BACKDATING AND DIRECTOR INCENTIVES: MONEY OR REPUTATION?

Transcription

1 BACKDATING AND DIRECTOR INCENTIVES: MONEY OR REPUTATION? Kristina Minnick Bentley College Mengxin Zhao University of Alberta We thank Kai Li (the referee), Jayant Kale (the editor), R. David Mclean, Roy Wiggins III, as well as workshop participants at Bentley University, and seminar participants at the 2008 European Financial Management Association conference, and the 2008 Financial Management Association Conference for their insightful comments. We would also like to thank the Center for Business Ethics at Bentley University for their financial support. Both authors acknowledge support from Bentley University summer research grant. We are grateful for Jiawei Zhang s excellent research assistance.

2 Abstract We investigate how director incentives affect the occurrence of firms backdating employee stock options. Directors with more wealth tied up in stock options may pursue activities that lead to personal gain, such as option backdating, which potentially increases the option recipient s compensation. We document a positive and significant association between director option compensation and the likelihood that firms backdate stock options. Our results question the effectiveness of director option compensation in aligning the interests with those of shareholders and help to explain the recent decline in the use of director option grants by many firms. JEL Classification: G34, G30 2

3 I Introduction Director compensation has been the subject of a heated debate for more than two decades. In the 1980s, corporate reformers and large institutional investors argued that options would motivate directors to focus on shareholder returns by giving them ownership incentives. Until recently, this idea has continued to gain popularity. According to Executive Compensation Reports, a newsletter that covers executive pay, about 1.6% of the 1,000 largest U.S. companies gave directors some kind of stock in By 1994, nearly one in five used options to compensate directors. The usage of director options has continued to grow into the early 2000s. Director options have been widely adopted by companies as a vital tool for rewarding board members and aligning their interests with those of shareholders. More recently, director options are falling out of favor. On December 20, 2006, IBM announced that it had stopped granting outside director options and instead would pay directors in cash or shares of stock. 1 Other companies that have dropped this practice include the retailer Gap Inc., recruiter Heidrick & Struggles International, and Tyson Foods. 2 Some companies recent aversion to director options suggests that rather than effectively providing monitoring incentives to the directors, options can lead to agency problems, such as backdating. In this study, we examine the association between independent director compensation and option backdating. We are interested in the role of director compensation in triggering the backdating behavior. In general, stock options are granted at the money (i.e., where the exercise price equals the market price of the stock on the grant date). Backdating helps the recipients of the options to obtain in-the-money options, thus enhancing the value of their option grants. Since 2006, more than 140 companies have come under investigation for possible backdating activity. 3 This phenomenon raises concerns about the effectiveness of corporate governance in setting executive pay. Options are designed and granted by the board of directors to better align management s and shareholders s incentives. Backdating boosts the financial gains of the option recipient without the requisite performance increase. Executives cannot change their own compensation contracts. Rather, the board of directors and the compensation committee set the option compensation. The board of directors also sets their own compensation. This responsibility gives directors the power to set the size, recipients, exercise date, and exercise price of the option grants (Ryan and Wiggns 2004; Yermack 2004). 1 Robert Mullins, IDG News Service, December 20, In 2001, as the stock market boom of the 1990s crested, nearly eight in 10 big companies were giving their directors options, according to a proxy analysis of 350 major companies conducted for The Wall Street Journal by Mercer Human Resource Consulting in New York. By last year, the figure was down to 53%. 3 The Wall Street Journal and Bloomberg publish the option scorecard listing the companies under investigation for possible option backdating.

4 Therefore, we cannot ignore the role of directors in explaining option backdating behavior. In this study, we examine both the amount of the option grants to the directors and the sensitivity of these director option grants to stock price changes. The sensitivity of director option grants to stock prices captures the ex ante incentives that might influence directors decision to allow option backdating to occur. According to Yermack (2004), directors have two types of incentives: monetary gains and reputational capital. Reputation is a key determinant of corporate directors market value. The possibility of losing a board seat due to malfeasance creates incentives for effective monitoring by outside directors (Harford 2003). Directors can face a possible trade-off when the benefits from ineffective monitoring outweigh the benefits of reputation retention. Backdating is likely to take place when directors personal gains are of a greater concern than the possible loss of reputation. To understand why some directors decide to participate in backdating activities, it is important to understand how these directors benefit from the involvement. We would expect to observe a link between directors compensation, especially option grants, and the tendency to backdate. Directors with more option grants have more potential gains from backdating. Extensive research focuses on how firms time their option grants (Yermack 1997; Lie 2005). More recently, Heron and Lie (2007) and Narayanan and Seyhun (2006) provide evidence that firms backdate options, particularly before the Sarbanes Oxley act (SOX). Bizjak, Lemmon, and Whitby (2006) find that interlocking boards are positively related to backdating. Collins, Gong, and Li (2006) link backdating problems with weak corporate governance proxied by a CEO s influence over the board and compensation committee. Bebchuk, Grinstein, and Peyer (2007a) not only document the extent of the practice in executive option backdating but also report a link between the lack of board independence or CEO influence and the executives option backdating. Another paper by Bebchuk, Grinstein, and Peyer (2007b) shows that in addition to executive gains from option backdating, directors also receive substantial amounts of lucky grants. Our paper differs from existing research on option backdating in that we focus on how director option compensation might play a role in the likelihood that firms engage in option backdating. Bebchuk, Grinstein, and Peyer (2007b) examine directors gains from lucky grants. We are most interested in examining whether compensating directors with stock options leads to poor incentives for the directors, resulting in agency issues, such as option backdating. We investigate how directors compensation might help explain why certain firms are more likely to backdate options. We create the sample of potential backdaters using the same methodology as Collins, Gong, and Li (2006). 4 In total, 1,582 firms potentially engaged in backdating from 1996 to We 4 Collins, Gong, and Li (2006) classify firms as backdaters if the grant date stock prices is in the lowest decile of 2

5 also find that 1,475 outside board members received questionable option grants, which is consistent with Bebchuk, Grinstein, and Peyer (2007b). Since these firms are just potential backdaters, we want to also narrow our focus to companies that are under investigation for backdating. We collect 146 firms that are being investigated for the possible backdating of options, as listed in The Wall Street Journal and Bloomberg. We find that directors of the backdating firms are compensated with more options and that the option values are more sensitive to stock prices as compared to the benchmark firms (i.e., those firms that are neither potential backdaters nor under investigation). Director option compensation is positively related to the likelihood of firms being investigated for backdating. The positive and significant relation is even stronger between the probability of backdating option grants and the sensitivity of director option values to changes in stock prices. Directors who have higher option pay-performance sensitivity (PPS) are more likely to backdate option grants. The result is stronger for older directors and directors with long tenure. These directors may have lower opportunity costs associated with potential loss of reputation as a result of wrongdoing. Small boards and independent directors are less likely to backdate options. On average, backdating investigation leads to negative stock market reactions around the backdating announcement. These negative reactions are stronger when the CEOs and directors have high option holdings and high option PPS. All of our results hold after considering the endogeneity of incentive compensation. Existing papers on the timing of option grants or backdating do not focus on the role of director compensation. Little prior work addresses the issue of director compensation with the exception of Ryan and Wiggins (2004), who find that the structure of the directors compensation is determined by the CEO s and outside directors bargaining powers. We complement these existing studies and question the effectiveness of option compensation granted to outside directors in aligning directors interests with shareholders. Implications of our study may help explain the recent reductions in option grants to the directors. II Literature Review and Hypotheses Development Literature Review Most studies focus on the structure of the board of directors and how it relates to a firm s investment decision and performance (e.g., Hermalin and Weisbach 1988; Yermack 1996). Ryan and Wiggins (2004) empirically examine how director compensation is determined by the relative bargaining power between CEOs and the board. Equity-based compensation has been documented to align the stock price distribution over the 240-trading-day window around the grant date. 3

6 the interests of shareholders with those of management and directors (e.g., Morck, Shleifer, and Vishny 1988; Frye 2004). Harvey and Shrieves (2001) document that executive compensation is determined by firms choices of governance structures, including outside directors. Typically, employee stock options are granted at the money, where the exercise price of the option is set at the market price on the grant date. Price appreciation following a grant increases the value of the options, which encourages management to time the granting of these awards. Good timing helps management profit from their option compensation. Aboody and Kasznik (2000) and Yermack (1997) show that options are awarded before increases in stock price, suggesting managerial manipulation in the timing of stock option grants. Chauvin and Shenoy (2001) find that stock prices decrease before option grants, again suggesting that firms release bad news before option grants to lower the strike price. Similarly, Lie (2005), Heron and Lie (2007), and Narayanan and Seyhun (2006) find poor stockprice performance before the option grant and a reversal in stock price performance after the grant. This pattern of share price reversal for stock option grants suggests that firms set the grant date retroactively to lower the strike price of the option. This is called backdating. Collins, Gong, and Li (2006) find opportunistic timing of option grants around news announcements, and management of information flows around fixed grant dates. Since the public exposure of firms backdating in The Wall Street Journal in 2006, several papers have tried to address the reasons for this widespread corporate behavior and its economic effects. Collins, Gong, and Li (2006) document an association between weak corporate governance and backdating. Similarly, Bizjak, Lemmon, and Whitby (2006) find that interlocking boards play a significant role in the spread of backdating. Firms are more likely to engage in backdating behavior when they have outside directors linked to the firms that also backdate option grants. Bebchuk, Grinstein, and Peyer (2007a, 2007b) provide evidence that CEOs as well as directors have benefited from timing the option grant dates. Hypotheses Development In our study, we focus on how director compensation can create incentives for directors to engage in backdating. Option recipients have incentives to time the granting of these awards to come either following poor stock performance (which lowers the exercise price) or prior to good stock performance (which increases options value). In Ryan and Wiggins (2004), 63% of the firms award options to directors. Most existing literature on option backdating (e.g., Bizjak, Lemmon, and Whitby 2006; Collins, Gong, and Li 2006) 4

7 does not examine the role of director compensation in backdating activities. Directors are supposed to monitor management and prevent firms from committing non value enhancing activities. Backdating benefits both top management and directors who receive options (Bebchuk, Grinstein, and Peyer 2007a, 2007b); however, the economic impact on shareholders is questionable. Solely focusing on the structure of corporate boards does not provide insight into how directors financial incentives relate to backdating. An independent compensation committee should be more efficient in designing and executing executive compensation contracts. Therefore, such a committee is expected to be associated with less opportunistic managerial behavior such as backdating employee options. However, this association may be mitigated if directors themselves also hold large amounts of option grants. Management and directors might have common interests in pursuing the gains from backdating, regardless of the directors independence. Option grants might not be an effective tool to motivate directors to efficiently monitor executives. We test the following hypotheses: Hypothesis 1: Firms are more likely to backdate option grants when the board of directors has a high level of stock options. When option grants are a major component of director compensation, there is an increased likelihood of backdating, controlling for other factors such as executive options grants, structure of the board, and other governance mechanisms. The value of option grants varies with stock price changes. Some grants are more sensitive than others to changes in stock price. The potential gains from backdating options are larger if the value of stock options is more sensitive to the changes in stock price. Therefore, in addition to considering the level or percentage of director option grants, we also test: Hypothesis 2: Directors incentives to backdate option grants increases when their stock option values have a higher sensitivity to stock price changes. There should be a positive relation between director option incentives and the likelihood of firms backdating. To evaluate backdating s effect on shareholder returns, we investigate stock price movements after a backdating investigation is revealed to the public. We then link the stock market s reaction to director option compensation. Shareholders might not like the fact that management engage in opportunistic behavior such as backdating. These negative reactions might be stronger when directors are involved in the backdating. III Sample and Data We construct two samples to test our hypotheses. Our primary sample consists of the 146 backdating firms that are listed in The Wall Street Journal and Bloomberg as of December These 5

8 firms were under investigation for possible backdating by the SEC, the FBI, the Department of Justice (DOJ), or the companies own boards. We list our primary sample firms in Appendix B. Executive and board of director compensation data are obtained from Execucomp. Board structure and board size data are from the IRRC Directors Database. Any other missing data are hand-collected from proxy statements. We also manually collect the exercise price of director option grants each year from proxy statements. We require that these firms have Compustat data, board data, and compensation data from 1996 to 2005, which gives us 665 firm years. We label this sample the WSJ sample. We generate our second sample starting with the universe of Compustat firms. Following Collins, Gong, and Li (2006), we classify a firm as potentially engaging in backdating if the stock price on the grant date for CEO options falls within the lowest decile over 120 trading days before and 120 trading days after the grant date. We label these firms potential backdaters. Benchmark firms are defined as those firms that are neither the backdaters in the primary sample nor the potential backdaters as classified above. We collect executive and director compensation data as well as other governance variables from Execucomp and the IRRC database. Financial data in this paper are obtained from Compustat; stock return data are from CRSP. In total this sample provides 2,898 firm years for potential backdaters and 11,112 benchmark firm years. Table 1 provides sample descriptions. Panel A breaks down the WSJ and potential backdating samples by year ( ). Examining the potential backdating sample, we see that the practice was most prevalent during the period and started to wane post Sarbanes-Oxley (SOX). Panel B provides further information on the WSJ sample. Surprisingly, 77 firms were investigated for backdating activities post SOX. Most of the firms were under internal investigation (124) and SEC investigation (98). Only 19 were investigated by the FBI and 56 by the Department of Justice. Nine firms were delisted from stock exchanges following the backdating scandal. Sixty percent of the firms experienced director, officer, or other key employee turnover (34 CEOs and 23 CFOs resigned due to the investigations). One reason that we pay particular attention to the WSJ sample is that this sample is a focused group of firms that were investigated for their backdating practices. We avoid the possible identification error in forming a sample of only potential backdaters by examining exercise prices and stock prices. Another advantage is that we are able to track down the market reaction to the announcement of firms backdating investigations, allowing us to determine the economic impact on the shareholders. We base our empirical analyses on both the potential and WSJ samples. The results are similar between these two samples and consistent with existing papers. 6

9 IV Empirical Design and Analyses Variable Construction The main variables in our empirical analyses focus on the board s incentive compensation. We first measure director option grants by scaling the total number of director option grants by shares outstanding. Option grants are measured as the total option holdings including both the existing options and the newly awarded options in the given year. To measure the incentive effects of option compensation, we calculate PPS as defined in Core and Guay (1999a,b) for directors. Option PPS measures the change of a director s wealth (in thousand dollars) from her option holdings given a 1% change in stock price. We create a similar PPS measure using stock grants (Stock PPS), as well as a PPS measure that combines stock and option grants (Total PPS). Similarly, we construct option grants and option PPS for CEOs of each firm. Options are valued using the Black-Scholes model, assuming a 10-year maturity, and stock return standard deviation is estimated from the monthly stock return over twelve months in the year of the grant. Since PPS is heavily skewed to the right, we use the natural log of PPS instead of the raw value in our regression analyses. Existing literature shows that certain board structures reduce agency problems (Hermalin and Weisbach 1988; Yermack 1996). Specifically, we examine board size (Bsize) and the percentage of independent directors on the board (Pct Indep). Independent directors include any nonemployee board members, as well as any members that are not considered gray (where gray is defined as consultants, lawyers, accountants, etc.). Director characteristics are also included in the analyses to examine whether they may increase the likelihood of backdating. Older directors or directors with a long tenure may have more incentive to backdate because there are lower opportunity costs associated with reputation loss resulting from potential wrongdoings. We measure age by taking the average age of the independent directors (Indep Age). We measure tenure by averaging the number of years the independent directors have held the position on the board (Indep Tenure). We also include an indicator variable that is equal to one if the independent directors have an interlocking relationship. Lie (2005) suggests that firm size may play a role in backdating, and finds that small, high growth firms are more likely to backdate. We measure firm size as book value of assets (Assets). Market-to-book ratio is used to proxy for growth options (MK BK). Companies with high stock return volatility have more to gain from potential backdating activities. We use the standard deviation of the monthly stock returns over 12 months, lagged one year to proxy for volatility (Ret Std). Appendix A describes the variables in detail. Empirical method We first carry out a univariate comparison between backdaters (both WSJ sample and potential 7

10 backdaters) and the benchmark sample, focusing on their firm characteristics, governance mechanisms, compensation, and especially director compensation. We then address the question of whether director stock options play a role in triggering backdating. We use a logit model and estimate the following equation: P(Backdater) = β 1 + β 2 FirmCharacteristics i + β 3 BoardCharacteristics i +β 4 DirectorCompensation i + +β 5 CEOCompensation i + ɛ i, (1) where firm characteristics include firm size, measured as the log of book value of assets, stock return volatility, and market-to-book ratios. They are included to examine whether certain types of firms are prone to backdating. Board characteristics include board size, percentage of independent directors, average tenure of independent directors, average age of independent directors, and an indicator variable for interlocking board relationships. Compensation characteristics include option grants and option PPS for directors as well as for CEOs. All of these variables are lagged one year. As discussed above, older directors (or CEOs with long tenure) with high option grants may have an additional incentive to backdate. Therefore, we interact age and tenure with director option PPS to examine how age and tenure combined with director option PPS can influence the likelihood of backdating. We control for year and industry effects. Problems can arise in equation (1) if the assumption of exogenous regressors is violated (Li and Prabhala 2007). The possibility exists that compensation is correlated with the same firm characteristics that determine the likelihood of backdating. Thus, we use the following specifications to carry out two-stage analyses that allow us to control for the endogeneity of incentive compensation for both CEOs and directors. There are potential multicollinearity issues if our selection variables in the first stage are similar to our outcome variables in our second stage. To prevent this, we use unique variables in our first stage (Li and Prabhala 2007). Our choices of determinants in the first stage are based on the existing literature. CEOOptions = β 1 + β 2 CashFlow i + β 3 MV i + β 4 NISTD i + β 5 CEOAge i + β 6 3Y rret i + ɛ i (2) CEOOptionPPS = β 1 +β 2 CashFlow i +β 3 MV i +β 4 NISTD i +β 5 CEOAge i +β 6 3Y rret i +ɛ i (3) DirectorsOptions = β 1 +β 2 3Y rret i +β 3 MV i +β 4 Intangibles i +β 5 BoardCharacteristics i +ɛ i (4) 8

11 DirectorsOptionPPS = β 1 +β 2 3Y rret i +β 3 MV i +β 4 Intangibles i +β 5 BoardCharacteristics i +ɛ i (5) Executive and director compensation are an optimal response to a firm s contracting environment. Numerous studies have shown that firm size, investment opportunities, capital intensity, capital structure, and industry help explain the cross-sectional variation of firms choice of managerial compensation contracts (e.g. Gaver and Gaver 1993; Kole 1997; Palia 2001). Following Cho (1998), we include firm size, liquidity, volatility of earnings and CEO age to measure CEO incentive compensation. Larger firms are usually correlated with more complexity in their operating environment, thus requiring greater managerial skills. Larger firms also suffer more agency costs, therefore, compensation contracts are designed to tie pay to firm performance. We use total market capitalization of the firm (MV) to proxy for firm size. We use cash flow (Cash Flow) as a proxy for liquidity, measured as cash flow divided by the total assets of the firm. Cash Flow is defined as after-tax income plus depreciation and amortization. As argued in Cho (1998), higher liquidity is associated with higher corporate value and more investment opportunities. The effect of volatility on compensation contracts can be two-fold. On one hand, volatility may increase the value of equity-based compensation, as uncertainty in a firm s operating environment may impact the degree to which management is effectively monitored. On the other hand, volatility may lead to greater risk aversion thus higher costs associated with equity compensation. We measure volatility (NISTD) as the standard deviation of a firm s net income five years prior. We also include CEO age in determining both option compensation and pay-performance sensitivity. There are less disciplinary mechanisms in the managerial labor market for older CEOs. Equity compensation is more effective in better aligning older CEOs interests with those of shareholders. Additionally, we also control for firm performance by including the long run return (3YrRet). 3YrRet is the market-adjusted 3 year buy-and-hold returns calculated following Ritter (1991) and Teoh, Welch, and Wong (1998a,1998b). Lippert and Moore (1994) used similar models to estimate CEO incentive compensation. To measure director option compensation and pay-for-performance sensitivity, we follow Brick, Palmon, and Wald (2005). When there is more need for firm monitoring or the directors tasks involve greater difficulty, we expect to observe firms granting more options to directors. Likewise, directors option compensation should be more sensitive to firm performance. We use firm size, growth opportunities and asset characteristics to proxy for the difficulty of monitoring by directors. If a firm s performance is more sensitive to monitoring, directors must expend more effort in monitoring to ensure better performance. Following this logic, directors compensation should 9

12 include incentives such as options, which motivate the directors to maximize the firms value. Thus, we expect the amount of option grants and option PPS should be positively related to firm size, intangible assets, and long term performance. Firm size is measured as total market capitalization (Log MV), and intangible assets as a ratio of intangible assets over total assets (Intangibles). We also include the prior three year market-adjusted buy-and-hold returns, board characteristics such as average tenure of the directors, board size, board independence, and independence of board compensation committees. Smaller boards, boards with more independent directors or boards with more independent compensation committee are more likely to design director compensation that is linked to firm performance. In addition to the likelihood of option backdating, we examine the resultant market effects of the backdating activity. We calculate the abnormal returns for the backdating companies at the time of their announcement. We run the following regression: AR = β 1 + β 2 FirmCharacteristics i + β 3 BoardCharacteristics i + +β 4 DirectorCompensation i + +β 5 CEOCompensation i + ɛ i, (6) where the independent variables are the same as equation (1). Abnormal returns are estimated based on a standard market model. Independent variables are defined the same as above. This regression analysis help us understand whether the market reacts differently to the backdating scandals given certain types of firm or director characteristics. Again, Appendix A describes the above variables. Empirical Results Table 2 reports the univariate comparison between backdaters (WSJ sample and potential backdaters) and the benchmark sample. The WSJ backdaters are generally smaller in terms of book value of assets, and have higher market-to-book ratios than the benchmark. Overall, WSJ backdaters have relatively larger boards and fewer independent boards of directors. What s more, WSJ backdating firms tend to have more interlocking directors on the board and their outside directors are older with longer tenure compared with benchmark firms. This might imply that older directors care less about their reputation. These findings are consistent with those of existing papers (e.g. Bizjak, Lemmon and Whitby 2006; Collins, Gong and Li 2006). The potential sample of backdaters is not that different from the benchmark sample. Both have similar market to book ratios and are of similar size. However, the potential backdaters have significantly higher return volatility as compared to the benchmark sample. The board composition is 10

13 similar between the two samples, except for the audit and compensation committees. The potential sample has significantly fewer independent directors on both the compensation and audit committees. We are interested in director option compensation and how it differs between backdating and benchmark samples. Backdaters directors have significantly higher option compensation compared to non backdaters. When we only compare the sensitivity of the option grant value to the stock price (option PPS), we find that both the mean and median PPS are significantly higher for backdaters than for non backdaters (this is true for both the WSJ and potential sample). Interestingly, there is no significant difference in the mean and median values of pure stock compensation for directors. This suggests that option holdings and option PPS are the major potential factors in backdating. This pattern is also true for CEO option and stock compensation. Table 2 suggests that option compensation and board characteristics are important determinants of backdating events. Before we run logit regression analyses, we provide a correlation matrix and the corresponding variance inflation factor (VIF) statistics in Table 3 to examine the correlations among all the variables in our study. Panel A reports the correlation matrix and Panel B shows the VIF statistics. The VIF statistics reflect the presence or absence of multicollinearity. Any VIF factor over 10 suggests multicollinearity. Overall, multicollinearity does not seem to pose serious problems in our estimation. In Table 4, we run a set of logit regressions using equation (1), where the dependent variable equals one if the firm is a backdater, and zero if the firm is a non-backdater (i.e. the benchmark firm). Backdaters and non backdaters are defined in the above section. We estimate the logit regressions based on both the WSJ sample (column 1-4) and potential backdaters (column 5-8). Independent variables are defined in Section 4.1 and Appendix A. Consistent with the univariate analyses, director option grants and the sensitivity of director option value to changes in stock price (director option PPS) are significantly and positively related to the probability of firms backdating option grants. This result is consistent with our hypothesis that director option compensation plays an important role in explaining backdating. It brings up the question of whether director option compensation is effective in motivating directors to monitor the management and protect shareholders welfare. 5 This result still holds even after we control for CEO incentives, which also shows to be positively related to the likelihood of firms backdating. The coefficients for board size are positive and significant in all regressions, implying that large boards allow backdating. Firms with more independent directors are less likely to be involved in backdating activities. Director tenure and age are positively and significantly related to backdating 5 The results are similar when we use directors total equity compensation (i.e., the sum of option and stock compensation). 11

14 occurrences. Older directors have much less potential reputation loss in the labor market compared with younger directors whose reputation carries more weight in their career. The value of these older directors reputation loss is less than the financial gains from option backdating. The interaction terms of director option compensation with director age and tenure reconfirm this implication. All regressions include year and industry dummy variables. To control for the endogeneity of director and CEO incentive compensation, we run a two-stage estimation in Table 5. In Panel A, we report the first-stage regression analyses of director and CEO option compensation and option PPS (i.e., the percentage change in option compensation value given a 1% change in stock price). The regressions in this table are based on equations (2) through (5). Overall, our results are consistent with previous studies on the determinants of CEO and director compensation. Large firms have lower levels of CEO options but CEO options are more sensitive to firm performance. This suggests that large firms require more complicated managerial skills. Given that CEOs human capital is very undiversified, they tend to negotiate more cash based compensation rather than equity based compensation. On the other hand, large firms which operate in more complex environments have a higher need for monitoring. The positive and significant coefficient of firm size and CEO option PPS in Panel A is consistent with this posture. Panel A also shows that director option compensation and option PPS are significantly and positively related to firm size, growth options, and board independence. Director equity compensation varies with firm and board characteristics. Our first-stage results are robust when we use alternative measures of firm size (e.g. assets, sales) and growth options (market-to-book ratios or research and development expenses). Based on the regression estimates in Panel A, we calculate the estimated values of both CEO and director option compensation as well as option PPS. We then use these predicted values as the instruments in our second-stage regression analyses. Panel B reports the second-stage regression results based on equation (1). The results are consistent with Table 4. After taking into consideration the endogeneity of incentive compensation, director option compensation and option PPS remain significantly and positively related to the likelihood of backdating activities. This strongly supports our hypotheses. To further examine how director option compensation impacts the likelihood of backdating, Table 6 shows the sensitivity of becoming a backdater by examining different levels of option compensation. Using the coefficients from the logit estimates in Table 4, we hold all variables constant at their mean levels, except for the compensation variables. We test how the probability of backdating changes by altering the value of these compensation variables. By setting the compensation 12

15 variables at the 25th and 75th% level (i.e. we first rank all the values of option compensation and option PPS, and then we choose the cutoff values of 25% and 75%), we examine how changes in the level of compensation variables affect the probability of backdating. Moving from the 25th to the 75th percentile in director options, the probability of backdating increases from 20% to 31% (a 52% relative change). Similarly, change in director option PPS from 25th percentile to 75th percentile increases the backdating probability from 14% to 20% (a 40% relative change). We find similar results when examining the potential backdaters. To understand how the increase in wealth may drive directors to forgo reputation concerns, we examine the value added to options by backdating. Using the Black-Scholes model, we calculate the value of options with the actual backdated exercise price versus possible exercise price. To estimate the possible exercise price, we use the average quarterly price during the year when the firm was engaged in backdating. By doing so, we have a possible estimate for each quarter. We use the actual vesting period of the options, as reported in the proxy, for the time of the options. We use the average price per quarter for each firm as the stock price for that quarter in the Black- Scholes model. We hand-collect the exercise price for director option grants each year from proxy statements. As Table 7 shows, backdating adds substantial value to the options. For each quarter, the backdated option value is substantially higher than the non-backdated value. This suggests that executives and directors can both gain substantial wealth benefits from backdating. Using the WSJ sample, we find that backdating increases the value of options by as much as 48%. Backdating indeed has significant economic impact. We next examine how shareholders are affected by backdating. Panel A of Table 8 reports the univariate analyses of the abnormal stock returns around the announcements of backdating. Again, we use 146 firms as backdaters. We compute abnormal returns using the market model. We show the abnormal returns around four windows: the day of the announcement, AR[0]; one day prior to one day after the announcement, CAR[-1,1]; two days prior to two days after the announcement, CAR[-2,2]; and three days prior to three days after the announcement, CAR[-3,3]. The mean, median, maximum, and minimum returns are reported. T-statistics and p-value are provided to test whether the abnormal returns are significantly different than 0. Overall, there are negative and significant stock market returns around event windows [-1, 1] and [-2, +2]. It is interesting to note the wide dispersion in returns though, from to 20.76% over the three day window. This dispersion suggests that shareholders react extremely negatively to some backdating announcements, but are not bothered by other companies backdating announcements. To examine whether director compensation helps explain the dispersion, we examine the multivariate analysis of the stock market reactions. 13

16 We run a set of regressions where the dependent variable is the cumulative abnormal returns around the announcement date of the backdating events. The results of the regression results are reported in Panel B of Table 8. The independent variables are the same as those in Table 4. Since there are certain months where the backdating announcements occur more frequently, we include a month/year indicator variable, as well as industry effects. Our goal is to examine whether certain firm characteristics, such as director compensation, are related to how the market reacts to the announcement of backdating behavior. Both the director option compensation and director option sensitivity to stock price changes (i.e., PPS) are significantly and negatively related to stock returns. Outside directors, long tenure, and interlocking boards are also likely to lead to more negative shareholder returns. The more negative returns imply the severity of the backdating problems for those firms with strong director involvement, indicating the distorted director incentives resulting from option compensation. In sum, our results show that director compensation plays an important role in triggering backdating events. Firms award directors with stock options to help align their interests with shareholders interests. However, the possibility of greater gain through option backdating leads to distorted director incentives, resulting in backdating. V Conclusions This paper examines the role of director compensation in the backdating of option grants. Based on a sample of 146 firms that are being investigated for possible backdating activity and a sample of potential backdaters, we find firms that grant their directors more options are more likely to backdate. Moreover, those firms option values are more sensitive to stock price changes compared to the benchmark firms. Consistent with existing papers, we also find that backdating firms have larger boards, fewer independent directors and more interlocked boards. Finally we find that directors backdated options are significantly more valuable than non backdated options. Firms in general experience negative stock market reactions around the announcement of backdating investigations, although there is wide dispersion in the abnormal stock returns. The sensitivity of the director options to stock price changes (PPS) helps to explain some of the dispersion. Companies with higher director PPS experience lower abnormal returns. Likewise, older outside directors with longer tenure and interlocked boards lead to more backdating and lower abnormal returns around the revelation of the backdating behavior. Existing papers on the timing of option grants or backdating do not focus on the role of director stock options as a catalyst for agency issues. Our paper is one of the few papers that examine 14

17 director compensation as a catalyst for agency issues. Given the phenomenon of backdating option grants, director option compensation plays a significant role in triggering such action. Directors with more option grants are more likely to favor the backdating practice. Backdating directly benefits the option recipients. Since director option grants are so significantly related to the backdating event, it suggests that directors obtain personal benefits in the process of option backdating. This questions whether option compensation is effective in aligning the interests with those of shareholders. Implications of our study may also help explain the widespread recent reduction or drop in option grants to corporate directors. 15

18 VI References Aboody, D. and R. Kasznik, 2000, CEO stock option awards and the timing of corporate voluntary disclosures, Journal of Accounting and Economics 29, Bebchuk, L., Y. Grinstein, and U. Peyer, 2007a, Lucky CEOs. Working Paper, NBER. Bebchuk, L., Y. Grinstein, and U. Peyer, 2007b, Lucky Directors. Working Paper, NBER. Bizjak, J., M. Lemmon and R. Whitby, 2006, Option Backdating and Board Interlocks. Working Paper, Portland State University and University of Utah. Brick, I., O. Palmon, and J. Wald, 2006, CEO compensation, director compensation, and firm performance: evidence of cronyism, Journal of Corporate Finance 12, Chauvin, K. and C. Shenoy, 2001, Stock price decreases prior to executive stock option grants, Journal of Corporate Finance 7, Cho, M., 1998, Ownership structure, investment, and the corporate value: an empirical analysis. Journal of Financial Economics 47, Collins, D., G. Gong, and H. Li, 2006, The effect of the Sarbanes-Oxley Act on the timing manipulation of CEO stock option awards. Working Paper, University of Iowa. Core, J. and W. Guay, 1999a, Estimating the value of stock option portfolios and their sensitivities to price and volatility, Journal of Accounting Research 40, Core, J. and W.Guay, 1999b, The use of equity grants to manage optimal equity incentive levels, Journal of Accounting and Economics 28, Frye, M., 2004, Equity-based compensation for employees: firm performance and determinants, The Journal of Financial Research 27, Gaver, J. and K. Gaver, 1993, Additional evidence on the association between the investment opportunity set and corporate financing, dividend and compensation policies, Journal of Accounting and Economics 16, Harford, J., 2003, Takeover bids and target directors incentives: the impact of a bid on directors Wealth and Board Seats, Journal of Financial Economics 69,

19 Harvey, K. and R. Shrieves, 2001, Executive compensation structure and corporate governance choices, The Journal of Financial Research 29, Hermalin, B. and M. Weisbach, 1988, The determinants of board composition, RAND Journal of Economics, Winter 19, Heron, R. and E. Lie, 2007, Does backdating explain the stock price pattern around executive stock option grants? Journal of Financial Economics 83, Lie, E., 2005, On the timing of CEO stock option awards, Management Science 51, Li, K., and N. Prabhala, 2007, Self-selection models in corporate finance, in: Handbook of Corporate Finance: Empirical Corporate Finance Vol. I (Elsevier/North-Holland), ed. B. E. Eckbo, Chapter 2, Kole, S., 1997, The Complexity of Compensation Contracts,Journal of Financial Economics 43, Lippert, R. and W. Moore, 1994, Compensation contracts of Chief Executive Officers: determinants of pay-performance sensitivity, The Journal of Financial Research 18, Morck, R., Shleifer, A., and R. Vishny, 1988, Management ownership and market valuation: an empirical analysis,journal of Financial Economics 20, Narayanan, M. and H. Seyhun, 2006, The dating game: do managers designate option grant dates to increase their compensation? Forthcoming,Review of Financial Studies. Palia, D., 2001, The endogeneity of managerial compensation in firm valuation: a solution,review of Financial Studies 14, Ritter, J., 1991, The long-run performance of Initial Public Offerings, Journal of Finance 46, Ryan, H. Jr. and R. Wiggins III, 2004, Who is in whose pocket? director compensation, bargaining power, and board independence, Journal of Financial Economics73, Teoh, S., Welch, I., and T. Wong, 1998a, Earnings management and the long-run underperformance of seasoned equity offerings, Journal of Financial Economics 50, Teoh, S., Welch, I., and T. Wong, 1998b, earnings management and the long-run underperformance of Initial Public Equity Offerings, Journal of Finance 53, Yermack, D., 1996, Higher market valuation of companies with a small board of directors. Journal of Financial Economics 40,

20 Yermack, D., 1997, Good timing: CEO stock option awards and company news announcements. Journal of Finance 52, Yermack, D., 2004, Remuneration, retention, and reputation incentives for outside directors, Journal of Finance 59,

21 VII Tables Table 1 Descriptive statistics on Backdating Firms Panel A - Backdating Samples by Year Year Potential WSJ Sample Total 2, Panel B - Status of WSJ Sample Total Pre-SOX Post-SOX Number of backdaters SEC investigation DOJ investigation FBI investigation Internal investigation NASDAQ delisting Restatement Any departure 60% 32% 25% Note: Panel A breaks down both of our backdating samples by year. The description of the WSJ and Potential sample are described in the text. Panel B further describes the WSJ sample. We split the sample into firms that stopped the backdating activity before SOX, and that continued after SOX, and we show who is investigating the firms. We report the number of firms delisted from stock exchanges, the number of firms that restated financial statements, and the percentage of firms experiencing director or employee departures due to backdating. 19

22 Table 2 Univariate Comparison of Backdaters versus Non-Backdaters 20 Benchmark WSJ Sample Potential Backdaters Mean Median Mean Median Mean Median Mean Median Mean Median Firm Specific Characteristics MK BK *** *** Assets 9, , , *** *** 7, * * Ret Std *** *** *** *** Board of Directors Composition Bsize *** *** Pct Indep *** *** * * Indep Chair Indep Comp *** *** *** *** Indep Audit * * *** *** Board of Directors Characteristics Indep Tenure * ** *** *** Indep Age *** *** *** *** Interlock *** *** *** *** Board of Director Compensation Options *** *** *** *** Stock Total PPS ** ** *** *** Option PPS *** *** *** *** Stock PPS *** *** *** *** CEO Compensation Salary ** * *** ** Bonus *** *** * ** Options *** *** *** *** Stock *** *** * Total PPS * * * * Option PPS *** *** ** *** Stock PPS * * * * Obs 11, ,898 Note: This table reports the univariate statistics of the three samples in our study; the WSJ sample, the potential backdater sample, and the benchmark sample. MK BK is market-to-book ratio of assets; Assets is the book value of total assets; MV is the market value of the equity; Bsize is the number of directors