Stock Option Manipulation

In my forthcoming Journal of Finance paper The Manipulation of Executive Stock Option Exercise Strategies: Information Timing and Backdating, I identify three common option exercise strategies, and analyze executives’ incentives for manipulating the exercise of options to maximize their payoffs under each strategy.

In the first strategy, executives exercise options and immediately sell the shares to a third party (the “Stock Sale Subsample”). This strategy encompasses about two-thirds of executives’ option exercises. As executives clearly reduce their exposure to their company through these transactions, the incentive is to exercise when future returns are expected to be poor. Consistent with this hypothesis, I find that exercises in the Stock Sale Subsample are followed by abnormal returns of approximately -2% over a 120-day trading period.

The second strategy involves exercising options with cash and holding the acquired shares (the “No Disposition Subsample”). Executives engage in this exercise-and-hold strategy about one-fifth of the time. This strategy is thought to be employed for tax reasons. When executives exercise options, they pay ordinary income taxes on the spread between the exercise price and the stock price, but they pay capital gains taxes on any subsequent appreciation when they eventually dispose of the shares. Given these tax rules, if an executive expects his stock to perform well in the future, he has an incentive to exercise the options and hold the shares instead of holding the unexercised options: in doing so, the executive can minimize the amount that is taxed as income at the time of exercise, and cause the subsequent appreciation to be taxed as capital gains when he sells the shares. Consistent with executives manipulating option exercises to maximize their returns under this strategy, I find that exercises in the No Disposition Subsample are preceded by negative abnormal returns over the 20-day trading period prior to exercise of approximately -1.5%, and are followed by positive abnormal returns over the 20-day trading period after exercise of approximately 3%, which continue to increase to approximately 5% over a 120-day trading window.

The third strategy involves either delivering previously held stock to the company or having some shares withheld to cover the exercise costs (the Company Disposition Subsample). These “stock swap” transactions constitute about one-tenth of executive option exercises. I show that executives benefit from executing stock swap exercises when the stock price is high, but, given that they continue to hold many of the shares, they also benefit from higher future stock prices. The return patterns are consistent with executives manipulating these exercises to maximize their returns. Abnormal returns are approximately -0.5% over the two months following exercise, and turn insignificant but positive thereafter.

My three samples generate much stronger evidence of option exercise manipulation than has been previously discovered. In particular, I find strong evidence that executives timed option exercises relative to private information to enhance the returns from each of the three exercise strategies in both the pre- and post-Sarbanes-Oxley (SOX) periods. In additional tests, I also find considerable evidence that before SOX executives sometimes backdated exercises to correspond with more favorable exercise prices when employing the two exercise strategies where the only counterparty is the executive’s own company (the No Disposition and Company Disposition Subsamples). Finally, I find that companies where executives likely backdated option exercises were also more likely to subsequently report weaknesses in internal controls over financial reporting.

The full paper is available for download here.