed over time. Executives might have become more effective in timing the awards to their advantage. Abnormal return trends around unscheduled awards have intensified over time. This suggests that executives are getting better or more aggressive at opportunistically timing awards during the sample period. If the distinct stock return pattern around scheduled awards is entirely attributable to executives timing awards relative to expected future price patterns, their collective ability to forecast future price movements based on inside information is striking. Erik Lie proposes a new hypothesis that could also explain the documented return patterns. In particular, the awards might be timed ex post facto, whereby the grant date is set to be a date in the past on which the stock price was particularly 23

24 low. Such retroactive timing obviously requires little skill, although outsiders might perceive it to be fraudulent. In any event, it is unlikely that outsiders would ever learn of it, because the company does not publicly report the grant date until months thereafter. To test the ex post facto timing hypothesis, he examines the predicted stock returns from the three-factor model of E. Fama and French (1993) around the unscheduled awards. He found that these returns are abnormally low before the awards and abnormally high afterward. Unless executives have a superior ability to forecast future short-term marketwide movements that drive the predicted stock returns, the results indicate that at least some of the official grant dates must have been set retroactively. However, some caveats are in order. First, it is not impossible that insiders are able to predict future short-term (such as daily or weekly) marketwide movements but there is no evidence that explains that insiders can forecast them. Second, it is not clear that retroactive timing is in violation of the stock option plan. In fact, the standard legal document behind the stock option plan does not specify whether a grant date can be set retroactively Opportunistic behavior around option awards and predicted price effects Once a company has adopted a stock option plan (which requires a vote of approval by shareholders), the board of directors generally assigns the administration of the plan to the compensation committee. The compensation committee officially determines the size and timing of stock option grants, but there are several reasons to suggest that executives affect these decisions. First, Yermack (1997) finds that executives often propose the parameters of the stock option grant, whereas the compensation committee merely ratifies these proposals. Second, executives might influence the committees decisions via their close friendships with individual 24

25 committee members. Third, executives might influence the timing of the compensation committee meetings, which regularly coincide with the award date. A key feature of executive option awards is that the exercise price typically equals the stock price on the day of the award. Because option values decrease with the exercise price, executives naturally prefer for the stock price to be as low as possible (and ideally lower than the fundamental value) on the award date to increase the value of their compensation. This preference might give rise to opportunistic behaviour. If the awards are unscheduled (i.e., the options are not awarded on the same date every year), executives might use their influence to time the awards on a date when the stock prices are particularly low. First, if executives perceive the current prices to be higher than the fundamental value and/or expect the prices to fall in the near future, they might try to push back the award date. For example, if they expect that the capital market will be disappointed in the current quarter s earnings, they might postpone any award until after the earnings announcement date. Such behaviour should manifest itself in poor stock price performance leading up to the award dates. Second, if executives perceive recent price drops to be unwarranted for example, because of rumours about the company or its products that executives know to be false they might promote immediate awards to take advantage of the artificially low prices. As the capital market realizes that the stock is undervalued, the price should increase. Third, if executives expect future price increases, irrespective of past price performance, they might also advocate immediate awards. An example of this would be that managers believe that the current period s earnings will pleasantly surprise the capital market when announced in the future. In this study, Erik Lie proposes an alternative way of opportunistically timing the awards that does not require the ability to forecast future stock price movements. In particular, the grant date could simply be set to be a past date on which the market 25

26 price was particularly low. A necessary condition for such retroactive timing is that the grant date precedes the decision date. There are several reasons to believe that retroactive timing occurs in practice. First, it would be a very effective and simple way of boosting the value of the awards. Second, stock options plans (which are standard legal documents) are vague as to how the grant date should be determined, and do not specifically prohibit the grant date from preceding the decision date. Finally, it is difficult for outsiders to uncover such practices, because individual stock option agreements are signed and dated by the employee-recipient, but are not publicly disclosed. If the awards are scheduled, executives could instead try to control the release of information to the capital market in an effort to depress the price on the award date (5.2. Aboody and Kasznik). However, any stock price effect is likely to be weaker around scheduled awards for two reasons. First, all of the techniques described above could be used to inflate the value of unscheduled awards, whereas the only way to inflate the value of scheduled awards is to control the information flow. Second, scheduled awards are partially predictable by the capital market, thus creating trading opportunities that, when exploited, will tend to remove any price effect Sample Since 1992, the Securities and Exchange Commission (SEC) has required firms to disclose certain information in proxy statements about stock option grants to top executives during the fiscal year. While firms are not required to disclose the award dates, they can be inferred from the stated maturity dates in combination with information about the beginning and end of the fiscal years and the assumption that the maturities of the options are in whole years. Note that because the proxy statements are generally filed several months after the end of the fiscal year (the 26

27 median is about three months afterward), it is not possible to exploit systematic stock price patterns around award dates, perhaps unless the awards are predictable 5. The sample of CEO stock option awards is taken from Standard & Poor s Execu- Comp database. Execu-Comp includes information about stock option grants from proxy statements for more than 2,000 large companies. The initial sample contained 11,949 grants to CEOs during the fiscal years from 1992 through After having excluded observations that lacked grant data the sample contained 11,249 grants. Next, closing prices are obtained from CRSP (Center for Research in Security Prices) from two days before through two days after the inferred grant date to identify the date whose closing price matched the share price from ExecuComp. This leads to a sample of 5,977 grants. Following Aboody and Kasznik (2000), an award is defined to be scheduled if it occurs within one week of the one-year anniversary of the prior year s award date and unscheduled if it does not occur or if no options were awarded during the prior year. If no award information is available for the prior fiscal year, such as for those in 1992, the award is left unclassified. This yields a final sample of 1,426 scheduled awards, 1,668 unscheduled awards, and 2,883 unclassified awards, although the scheduled awards are excluded for most of the analysis. 5 However, August 29, 2002, the SEC changed the reporting regulations with respect to stock option grants. Specifically, firms must now report executive stock option grants within two business days. This is likely to affect the timing of stock option grants documented herein. 27

28 Table 1 presents the sample of option grants to CEOs during by fiscal year, calendar month, and fiscal quarter. The number of awards is considerably lower for the first couple of years, but this is at least partially due to more spotty coverage by ExecuComp during those years. Further, the number of unscheduled awards has gradually increased during the sample period, whereas the trend for 28

29 scheduled awards is more stable. Option awards, especially scheduled awards, occur more frequently during the months of January, February, and December than during other months. Further, half of the scheduled option awards take place during the first fiscal quarter, whereas 43% and 48% of the unscheduled and unclassified awards, respectively, take place in this quarter. Table 2 provides descriptive statistics for the fiscal year preceding the option awards. The sample firms are large, with an overall average book value of assets of $6.9 billion. Interestingly, firms that award options on a scheduled basis appear to be more mature than firms that award options on an unscheduled basis, as evidenced by their greater size and profitability and lower market-to-book ratio. 29

30 Firms with unclassified awards resemble firms with unscheduled awards, consistent with the notion that a majority of the unclassified awards are actually unscheduled Empirical results Abnormal returns around option awards Figure 1 displays the average cumulative abnormal returns around unscheduled, scheduled, and unclassified awards. Abnormal returns around option awards are the difference between the stock returns of the awarding firm and the returns predicted 30

31 by E. Fama and French s (1993) 6 three-factor model, where the estimation period is the year ending 50 days before the award date. For the samples of unscheduled and unclassified awards, the stock prices (when adjusted for market effects) start to decline more than a month before the award first gradually, and then more dramatically during the days immediately before the awards. However, there is a sharp reversal of the price trend on the award dates. Immediately after the awards, the prices tend tο increase. The price increase is more pronounced during the first few days, but continues for at least a month. Though this pattern is also evident for scheduled awards and awards with uncertain grant dates, it is considerably less pronounced. The similarity of the patterns for unscheduled and unclassified awards suggests that unclassified awards generally are unscheduled Return patterns over time Executives might have become more effective in timing the awards to their advantage, especially as executive options have become increasingly more common. In order to examine this hypothesis Erik Lie examines the return patterns for three groups based on the year of the awards. The first group consists of unscheduled awards during 1992 through 1994, while the last two groups split the remaining eight years into two four-year periods. If the awards are scheduled, the executives cannot time them to their advantage, and they are therefore excluded from this analysis. 6 E.Fama, R. French Common risk factors in the returns on stocks and bonds. J. Financial Econom

32 Figure 2a shows the cumulative abnormal returns from Day 30 through Day +30 for the three groups of unscheduled awards, while Figure 2b shows the same returns for the three groups of unclassified awards. The trends for unscheduled awards have become more distinct over time. The pattern for the first two years (which admittedly only consists of 113 unscheduled awards) is rather vague, whereas the pattern for the last four years is very strong. The pattern for the middle period falls roughly in-between the patterns for the other two periods. The results for unclassified awards are very similar, thus corroborating the results for 32

33 unscheduled awards. That is, the pattern for the first period is weakest and the pattern for the last period is strongest. Overall, the return trends around awards have become more pronounced during the sample period. This is consistent with the notion that executives have become more effective over time in timing the awards to their advantage Predicted returns around option awards The sharp decline in prices immediately before unscheduled and unclassified awards followed by a sharp reversal immediately afterward suggests that executives collectively have a remarkable ability to time the awards to their advantage. One might even say that the executives collective ability is uncanny, especially considering that the compensation committee formally makes the decisions regarding the option awards. This prompts the question as to whether some of the awards are timed ex post facto. That is, when the decision regarding the official award date is made, the official award date (and, hence, the exercise price of the options) might be determined to be an earlier date that had a particularly low price. Because the terms associated with the awards are revealed much later, outsiders would not learn of this, thus preventing them from crying foul. Stock option plans generally state that the exercise price should be the market price at the grant date, but does not state that the grant date cannot precede the decision date. It is not possible to ascertain from an examination of the abnormal returns whether the awards are timed proactively or retroactively. However, an examination of the predicted returns from the three-factor model might provide valuable insight. Suppose that executives have superior forecasting ability for future firm-specific price changes, but not for future marketwide movements. The intuition for this is that while executives clearly possess unique information about their firm s future cash flows and imminent public announcements that is not generally available to 33

34 other market participants, it is less likely that they possess unique information that pertains to the overall market. If so, executives might be able to time future award dates to coincide with low prices that are attributable to the arrival of firm-specific information to the market, but not to overall market movements. This would manifest itself in negative abnormal returns before the awards and/or positive abnormal returns afterward. In contrast, the predicted returns from the market model should be normal both before and after the awards. Erik Lie ran a logistic regression of the occurrence of awards against prior and subsequent abnormal stock and predicted returns. This requires generation of a control sample with no awards. For each observation in the original sample (i.e., firm and award date), he generates five control observations with no awards by using the same firm combined with a random date drawn from the period from six months to one month before the award date or the period from one month to six months after the award date. Thus, the returns for the control observations effectively serve as benchmarks. By including dummy variables for the month of the observation, the regression analysis controls for seasonality in returns. Because previous results show that awards vary across the calendar months, the absence of such control variables could give rise to spurious relations between returns and the occurrence of awards. A further advantage of this analysis is that it effectively controls for firm-specific risk factors that affect stock returns, irrespective of whether these factors can be identified. As long as the risk factors are reasonably constant over time, they should be present for the original observation as well as for the associated control observations. 34

35 35

36 Table 3 presents the results from the regression analysis. Consistent with earlier evidence, unscheduled awards are more likely to occur after negative abnormal stock returns and before positive abnormal stock returns. The abnormal returns immediately surrounding the awards have the greatest effect on the occurrence of awards, but even abnormal returns at least a couple of weeks before or after the awards have a statistically significant effect. The most interesting result in Table 3 is that unscheduled awards are more likely to occur after dismal predicted returns and before high predicted returns. The effects of the predicted returns during the two days before and the two days after are particularly strong, with p-values less than Unless executives could have anticipated the marketwide returns and, hence, predicted returns from the three factor model, the results suggest that executives time at least some of the awards ex post facto. To further validate these results, Erik Lie runs the same regression for unclassified awards, a majority of which are likely to be unscheduled. The results are similar to those for unscheduled awards. In particular, the unclassified awards are also more likely to occur after low abnormal and predicted returns and before high abnormal and predicted returns, although the effect from the predicted returns immediately before is weaker. This lends further credence to the results for unscheduled awards and the notion that awards are timed retroactively 7. Finally, we run the regression for scheduled awards for comparison purposes. As expected, the results are generally much weaker than for the other award 7 Erik Lie ran the regression for each of the years from 1994 through 2002 for unscheduled awards (He excluded 1993 due to the small number of observations), and from 1992 through 2002 for unclassified awards. The coefficient on the predicted return during the two days immediately after the option grant is of most interest given its statistical significance in Table 3 and its implication about grant behavior. This coefficient is statistically significant at the 1% level for only one year (2001, which has the most observations) for unscheduled awards and for no year for unclassified awards. More importantly, it is positive for all but one year (1994, which has the fewest observations) for unscheduled awards and for all years for unclassified awards. He interprets these results as evidence that the results do not appear to be driven by just a few years, and that a large sample is needed to uncover the underlying relationships. 36

37 categories. However, the predicted returns during the two days afterward positively affect the probability even for scheduled awards. Erik Lie conjectures that this result arises because even with grants classified as scheduled, there might some leeway with the precise date Conclusion Using a large sample of stock option awards to CEOs from 1992 through 2002, Erik Lie found that the abnormal stock returns are negative before the award dates and positive afterwards. While these trends are evident around both scheduled and unscheduled awards, they are much more pronounced around unscheduled awards. The return patterns around unscheduled awards appear to have intensified over time, suggesting that executives have gradually learned how to better time awards to their advantage or become more aggressive in their timing efforts. Prior studies have attributed the stock returns around unscheduled awards to executives timing awards relative to expected future price patterns. If so, the distinct stock returns documented here suggest that executives ability to forecast future price patterns is uncanny, especially for later years. This prompts him to propose a novel alternative hypothesis that the awards are timed ex post facto. That is, the grant date might be set to be an earlier date with a particularly low price. We find evidence consistent with this ex post facto timing hypothesis. In particular, we report that predicted returns from the three-factor model are abnormally low leading up to the awards and abnormally high afterward. Unless executives have an informational advantage that allows them to develop superior forecasts regarding the future market movements that drive these predicted returns, the results suggest that the official grant date must have been set retroactively. B) On 2006 at their paper Does Backdating explain the stock price pattern around executive stock option grants? Erik Lie and Randall Heron document that stock 37

38 returns are abnormally negative before executive option grants and abnormally positive afterward. But now this return pattern is much weaker since August 29, 2002, when the Securities and Exchange Commission requirement that option grants must be reported within two business days took effect. This study exploits a recent change in the reporting requirements for stock option grants to conduct refined tests of the backdating hypothesis. Effective August 29, 2002 and in response to changes to Section 16 reporting of the Securities and Exchange Act of 1934 mandated by the Sarbanes-Oxley Act, the SEC changed the reporting regulations for stock option grants. Prior to the change, executives receiving stock option grants often reported them to the SEC on Form 5, which was not due until 45 days after the company s fiscal year-end and also to stockholders in the proxy statement for the following year s annual stockholder meeting. (Alternatively, option grants could be reported to the SEC on Form 4, which was due on the 10th day of the month following the grant.) Now, following the legislative change, stock option grant recipients must report them to the SEC on Form 4 and must do so within two business days of receiving the grant 8. The SEC makes this information available to the public one day after receiving it. Firms with a corporate 8 The SEC s general instructions regarding when Form 4 must be filed read as follows: This form must be filed before the end of the second business day following the day on which a transaction resulting in a change in beneficial ownership has been executed. Alan Dye, a renowned expert on Section 16 compliance, notes that in practice most issuers treat the date of committee approval as the date of an award, and report the award within two business days thereafter. According to Dye, That practice is based on a number of factors that suggest that the date of committee approval is the date on which the insider acquires beneficial ownership of the award [excerpt from Alan Dye s Section16.net Blog, September 20, 2005]. The Financial Accounting Standards Board (FASB) provided further guidance on this issue on October 18, 2005, when it issued a staff position (FSP FAS 123(R)- 2) in response to inquiries regarding the determination of option grant dates given that FASB Statement No. 123(R) includes the concept of mutual understanding in its definition of a grant date. The position reads as follows: As a practical accommodation, in determining the grant date of an award subject to Statement 123(R), assuming all other criteria in the grant date definition have been met, a mutual understanding of the key terms and conditions of an award to an individual employee shall be presumed to exist at the date the award is approved in accordance with the relevant corporate governance requirements (that is, by the Board or management with the relevant authority) if both of the following conditions are met: (a) The award is a unilateral grant and, therefore, the recipient does not have the ability to negotiate the key terms and conditions of the award with the employer. (b) The key terms and conditions of the award are expected to be communicated to an individual recipient with a relatively short time period from the date of approval. 38

39 website are also now required to make the option grant information available on their website on the day following when they disclose the information to the SEC. Given the new regulations, the ability to backdate option grants to coincide with days with low stock prices is greatly diminished. Thus, if backdating produced the abnormal return patterns around executive option grants, writers hypothesize that the new reporting requirements should substantially dampen the abnormal return patterns that previously had been intensifying over time. Writers gather a sample of 3,735 stock option grants to CEOs between August 29, 2002 and November 30, 2004 from the Thomson Financial Insider Filing database. They found that the average abnormal stock return during the month leading up to the grants is about -1%, and it is about 2% during the month after the grants. Next, they compare the return pattern for the new sample with the return pattern for a sample from January 1, 2000 to August 28, 2002, which is a subsample of that used by Erik Lie (2004). These results are consistent with the notion that most of the return pattern for the earlier period is attributable to backdating of option grants. While the return pattern since the new reporting requirements is much weaker than for the preceding couple of years, it is still present. The two day lag between the grant date and the reporting date could still give some leeway to opportunistically backdate grants. Further, to the extent that executives do not comply with the reporting requirements, they can still backdate the grants. Indeed, most executives choose to delay the reporting as much as possible (i.e., until the second day after the grant date), and roughly one-fifth violate the 2-day reporting requirements. To further investigate the effects of backdating since the new reporting requirements, Erik Lie and Randall Heron partition their sample according to the number of days between the transaction date and the SEC filing date and then estimate the abnormal stock returns surrounding the grants for these sample partitions. When the option grant is reported within one day (in which case the 39

40 decision makers presumably do not have much of an opportunity or desire to backdate the grants), there are no abnormal returns around the option grants. When the option grant is reported two days after the grant, the average abnormal return is negative and statistically different from zero on the grant day and positive and statistically different from zero the day thereafter. The abnormal return pattern is stronger yet when executives fail to report the grant date within the two-day requirement. These results are evidence that even after the new reporting requirements took effect; some option granters have resorted to backdating to inflate option values. 40

41 Overall, backdating is the major source of the abnormal stock return patterns around executive stock option grants. This paper suggests that the new reporting requirements have greatly curbed backdating but have not eliminated it. To eliminate backdating, it appears that the requirements need to be tightened further, such that grants have to be reported on the grant day or, at the latest, on the day thereafter. In addition, the SEC naturally has to enforce the requirements. 41

42 6. Companies caught backdating Only a minority of firms that have engaged in backdating of option grants will be caught. There are at least two reasons for this: Backdating can be hard to identify. First, if a 30-day look-back period is used when backdating options, the stock price on the purported grant date will not necessarily be at a low for the period centred on this date and there are likely to have been many other prices during the year that were significantly lower. Second, companies sometimes have a mix of option plans, some of which might dictate the grants to be scheduled in advance, in which case the overall evidence of backdating will be murky. Third, firms might have concealed any traces of backdating by not choosing the absolute lowest price for the look-back period or by only backdating some of the grants. Fourth, many of the grants (even at the executive and director level) have never been filed with the SEC. Both the regulators and the investment community might be content to set some precedents based on a limited set of egregious backdating cases to send a signal that backdating and similar behaviour will be punished severely. In any event, resources will be put in place to improve the disclosure requirements for option grants and enforce existing regulations. However, Erik s Lie essays helped SEC to recognize potential companies that backdate. Prompted by SEC investigations, the Wall Street Journal (WSJ) ran a big story on the issue of backdating on November 11, One Silicon Valley software company, Mercury Interactive Corp., admitted to backdate stock options, in an outgrowth of a 42

43 broader probe of option granting by the Securities and Exchange Commission which has made backdating a focus. Mercury said its chief executive and two other top officials resigned after an internal investigation found they "benefited personally" from widespread manipulation of stock-option grant dates. Mercury is one of about a dozen companies currently being looked at in the SEC investigation. Mercury has said it will need to restate its past results back to at least 2002 due to the optionstiming problems. The company's stock-price pattern shows it chose low points for every major grant from 1996 to For instance, Mercury gave 1.3 million options to executives on March 31, Its stock, which trades on the Nasdaq Stock Market, fell 21% over the 10 prior trading days, and rose 22% in the 10 days afterward. Similarly, on Jan. 6, 2000, top executives were given 1.2 million new options. The stock had dropped 20% over the 10 previous trading days. It rose 56% in the 10 trading days afterward -- creating a paper gain of $27 million for the recipients. Erik Lie also supplied the WSJ with data that allowed it to identify three companies as possible backdaters. The publication of his article on March 18, 2006 triggered several events among the identified companies: Comverse Technology Inc. indicated it will restate more than five years of financial results and three executives (including the CEO) have resigned. In addition, federal prosecutors have begun a criminal investigation of stock-option-granting practices, and a class action lawsuit has commenced in the United States District Court for the Southern District of New York on behalf of Comverse stockholders. UnitedHealth Group Inc. will suspend many forms of its senior executive pay, including stock options. A shareholder suit (supported by the Minnesota attorney general) alleges that shareholders were harmed by backdated option grants. 43

44 Vitesse Semiconductor Corp. placed CEO Louis R. Tomasetta and two other top executives on administrative leave and might restate three years of financial results. The SEC and the investment community will certainly uncover more cases in the near future. As the SEC discloses information from its investigations, we are also likely to learn more about how exactly the backdating was done in various companies and who was involved in these schemes. There are many examples of companies that SEC investigates. ACTIVISION: The Santa Monica, Calif., videogame company said on July 28 that the SEC has asked the company for documents related to its stock-option grants as part of an informal inquiry. The company also said its board has appointed a special subcommittee of independent directors to conduct an internal review of the company s historical stock-option grant practices. On Oct. 25 the company said it appears likely that actual measurement dates for certain historical stock-option grants will be found to differ from the recorded grant dates for such awards. As a result, it is possible that Activision will be required to record additional stock-based compensation expense related to stock-option grants. On June 7, 2007, the company said the SEC issued a formal probe order related to its stock-options grants. ALTERA: On June 21, 2006, Altera said its special committee has reached a preliminary conclusion that actual measurement date for certain option grants issued between 1996 and 2000 differed from the recorded grant dates, and that it expects to restate 44

45 its financial statements for the fiscal years ended 1996 through The San Jose, Calif., programmable-chip maker said on May 25 that the SEC and the U.S. attorney in Northern California are looking into its stock-option grants. On May 8, 2006, Altera said its board ordered an independent review of "historical stock-option practices and related accounting." The special probe followed a management review sparked by media reports that raised questions about options practices at other companies, Altera said. On Oct. 16, 2006, the company said it completed its internal probe, found misdated options, sees restatement adjustments totalling $47.6 million pretax, and said its CFO was retiring. On Feb. 20, 2007 the company said the SEC ended its probe of the company's stock-options practices and won't recommend any enforcement action. APOLLO GROUP: On June 19, 2006, the Phoenix education provider received a subpoena from the U.S. attorney for the Southern District of New York relating to stock-option grants. Apollo said June 9 its board will hire an outside firm to review its stock-option practices, following a brokerage report that raised questions about whether the forprofit educational firm had backdated some past options grants. The report, from a Lehman Brothers analyst, called the company s historical options-granting practices "highly questionable." On July 10, the company disclosed that it had received a letter from the SEC about an informal investigation into the company s stock-option grants. On Nov. 3, the company said it will likely have to restate past results as a result of problems with past grants. Its financial chief resigned, citing personal reasons. On Dec. 14, 2006 the company a review found the company misdated certain stock option grants and that it found that some former officers might have covered errors in the grant approval process. The company added that it might face "significant tax liability" for prior years because it misapplied IRS rules. On May 21, 2007 the company became current on late SEC filings and recorded, as a result of a restatement, for the fiscal years 1994 through 2005, pre-tax noncash compensation 45

46 expense of $52.9 million. On July 3, 2007, the company announced it received notice from the SEC staff that the staff had completed its investigation and doesn't intend to recommend any enforcement action by the SEC. John Sperling Apollo Group, founder, chairman and former CEO Total grants: 5 Examples of options granted Company's Response at Date of Publication (June 12, 2006) Apollo officials didn't return numerous calls and s seeking comment. On the Friday before the article was published, the company announced an outside firm was being hired to review its options practices and said its management "believes that it has complied with all applicable laws" and hadn't backdated options. The company said it would hire the outside firm to "review and confirm these conclusions." APPLE INC.: On Aug. 3, 2006, the Cupertino, Calif., computer maker said it will delay filing quarterly results and will likely restate past results after discovering more "irregularities" as part of an internal probe of stock-option grants going as far back to In June, Apple said "one of the grants in question" was made to CEO Steve Jobs. On Oct. 4, the company said its internal investigation had found Jobs was 46

47 aware of options backdating but didn't benefit from the practice. Director Fred Anderson, who served as the company's chief financial officer from 1996 until 2004, resigned from its board of directors. U.S. prosecutors are investigating Apple's options practices. Apple said Dec. 29, 2006 that CEO Jobs had recommended the selection of some favourable stock-option grant dates, but didn't personally benefit. It also said it will restate financial data going back to 2002 and take an $84 million charge. On April 24, 2007, the SEC filed civil charges against Apple's former general counsel, Nancy Heinen, and former CFO Fred Anderson for their alleged involvement in backdating of stock options at Apple. Mr. Anderson settled the charge with the SEC without admitting wrongdoing. Apple Inc. Fred Anderson Steve Jobs Four top executives Former CFO CEO Company's Response at Date of Publication (Aug. 7, 2006) An Apple spokesman said the company is refraining from further comment on the matter until an independent investigation of the irregularities is completed. **Mr. Jobs's options were later cancelled in exchange for restricted stock. 47

48 ARTHROCARE: On Aug. 23, 2006 the Austin, Texas, medical-device maker said it has received correspondence from the SEC requesting certain documents and information related to its option grant practices. The company said prior to receiving the request, it did an internal review of all equity compensation activities since its February 1996 IPO, and said it "believes that there have been no unusual patterns in the timing or pricing of its equity awards and that there is specifically no evidence of backdating of option awards. On June 1, 2007, ArthroCare said the SEC has completed its formal investigation of the company and that doesn't plan to recommend any enforcement action against ArthroCare. ASYST TECHNOLOGIES: The Fremont, Calif.-based semiconductor manufacturing equipment maker on June 13 announced a delay in its annual filing while a special committee of independent directors conducts an inquiry into past stock option grants and practices. Asyst disclosed that it received a letter dated June 7 from the SEC requesting documents relating to stock options granted from 1997 to the present. Asyst said it is cooperating in the SEC's inquiry. Asyst said June 28 it received a grand jury subpoena from the U.S. District Court for the Northern District of California requesting documents related to stock-option grants. On Oct. 9, the company said it had completed its options probe and would restate several years of financial results because of wrongly dated grants. The company said a committee of independent directors concluded that "none of the incorrect measurement dates was the result of fraud" and found no evidence to raise concerns about "the integrity of current management." On Feb. 6, 2007, the company said the SEC ended its probe without recommending any enforcement action. 48

49 BARNES & NOBLE: The New York bookseller said on July 12 that its board s audit committee will conduct a review of the company s stock-option practices after a shareholder filed a lawsuit alleging that the company improperly backdated dozens of options grants to executives. Barnes & Noble said there was no merit to the suit. On July 21, the company said the SEC is conducting an informal inquiry into its options practices. The company said Aug. 29 that it has received a subpoena from the U.S. Attorney's Office for the Southern District of New York related to its options practices. On April 4, 2007, the company said its special committee found "numerous instances" of improper backdating but no intent to defraud. Barnes & Noble will take a $23 million charge. BROADCOM: On July 14, 2006, the Irvine, Calif., chip maker said it expects to record additional non-cash stock-based compensation expense of more than $750 million, as it corrects accounting for past stock-option grants. The company believes that substantially all of that expense will be recorded in the years On June 12, the company said it had been notified that it will receive an informal request from the staff of the SEC regarding its option granting practices. Broadcom said it had started an internal review May 18 amid media reports about options practices. On Sept. 8, the company said compensation expenses it records related to historical stock option grants will be at least double its previous estimate, "and could be substantially more," after additional accounting issues were identified. It said it has been informally contacted by the U.S. Attorney's Office of Central California. Broadcom said on Sept. 19 that William J. Ruehle, who had served as CFO since 1997, "decided to accelerate his retirement as a result of" its internal options review. On Dec. 18 the company approved the findings and recommendations of its audit committee's review of its stock options. Broadcom expects to file an amended annual report for 2005 and the first quarter of It added that the SEC told the 49

50 company it has issued a formal order of investigation. The audit committee found each of the option grants made since May 2003 has complied with prevailing accounting rules and isn't subject to restatement. On Jan. 23, 2007, Broadcom said ina filing that Henry T. Nicholas III, its co-founder, bears responsibility for much of the backdating that occurred. The company, in recording $2.24 billion in extra expenses, noted 68 instances in which it couldn t find contemporaneous paperwork to document grant-approval meetings, and 18 cases when grant dates were selected after the fact. CNET NETWORKS: The San Francisco operator of Web sites on May 22, 2006 appointed a special committee of independent directors to investigate option grants and their timing. On May 24, the company said it had received a letter indicating the SEC had launched an informal investigation. On June 27, CNET announced it has received a grand jury document subpoena from the U.S. attorney for the Northern District of California requesting records on its option grants. The company said on July 10 that it expects to restate financial statements for 2003, 2004 and 2005 to correct errors related to accounting for stock-based compensation. Based on the continuing review by the special committee, CNET may also restate its financial statements for earlier years and its operating results for the first quarter of 2006.On Oct. 11, co-founder and Chief Executive Shelby Bonnie resigned as chairman and CEO after an internal probe found evidence of backdating. On Sept. 4, 2007, CNET said the SEC probe into the company's stock options grant practices has concluded, and that "no enforcement action was recommended." 50

51 COMVERSE TECHNOLOGY: The maker of telecom software said May 4 that it received a subpoena from the U.S. attorney's office for the Eastern District of New York, indicating a criminal investigation of stock-option-granting practices. CEO Kobi Alexander, as well as the company's CFO and senior general counsel, resigned just a few days earlier. In April, the company said some option-grant dates used in its accounting "differed" from the actual grant dates, and that it would restate more than five years of financial results. On Aug. 9, the former CEO, CFO and general counsel were charged with criminal fraud. On Sept. 27, Alexander Kobi, who failed to show up in court and was declared a fugitive by the FBI, was found in Namibia, and was set to be extradited to the U.S. On Oct. 24, ex-cfo Kreinberg pleaded guilty to securities-fraud charges in federal court, making him the first person to plead guilty in the backdating scandal. On Nov. 2, 2006 former general counsel William F. Sorin pleaded guilty to a conspiracy charge. On Jan, 10, 2007, it was announced that Sorin will pay $3 million to settle an SEC lawsuit over stock-option grants. Kobi Alexander Comverse Technology, chairman and chief executive Total grants: 8 Odds: About 1 in 6 billion Examples of options granted Company's Response at Date of Publication (March 18, 2006) 51

52 Company said its board has begun a review of past options practices, including "the accuracy of the stated dates of options grants." As a result, it expects to have to restate financial results. GAP: On Sept. 7, the San Francisco apparel retailer said that it has reviewed its stockoption practices over 10 years and discovered unrecorded compensation expenses of less than $5 million. Gap said the amount isn't material to its historical financial statements and will be recorded as an additional compensation expense in the fiscal third quarter once the final figure is determined. Gap said that it had identified no backdating in connection with grants to employees at or above the level of vice president. HANSEN NATURAL: The Corona, Calif., drink distributor said on Oct. 31, 2006 that the SEC requested that the company voluntarily provide documents and information about its past stock grants. The news came after Hansen Natural was listed in a recent report by independent proxy advisory firm, Glass Lewis & Co, as an example of a company where grants to insiders were disclosed late, and the stock price rose materially from the purported grant date to the disclosure date. In June 2007, the company's special committee completed its independent investigation and found no wilful or intentional misconduct, and then the late disclosure did not indicate backdating. The committee found no evidence raising concerns with the integrity of management On Aug. 7, 2007, the company announced that the SEC had completed its informal inquiry and didn't intend to recommend any enforcement action against or related to the company. 52

53 HOME DEPOT: The Atlanta home-improvement giant said June 23 that the SEC had initiated an informal inquiry into its option-grant practices. On June 16, the company said that in five instances prior to December 2000, the date of the meeting or resolution approving an option grant was later than that used to determine the exercise price. The company estimates that the unrecorded expense over the affected period was not more than $10 million. As a result, Home Depot said it doesn't plan to restate any prior financial statements. On Sept. 6, Home Depot said that the Office of the U.S. Attorney for the Southern District of New York has also requested information on options. On Dec. 6, 2006, Home Depot said an internal investigation found that it routinely backdated stock options for 20 years starting in 1981 and as a result it understated compensation expense by $200 million. KLA-TENCOR: On May 30, 2006, KLA said it received a notice from the SEC of an informal inquiry relating to stock-option grants, after disclosing on May 22 that U.S. prosecutors had requested data on grants. On May 24, the semiconductor-equipment maker said its board of directors had appointed a special committee to run an internal investigation of "past stock option grants, the timing of such grants and related accounting and documentation." In 2001, the semiconductor-equipment maker granted its top executives, including Chairman Ken Levy, two batches of stock options. They arrived on unusually fortunate days for the executives: The first dated at the share price's first-half low; the second at its second-half low. On June 30, 2006, KLA said a special board committee has reached a preliminary conclusion that the actual measurement dates for financial accounting purposes of certain grants issued in prior years likely differ from the recorded grant dates. On Oct. 16, KLA said it expects to record total additional non-cash charges for stock-based compensation expenses of no more than $400 million, following the completion of its internal 53

54 probe. It said its general counsel resigned and that it terminated its employment agreement with its former CEO. On Feb. 9, 2007, the company announced that the SEC had informed the company that it was now subject of a formal probe. On July 25, 2007, the SEC charged KLA and former CEO Kenneth Schroeder, seeking various penalties. KLA-Tencor agreed to settle the SEC matter by consenting to a permanent injunction from further violations. Ken Levy KLA-Tencor, founder chairman and former chief executive Total grants: 10 Odds: About 1 in 20 million Examples of options granted Company's Response at Date of Publication (May 22, 2006) Mr. Levy and company executives didn't return repeated phone and messages prior to publication. On the day of publication, KLA disclosed that U.S. prosecutors had requested data on stock-option grants. McAFEE INC: On May 30, McAfee ended the employment of General Counsel Kent Roberts after an internal review of the company's employee stock options revealed an improper grant involving Roberts in McAfee announced on May 25, it is in informal talks with the SEC in connection with its stock-options practices. On June 9, McAfee disclosed it 54

55 received a document subpoena pursuant to a formal SEC investigation. On July 27, McAfee said findings from a review of its practices and accounting for stock-option grants will force it to restate prior results for at least one, and possibly several, past periods. On Aug. 18, the company said it received a grand jury subpoena from the U.S. attorney s office for the Northern District of California relating to the termination of Roberts. On Oct. 11, the company said George Samenuk has resigned as the company's chairman and chief executive in the wake of findings of a stock-options probe. The board terminated the employment of Kevin Weiss as president. MONSTER WORLDWIDE: The New York job-search company received as a subpoena from the U.S. Attorney for the Southern District of New York on June 12 relating to its option grants. Monster's securities filings show it made seven options grants between 1997 and 2001 to James J. Treacy, who became its No. 2 executive before leaving the company in One was dated at the stock's lowest closing price of 1997, and three others carried the lowest closing prices of various quarters. Other senior executives and employees also received grants with some of those dates. The company is conducting an internal review. On June 14, Monster said it had been notified of an informal SEC probe. On July 11, Monster said it might need to restate financial results for 2005 and prior years to record additional stock-based compensation charges. In a short statement on Sept. 19, Monster said long-time general counsel Myron Olesnyckyj was suspended "effective immediately." On Oct. 9, the company said Chairman and CEO Andrew McKelvey resigned both positions, citing in part the demands of coping with the options probe. On Oct. 30, Monster said McKelvey has resigned from the board and had declined to be interviewed by a board committee that is reviewing grants. The company said on Dec. 13 that former officials "intentionally" backdated option grants during a six-year period. Monster lowered nine years of reported net income by $272 million to account for the backdating. On Feb. 15, 2007, Myron Olesnyckyj, the former general counsel of 55

56 Monster Worldwide, pleaded guilty to two criminal charges related to backdating stock options. James J. Treacy Monster Worldwide Inc., former president and COO Total grants: 7 Odds: About 1 in 9 million Examples of options granted (Stock prices adjusted for splits) Date of grant Company's Response at Date of Publication (June 12, 2006) Founder and CEO Andrew McKelvey, who himself never received options from the company, said he is "completely responsible," as the company's most senior executive, for option grants to everyone else. He said Monster had begun a review to determine why the grants were often priced at lows. "To date there is nothing that we see in terms of backdating or improprieties," he said, stressing that the review wasn't complete. Monster's board has also begun a review. PIXAR: Disney disclosed on Nov. 9 that it had received government inquiries about past stock-option grants at its recently acquired Pixar Animation Studios. The Burbank, Calif., media giant said it has begun an independent review of Pixar's option grants after inquiries from the SEC and the Justice Department. Disney said March 16,

57 that it concluded that options at Pixar were backdated before its acquisition of the company, but said no one now associated with Disney committed "any intentional or deliberate acts of misconduct". The statement appeared to indicate that Steve Jobs, a Disney director and Pixar's founder, will not be faulted by Disney. QUEST SOFTWARE: On May 22, the Aliso Viejo, Calif., software maker said its board had formed a special committee to investigate historical stock-option practices and related accounting. Quest said it began this investigation following the release of a thirdparty report about the timing and pricing of stock-option grants. On June 1, Quest said it had received noticed of an informal SEC inquiry into past options grants. On July 5, Quest said that it will restate more than five years of financial statements after an internal investigation found that "many" stock options to employees were wrongly dated. On Nov. 24, the company said it accepted the resignation of M. Brinkley Morse, senior vice president, corporate development, after he declined to be interviews in the options probe. RAMBUS: The Los Altos, Calif., maker of technology that speeds up memory chips said on May 30 that the audit committee of its board has begun an internal investigation of the timing of past options grants and other potentially related issues. The committee expects to focus primarily on options issued in or before 2003 and will be assisted by outside legal and accounting experts. On June 27, Rambus announced that the board's audit committee reached a preliminary conclusion that the actual measurement dates for certain grants issued in prior years differed from the recorded grant dates. On July 19, the company said it plans to restate financial statements dating back to 2003 and incur "significant" costs to correct errors related to its stock-option accounting. Shares of Rambus plunged on the news. On Aug. 15, the company said former CEO Geoff Tate plans to resign from the board, in the 57

58 wake of improper stock-options dating at the company. On Oct. 19, the company said improper grants would result in charges of more than $200 million. SANMINA-SCI: On June 9, the SEC requested information regarding the San Jose, Calif., electronic contract manufacturer's stock-option grants since Sanmina-SCI, which noted it plans to fully cooperate with the SEC's request, said it has already initiated an internal inquiry concerning grants to its executive officers. On Aug. 14, the company said it has delayed the filing of its 10-Q for the quarter ended July 1 after discovering what may be discrepancies in its accounting for stock options, although it stressed that its initial findings aren't conclusive. The company said on Sept. 13 that it will restate its financial results for periods as far back as 2002, and will incur additional, material charges in those periods because of errors in accounting for past stock-option grants. On Oct. 12, the company said a U.S. grand jury is probing its stock option grant practices, adding that its own internal probe found that most option grants to executives and employees weren't correctly dated or accounted for since Sanmina-SCI said it plans to restate its historical results and record noncash compensation charges. The company's four-month investigation found that a former executive and a current manager improperly dated or accounted stock options from 1997 to The current executive, who the company declined to disclose, has resigned. XILINX: The San Jose, Calif., chip company said June 23 that the SEC is making an informal probe into its "practices, procedures and disclosures" related to its stock options grants. On July 25, Xilinx reported earnings, including a $1.5 million charge to cover what the company termed "minor differences between approval documentation and certain recorded stock option grant dates." On Aug. 16, the company said it has finished its investigation of its stock-options grants, finding no fraud but taking an 58

59 additional $700,000 charge in its first fiscal quarter. On Nov. 30, 2006, Xilinx announced that the SEC has formally notified Xilinx that its investigation has been terminated and that no enforcement action has been recommended. Taking all the above elements under consideration, we can understand that backdating is a real problem and many companies adopt this practice. 59

60 7. Backdating, Market Efficient Hypothesis and Andrew Redleaf Erik Lie with his studies essentially set off the options backdating scandal. Although he did not name names, his work showed, indisputably, that there were simply too many cases where options were granted to top executives just before a nice run-up for it to be happening randomly. He suggested that companies had to be backdating option grants to enrich executives. These studies pick the interest of Andrew Redleaf. Andrew Redleaf had a distinguished academic career at Yale University. In only three years, he earned both BA and MA degrees, with distinction, in mathematics. Upon graduation, he was honoured with the mathematics prize as the top undergraduate in that field. Attracted at first to the newly organized options markets, where he could use his math skills to advantage, he began his career as a trader for Gruntal Securities. Andrew Redleaf began to develop some of his distinctive insights into relationships between markets. He began to understand prices were best viewed not by what was inside markets, but by what lies between them. The larger lesson was to look for opportunities in market structure and other behavioural eccentricities, which has been the cornerstone of his success since then. Andrew Redleaf, 50 years old, now is chief executive of Whitebox Advisors, a $1.8 billion Minneapolis hedge fund that has had sparkling returns since he started it in 2000 and he is responsible for all operations of the firm as well as the development and operation of all asset management strategies. 60

61 Robert Shiller, professor at Yale University invites him in order to talk about efficient markets in a classroom. Andrew Redleaf explains the way he economically exploited public information such as Erik Lie s studies and data from SEC in this guest lecture at Yale University. When bonds are governed by what's called "an indenture", which is the sort of legal agreement between the company and bond holders, important data supplied within the text of the bond indenture includes the maturity date on the bond, any call provisions or protective covenants that are extended according to the terms of the agreement, and interest rate that is to be paid to the bondholder. In the event that any type of collateral is involved in the sale of the bond, the bond indenture will make note of the assets that are pledged, and what type of circumstance would have to occur in order for the collateral to change ownership. In a typical bond indenture, if a company fails to file financial statements on time that is an event of default under their bond agreement and usually the remedy for an event of default is where you can demand acceleration and immediate payment. As a document that is designed to ensure that both the bond issuer and the buyer and seller have a clear understanding of the terms of the transaction, the bond indenture generally employs a relatively easy to read format. While the actual text will include legal terms that are required by the laws of the jurisdiction where the sale is taking place, the bond indenture tends to follow a logical pattern in identifying the terms. This makes the text of the bond indenture accessible to everyone, especially to new investors who may not be completely comfortable with documents that contain a great deal of financial terminology. However, according to Andrew Redleaf there are people who own bonds without reading the indenture because it is long, it is not written in English and in most set of circumstances they are irrelevant. If a company cannot file financial statements on time then the bondholder can demand immediate payment. Andrew Redleaf and his colleagues 61

62 actually did not really know this until they owned a bond in a company that couldn't file their financial statements on time. Somebody who owned bonds too, discovered the possibility of immediate payment and by demanding that they have to get paid, ended up negotiating with the company. This was the first experience that made Andrew Redleaf aware that not filing financial statements was an event of default and, therefore, something that would entitle you to the immediate payment for companies that could pay bondholders back, but their bonds are trading below par, probably because they have a low coupon. So, if a bond was issued when interest rates were lower, they might have a 4% coupon when the prevailing rate is 6%. So, if it is a four-year bond, it would trade at about $90, so it would be yielding 6%. But if they default, you can buy them at $90 and if they cannot file their financial statements, you are entitled to par. Andrew Redleaf and his colleagues tried to take an advantage of this information. They were interested in finding bonds trading below par where they thought there was a chance that companies would not file their financial statements on time in order to get paid to par. One of the big causes of companies not filing financial statements on time was if they had backdated the stock options. Andrew Redleaf had discovered a way to make money. If he could buy bonds below par and if the company did not file financial statements on time he would be paid the bond to par. The next step was to understand which companies are going to file their financial statements on delay. Erik s Lie studies helped Andrew Redleaf and his team to recognize which company backdates its stock options. Companies that are caught backdating options have huge accounting problems. Options that have been backdated require a different accounting treatment and companies usually have to restate their financial data for the years during which they were backdating. This almost inevitably means that they will also not be able to file their current quarterly or annual report on time. Which therefore means their bonds will technically be in default and bondholders would demand to get paid to par. Also, if a company had backdated their stock options SEC has to investigate this situation and has to come 62

63 to a conclusion about these suspicions. Investigation takes time and it is possible for the company to file their financial statements on delay. Andrew Redleaf tried to identify companies that he thought that they backdated their stock options. Andrew Redleaf, who was interested in Erik Lie s reports, and several of his Whitebox colleagues decided to do their own options backdating study. They ran 6,000 companies and 60,000 options grants through their computers. They looked at a 40-day window: 20 days before the options were granted and 20 days after. And sure enough they discovered several hundred companies whose pattern of granting options at the precise moment the stock was about to jump was eyebrow-raising, to say the least. And while Whitebox Advisors does not have absolute proof that options backdating took place they had done a statistical detective work. They acquired a database where they selected and categorized their data and they looked at the pattern of stock option issuance, attempting to figure out the probability of being caused by chance. For those companies that Andrew Redleaf and his team suspected they had backdated stock options, they bought their bonds without the companies being aware of this potential event of default. This was kind of a risk-free trade because if the company filed on time, they had not paid anything. If the company was late, they had the prospect of getting par quickly. Now they had their list of potential options abusers, Andrew Redleaf and his team shorted about 80 of them. But Whitebox also went into the marketplace and bought bonds of some of the companies in question. In other cases, Whitebox already owned the bonds. One example of potential option abuser was Affiliated Computer Services, a Texas-based technology outsourcing company with over $4 billion in 2005 revenue and 50,000 employees. It was one of the first companies to be fingered as a possible options backdater, and instigated an internal investigation by SEC. 63

64 In July 2006, when the company released its quarterly results, it said that while the investigation wasn t complete, it did not think it would have to restate results. However, Andrew Redleaf sent a letter to the company in early August. There were 14 grants between November 1995 and March 2005, he wrote to Darwin Deason, the chairman of the board. Every single grant was better than a random day for the period, a 1-in-16,384 occurrence. He added, If we look at the stock return for the 20 days after the grant, the award days were in the 91st percentile, a result very consistent with backdating but hard to square with legitimate methods. Within days of receiving the letter, A.C.S. announced that its previous statement about options backdating can no longer be relied upon. This statement strongly implies that things were worse than it had claimed a few weeks earlier. A few days later, a lawyer working for the company s audit committee contacted Whitebox to see what the firm had found. A.C.S. announced that it had missed the deadline for filing its annual report. This was the exact event that Whitebox was hoping would result from its letter. The company also reported that because of that missed deadline it may face covenant compliance issues, meaning that it may be in default of some $2 billion worth of loans. The company said it would seek a waiver. This means that Whitebox is going to negotiate with the company and finally take money. Below is the number of option grants that Jeffrey Rich, the former chief executive of Affiliated Computer Services received between roughly 1995 and 2002 and the odds that such a favourable pattern of grants would occur by chance. Charts show three especially propitious grants and what the stock did two months before the grant and two months after. 64

65 Jeffrey Rich Affiliated Computer Services, chief executive Total grants: 6 Odds: About 1 in 300 billion Examples of options granted (Stock prices adjusted for splits) : Date of grants Company's Response at Date of Publication (March 18, 2006) 65