Taxes and the Backdating of Stock Option Exercise Dates

In our paper “Taxes and the Backdating of Stock Option Exercise Dates”, which was recently accepted for publication at the Journal of Accounting and Economics, we investigate the opportunistic timing of stock option exercises by insiders. We focus on a group of exercises where there likely exists both the incentive and the ability to backdate an option exercise: exercises paid in cash where the insider holds the acquired shares. Once the decision to exercise is made, insiders who plan to hold the acquired shares have an unambiguous personal tax-based incentive to exercise on the day with the lowest possible stock price. Unlike exercises in which the acquired shares are sold immediately through a broker, these exercise-and-hold transactions are often accomplished in-house. Thus, we expect that opportunistic backdating, to the extent it exists, is more likely to occur in exercise-and-hold transactions. We find that exercise-and-hold transactions tend to occur at monthly stock price lows. Before SOX, we find that 13.55% of exercise-and-hold transactions by CEOs occurred on the day the stock was at its lowest price during the month (i.e. suspect exercises). After SOX, only 7.20% of CEO exercise-and-hold transactions occurred on that day.

Consistent with the prediction that backdating an exercise-and-hold transaction is driven by personal tax considerations, we find that the likelihood of a suspect exercise is increasing in the potential taxes saved by the option holder from exercising on the day of the month with the lowest closing price before SOX, but not after SOX. Finally, suspect exercises are more likely in small firms. While this finding is consistent with the conclusion that backdated exercises are more likely when the firm has a relatively weaker internal control environment we also find that the probability of a suspect exercise is not consistently related to common proxies for corporate governance based on the subsample of observations with available governance data.

We estimate that our sample of CEOs saved an average of $96 thousand in taxes per exercise by exercising on the day of the month with the lowest closing stock price. These tax savings make up only about 3.2% of the total value of the options exercised, and are even smaller at the median. Given that filing a false tax return can be a felony, can result in individual level penalties in excess of $100 thousand (among other costs), and can have significant adverse consequences for the firm and shareholders, the tax savings realized by CEOs through suspect option exercises seem remarkably modest. One likely explanation is that insiders believed the probability of getting caught was low enough to justify the risk. We also find that the firm’s foregone tax benefits from suspect exercises are of similar magnitude to the taxes saved by the CEO.

Finally, we find that suspect exercise-and-hold transactions are more likely in firms with a higher likelihood of stock option grant backdating. For the sample of exercise-and-hold transactions by insiders of firms under scrutiny for option grant backdating as listed in the Wall Street Journal’s “Options Scorecard”, we find that 21.53% of exercises by CEOs and 18.41% of exercises by non-CEOs occurred on the day the stock was at its lowest price during the month. That is, insiders from firms with alleged grant backdating practices were more likely to have a suspect exercise than other insiders. We also find that the firm-specific odds of option grant backdating are positively associated with the frequency of suspect exercises among firms not mentioned in the Wall Street Journal’s list. Together with the remainder of this study, our analysis provides additional evidence on the magnitude and determinants of opportunistic behavior associated with executive stock options.

The full paper is available for download here.