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Shareholder Impact of Option Backdating

By Harvard Law School Program on Corporate Governance

(Editor?s Note: This post comes from Gennaro Bernile at the University of Miami and Gregg Jarrell at the University of Rochester.)

In our paper ?The Impact of the Options Backdating Scandal on Shareholders? which was recently accepted for publication in the Journal of Accounting and Economics, we analyze the excess returns that occurred in short windows surrounding ten distinct news events related to backdating of stock option grants.

Our analysis focuses on 129 firms identified by the Wall Street Journal as implicated in the backdating scandal as of December 31, 2006. We independently identify 764 firm specific backdating-related news events taking place on 580 separate firm-dates. For the first news event (typically the announcement of an internal investigation by the firm), we find a statistically significant excess return of about -4.50% in the -20 to -2 window and -2.40% in the -1 to +1 window. The magnitude of the implied wealth changes seems too large to be attributed to any reasonable estimate of direct out-of-pocket costs of the backdating scandal or to the resulting legal penalties disclosed to date (direct cost hypothesis). Therefore, the alternative hypothesis we propose, which we broadly label Agency Hypothesis, is that a firm?s involvement in the backdating scandal has significant economic implications, despite its limited (direct) impact on cash flows. Under this hypothesis, the losses generated by the option backdating scandal can arise because management?s involvement in backdating practices may prompt investors to reassess the agency costs stemming from the separation of ownership and control.

A series of multivariate show that measures we expect to be related to the effect of the scandal on the value of firms? reputational capital and information risk are significantly related to changes in shareholders? wealth. Conversely, variables one would expect to be related to the magnitude of direct out-of-pocket expenses, namely the number of past grants and/or their value, are not significantly related or are positively related to shareholders? wealth effects, inconsistent with the direct cost hypothesis. In addition, consistent with this interpretation, the occurrence of government investigations or delisting notices have no incremental explanatory power, after controlling for firms? likely culpability. We find that the losses are attenuated when tainted management of less successful firms is more likely to be replaced. We also find that institutional investors reduce their holdings in firms accused of backdating, possibly due to higher monitoring costs, and that firms involved in the scandal are very likely (10% of the sample) to receive arguably fair takeover offers.

Overall, the evidence is consistent with the hypothesis that the loss of investors? confidence in the firm?s management is a first-order determinant of the economic consequences resulting from the option backdating scandal.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on January 15, 2009 (boomark / email).