Backdating Study Gives Lawsuits New Ammo

As regulators, prosecutors, and lawmakers continue their scrutiny of stock option backdating, a new study may offer investors more ammunition as they ramp up legal complaints against companies implicated in the much-maligned practice.

A study by researchers at the University of Michigan concludes that backdating is costing shareholders big bucks for what amounts to relatively paltry gains for executives who receive backdated option grants.

“From a litigation standpoint, this study indicates there’s been [a] significant effect on shareholder value as result of backdating,” says Ken Raskin, head of the executive compensation, benefits, and employment law practice group at law firm White & Case. “It’s further ammunition for lawsuits claiming that the actions taken by whoever is responsible for backdating harmed the company and the share value.”

Using a sample of 48 firms that already have been implicated in backdating, the authors estimate that the revelation of backdating results in an average market value loss to shareholders (adjusted for market movements) of about 8 percent, which translates to about $510 million per firm, during a 21-day window around the first announcement that implicated a company. By contrast, the report says, the average potential gain from backdating, if executives backdated every grant where it would have been profitable to do so, is at most, $600,000 per firm annually.

“It appears that the potential benefit to executives from clandestine backdating is miniscule compared to the potential damage to shareholder[s] at the revelation of this activity,” the study says.

Indeed, recent actions against executives hit with backdating charges underscore the notion that even in cases where the alleged gain from backdating seems large, it is small change compared to the overall sums executives reap. In one of the first criminal cases filed over backdating, prosecutors say former Comverse Technology Chief Executive Officer Jacob Alexander netted a gain of about $6.4 million from backdating schemes. That amounts to about 5 percent of the $138 million profit he realized from sales of stock underlying the exercises of backdated options that were granted from 1991 to 2001.

M. P. Narayanan, one of the study’s authors, says the paper, which is due to be published in the Michigan Law Review next year, is an attempt to “get a sense of the order of magnitude” of the impact of backdating.

Narayanan

“For a small gain to themselves, they’re putting their shareholders at huge risk,” Narayanan says. “They’re also putting their own career at risk. Shareholders might have been better off if the executives just asked for more money.”

Erik Lie, a professor at the University of Iowa widely known for his extensive research on backdating, says he “agrees with the general conclusions that the damage to the market cap of companies exceeds what might be calculated as gains from backdating,” although he stressed that he has not validated the Michigan study’s findings himself.

Lie

Lie says the gains executives reaped will seem even smaller compared with the penalties they’ll have to pay if they’re caught. “This is going to cost companies far more than the executives gained from backdating, even beyond the loss in market cap,” Lie tells Compliance Week. “It’s going to be extremely costly to clean up. [Companies] may end up having to pay accountants, lawyers, shareholders, and bondholders, not to mention the loss of reputation, and some executives might be fired.”

The ‘Trust Issue’

While an apparent gap in shareholder losses and the potential gains to executives is sizeable, observers said they aren’t all that surprised.

“Given the restatements, potential fines legal and other costs of cleaning up this mess, it’s not surprising market participants have reacted by bringing the stock prices of these companies down substantially,” says Patrick McGurn, special counsel for Institutional Shareholder Services. “There’s a fear out there that perhaps the downside here is quite significant.”

EXCERPT

Below is an excerpt from the paper “The Economic Impact of Backdating of Executive Stock Options,” by M.P. Narayanan, Cindy Schipani, and Nejat Seyhun.

[O]ver a 21-day period surrounding the announcement date, the average cumulative abnormal return of the stock of the firms implicated in backdating was about -8 percent. This implies that, adjusted for market movements, the average drop in market capitalizations of these firms was 8 percent up on announcement of investigation by SEC or the Justice Department or acknowledgment of backdating by the company itself. The median drop over the 21-day period was about 7 percent. Thirty-five of the 45 firms in the sample record a negative cumulative abnormal return. Some firms had dramatic cumulative market-adjusted drops: Vitesse Semiconductor dropped 57 percent and Jabil Circuit dropped 31 percent.

Interestingly, most of the stock price drop occurs before the first public disclosure of the backdating accusations. About 5 percentage points of the total 8 percent drop occurs during the nine days prior to the first public disclosure. This finding suggests that some insiders or hedge funds may be receiving word of the likely filing of backdating complaints and either selling or shorting the stock in advance. Intense selling activity is likely to drive the price down as shown in Figure 3.

We also computed the value loss in the market capitalization of these firms. The market capitalization of the firms was measured 11 days before the announcement date, just before the beginning of the measurement period in Figure 3. By multiplying the market capitalization of each firm by its cumulative abnormal return over the 21-day measurement period, we obtain an estimate of the value loss of each firm upon the announcement that it is implicated in backdating. The average market capitalization at the beginning of the measurement period was about $8 billion and the average value loss was about $510 million. Each of the top nine firms sustained a loss of $900 million or more.

How does the value loss from being implicated in backdating compare to the potential benefits from backdating? … The upper bound of the aggregate potential benefit for all firms in our sample from backdating during the 2000-2004 period was $131 million. This figure was obtained by assuming that all grants that benefit from backdating are backdated, and that they are backdated for 90 days. This translates to less than $3 million during this period per firm in our sample, or $0.6 million per year per firm. When compared to the $510 million average loss from being implicated in backdating, the upper bound of the potential benefit of $3 million is negligible (about 0.6 percent of the value loss). It appears that the stockholders are paying a substantial price for managerial indiscretions of rather small benefit to the executives of these firms. If outrage costs are what make executives seek camouflagedcompensation arrangements, with or without the approval of the board, it appears to be a poor trade-off. For a benefit of about $600,000 a year to the executives, shareholders are being put at risk to the tune of $500 million.

Source

Michigan Law Review (August 2006)

McGurn says the market also may be factoring in the “trust issue.” “Investors may be thinking, ‘If we can’t trust the company on this issue, perhaps we can’t trust them on other issues as well.’”

Hunter Wiggins, a former SEC enforcement attorney and now a partner at the law firm Sonnenschein Nath & Rosnethal, agrees. While he says averages “can be useful” for academic purposes, “they probably don’t reflect how egregious the behavior was at some firms, and how innocuous the behavior was at others,” he says.

Observers also note that the Michigan study only examined options granted at the executive and director level, which are disclosed in Form 4 filings. It did not look at options granted to lower-level employees, since that information isn’t accessible.

“They’re not capturing backdating that occurred at lower levels,” Lie says. “A lot of the big money is there. These numbers might be larger than the findings suggest.”

Tyukody

Daniel Tyukody, a partner at the law firm Orrick Herrington & Sutcliffe, agrees. “In some cases I’ve seen, executives on a per capita basis got more than the average rank and file employee, but if you aggregated the rank and file employees as a group, they’re getting more shares than the executives,” which could impact the results, he says.

Narayanan, however, says that even if lower level employees received backdated options, the gains wouldn’t be much larger. “It probably wouldn’t go up by more than $100,000 or $200,000, since those employees don’t get options grants as large as the executives,” he says.

Wiggins also warned of another ominous trend: a tendency for a company’s stock price to drop before the first public disclosure of backdating accusations. The Michigan study noted that overall, a company’s stock price tended to fall about 8 percent around the time backdating came to light—but 5 percentage points of that tumble happened during the nine days prior to announcing the news.

The study concludes that “this finding suggests that some insiders or hedge funds may be receiving word of the likely filing of backdating complaints and either selling or shorting the stock in advance,” although Narayanan cautions that the research “isn’t exhaustive enough” to make firm conclusions on that point.

Still, Wiggins says it may encourage plaintiffs’ attorneys, who usually estimate their damages by using a date immediately prior to the disclosure of bad news, to look back another preceding week or two to see whether insider trading was afoot.

Wiggins

“If a huge stock price drop occurred before the public disclosure date, plaintiffs’ attorneys might try to use date earlier than the traditional date immediately before the public disclosure,” he says. “They won’t want to leave 75 percent of the damages on the table.”

Wiggins says backdating is just one of “several compensation issues coming out over [the] next couple of years … People should now realize when they see a problem touches [on] issues of executive compensation, that where there’s smoke, there tends to be fire,” he says.

Raskin at White & Case agrees. “I don’t think we’re by any means done with any of this,” he says. “I think we’ll continue to see more companies announcing internal investigations or investigations by authorities, more companies being sued in class action suits, and more enforcement actions by the SEC and DoJ.”