Friday, December 15, 2006
Posted by Jeff Lipshaw
I have harped on the need for empirical data rather than political hyperbole on the prevalence of option backdating. The Harvard Program on Corporate Governance, operating within the John M. Olin Center for Law, Economics, and Business has announced a new paper on the subject, entitled "Lucky CEOs" (which is posted on SSRN), authored by Lucian Bebchuk, Yaniv Grinstein, and Urs Peyer. Here is the abstract, after which I have some commentary:
We study the relation between corporate governance and opportunistic option grant manipulation. Our methodology for studying grant manipulation focuses on how grant date prices rank within the price distribution of the grant month. Investigating the incidence of "lucky grants" -- defined as grants given at the lowest price of the month – we estimate that about 1150 lucky grants resulted from manipulation and that 12% of firms provided one or more lucky grant due to manipulation during the period 1996-2005. Examining the circumstances and consequences of lucky grants we find:
- Lucky grants were more likely when the company did not have a majority of independent directors on the board and/or the CEO had longer tenure -- factors that are both associated with increased influence of the CEO on pay-setting and board decision-making.
- Lucky grants were more likely to occur when the potential payoffs from such luck were high; indeed, even for the same CEO, grants were more likely to be lucky when granted in months in which the potential payoffs from manipulation were relatively higher.
- Luck was persistent: a CEO's chance of getting a lucky grant increases when a preceding grant was lucky as well.
- In contrast to impressions produced by cases coming under scrutiny thus far, grant manipulation has not been primarily concentrated in new economy firms but rather has been widespread throughout the economy, with a significant incidence of manipulation in each of the economy's 12 (Fama-French) industries.
- We find no evidence that gains from manipulated option grants served as a substitute for compensation paid through other sources; indeed, total reported compensation from such sources in firms providing lucky grants was higher.
- We estimate the average gain to CEOs from grants that were backdated to the lowest price of the month to exceed 20% of the reported value of the grant and to increase the CEO's total reported compensation for the year by more than 10%.
- About 1,000 (43%) of the lucky grants were "super-lucky," having been given at the lowest price not only of the month but also of the quarter, and we estimate that about 62% of them were manipulated.
- We identify certain pools of grants with an especially high probability of manipulation. For example, we identify a pool of 600 grants out of which 88% are estimated to be manipulated.
Larry Ribstein has already commented on the article, thus providing an initial reaction at the other end of the ideologicaI continuum (Professor Bebchuk's shareholder activism being a matter of public record). Being the wishy-washy and anal type I am, I have a slightly different take.
If you look at the body of the article, the great value here is that the authors had access to the entire database of options granted by public companies from Thomson Financial's insider trading data base from 1996 to 2005, which in turn is based on all of the Forms 3, 4, 5 and 144 filed with the SEC. And I am not in a position to argue, at this point, with the authors' statistical work. I am, however, still trying to figure how, if at all, this data speaks to the prevalence of manipulation, even if we take the statistics as correct.
The reason for my hesitance goes back to the creation of the sample set, and the assumptions for inclusion and exclusion of certain grants.
1. "The universe of grants we study contains all at-the-money unscheduled grants awarded to public companies' CEOs during the decade of 1996-2005." (Bebchuk, et al., p. 2) Almost by definition, an unscheduled grant in the corporate world is manipulated; I'm surprised so few were lucky! That is, we are studying now a sample set of manipulated grants, trying to find the super-manipulated grants (and super-super-manipulated grants). What I cannot tell from the data present is what percentage of all grants, either to CEOs, or to all insiders were unscheduled versus scheduled.
2. In my experience, the reason for unscheduled grants would be hiring. Again, while the CEO had the authority to grant options in small number for lower level hires, more senior executives, including the CEO, would require board or compensation committee approval for the grants. So an unscheduled grant would still correlate, generally, to a board meeting. I cannot tell from the data how many of these quasi-scheduled grants were included in the sample set. Indeed, I cannot tell how many of the grants were those given on the CEO's initial hiring.
3. "From this sample we eliminate grants that are scheduled, which might be less likely to have been manipulated. A grant is defined as a scheduled grant if the CEO received the grant on the same date plus/minus one day in the preceding years." (p. 10.) My experience (and intuition) is that scheduled grants are based on board meeting or compensation committee meeting scheduling, and not calendar scheduling. At Great Lakes Chemical and AlliedSignal/Honeywell, where I worked (and I suspect GE and other companies), options, including those to the CEO, were regularly considered, granted, and dated as of a board meeting held some time after the first of the year. I have not gone back to study whether board meeting dates could meet the Bebchuk definition of "scheduled," but in fairness, the sample, in my mind, is flawed, if it counts these as "unscheduled."
Good start. But, as they say, needs work.