Executive Turnover Following Option Backdating Allegations

The following post comes to us from Ed Swanson, Professor and Durst Chair at the Mays Business School at Texas A&M University; Jap Efendi of the Department of Accounting at The University of Texas at Arlington; Rebecca Files of the Naveen Jindal School of Management at The University of Texas at Dallas; and Bo Ouyang of Penn State Great Valley.

In the paper, Executive Turnover Following Option Backdating Allegations, forthcoming in The Accounting Review, we investigate how the Board of Directors and the managerial labor market (two private-sector monitoring mechanisms) respond to an allegation of option backdating. Allegations have been directed at numerous well-known public companies, including Microsoft, Apple, Home Depot, Costco, and United Health. Backdating occurs when executives designate as the grant date a day earlier than the one on which the board actually made the decision to grant options. Managers typically select an earlier date when the market price was lower, so they receive options that are already “in-the-money” on the actual grant date.

Critics attribute backdating to an agency problem in which managers (agents) manipulate the terms of their option awards to increase their compensation at the expense of shareholders and debt holders (principals). Alternatively, a reasonable case can be made that in-the-money options provide strong incentives for managers to implement strategies to improve the firm’s stock price. We provide a comprehensive investigation of how boards respond by examining (1) whether the rate of forced CEO and CFO turnover increases, (2) whether the displaced executives are rehired at comparable positions, and (3) whether executive compensation is restructured to rely less on stock options. We next summarize the results of these tests.

First, we find that forced turnover in the CEO and CFO positions is significantly higher in the aftermath of option backdating than in control firms with similar attributes (determined by propensity-score matching). Forced turnover occurs in 36 percent of the accused firms compared to only 10.6 of the control firms. The turnover rates are similar for CEOs and CFOs, indicating they are held equally accountable. Turnover remains significantly higher but is reduced under two conditions: (1) stock returns are more positive, or (2) the CEO is a firm founder. Turnover is increased when the backdating allegation results in a regulatory investigation or a restatement of the financials.

Second, we discover the CEO and CFO careers are further impaired because executives from backdating firms are significantly less likely to be rehired at comparable positions, relative to displaced counterparts at control firms. To illustrate, about 48 percent of displaced backdating executives are hired as an employee at another public or private firm, compared to 84 percent at control firms. Managers who held the dual position of CEO and board Chair are less likely to obtain a comparable managerial position. Third, we find that compensation at firms alleged to backdate is restructured because the number of options granted to the CEO declines significantly more in backdating firms than in control firms (during the two years following the backdating allegation).

In an extension, we examine turnover for the firm’s General Counsel (GC). The role of the GC in the integrity of reported information has received little attention in prior academic research. Option backdating provides a setting in which the GC’s responsibility is high because a contract is involved. Once again, we find a significantly higher turnover rate at backdating firms than control firms.

The overall evidence shows that, while boards are often viewed as unresponsive to criticisms involving executive compensation, boards did respond quite decisively to option backdating allegations and the accompanying adverse publicity.

The full paper is available for download here.

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