Researching a Scandal
Associate Professor of Finance
Randall Heron, associate professor of finance at Indiana University's Kelley School of Business in Indianapolis, certainly wasn't expecting fame when he and a friend and colleague from the University of Iowa started looking into the way companies file regulatory reports about stock options granted to executives. After all, it's a subject that affects only a select group of people, and much of the rest of the population probably isn't even certain what a stock option is.
But headlines are what Heron and Iowa colleague Erik Lie generated in late 2005, when government regulators and the business world began paying a lot of attention to a practice known as stock-option backdating—manipulating the dates on certain corporate filings in a way that could potentially mislead shareholders and regulators (see sidebar, page 32). Suddenly, the researchers were named in the pages of The Wall Street Journal, then BusinessWeek, Fortune, U.S. News & World Report, and The Economist. They made television appearances and provided testimony on Capitol Hill. And executives at scores of companies across America began to be concerned about their jobs.
Something's Fishy
Backdating stock options may sound like a technicality of little interest to the average stockholder, and it is true that in most cases the practice isn't likely to have a major, lasting impact on the value of an investor's 401(k) or mutual fund. In some cases, however, backdating may have caused the company's accounting to be inaccurate, and when companies are forced to revise or restate their figures, it can have a negative impact on the stock price. In any case, investors like to know that a company's financial statements are above board, and any hint of potential impropriety can give Wall Street the jitters.
Scrutiny of stock options and the way they are reported actually began several years ago, when New York University Professor David Yermack spotted and documented an odd-seeming trend.
"David Yermack wrote a paper that showed that after options were granted, stock prices went up an atypical amount," Heron recalls. Stock options aren't worth a dime if the company's stock price doesn't rise after the grant is made, but Yermack's research indicated that in many cases the stock prices were rising more than one would expect.
Those following the puzzle at the time speculated that some companies were "springloading" the grants, Heron says. Under that theory, he explains, board members would award the stock options to executives knowing that the company's stock price would very soon be rising due to an upcoming development or announcement.
Lie, with whom Heron went to graduate school at Purdue University, started looking into the practice as well. He generated evidence showing that in many of these cases, not only did the stock appreciate an unusual amount after stock options were granted, it also declined an unusual amount just before. To the standard explanation of "springloading" was added another theory, Heron says: Companies were "potentially manipulating the flow of information, only releasing negative news items before, then afterward coming out and putting on their happy face and saying good things."
Plot the phenomenon on a stock price chart and the impact is visually clear: There's a distinct valley that forms, with the price significantly declining just prior to the time of the stock-option grant, then turning sharply upward. What's more, Heron says, "this stock price pattern started getting larger and larger around these grants. Over time this was getting to be a bigger and bigger phenomenon."
That gave rise to a completely different theory. What if companies were backdating their stock-option grants? What if they were using the benefit of hindsight, looking back over the stock price charts and intentionally picking grant prices right at the bottom of significant stock price valleys, and recording those dates as the grant dates? Such a practice was possible, they surmised, because companies could wait until after the end of the fiscal year before reporting their option grants. That allowed lots of time to look back and pick the best valleys for lucrative stock-option grants.
Heron and Lie joined forces on a new study that aimed to test that hypothesis. They had the benefit of a recent regulatory change mandated by the Sarbanes-Oxley Act of 2002, which had been passed following a myriad of corporate scandals with the aim of tightening corporate-governance requirements and achieving greater accountability.
