Abstract
We examine whether revealing misreporting affects the careers of executives and independent directors. To isolate the effects of revealing misreporting from the underlying malfeasance, we analyze executives and directors who joined firms after stock option backdating ceased, but who were in place to determine how the firm would respond to the unfolding backdating crisis. Overall, these new executives and directors faced career penalties at firms that issued a backdating restatement relative to those at firms that remained silent despite strong evidence of backdating having occurred. We conduct a variety of tests to rule out alternative explanations, and conclude that new executives and directors face career penalties after firms reveal misreporting.
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Notes
For example, studies examine consequences to executives and directors associated with firms that restate (Arthaud-Day et al. 2006; Cheng and Farber 2008; Desai et al. 2006; Hennes et al. 2008; Leone and Liu 2010) and consequences to firms that restate (Badertscher et al. 2011; Palmrose and Scholz 2004; Palmrose et al. 2004; Files et al. 2009).
The SEC reiterated that material errors from backdating require restatements. See http://www.sec.gov/info/accountants/staffletters/fei_aicpa091906.htm (accessed August 2017).
Monster issued the backdated option grants from 1997 through March 31, 2003. See the 2005 10-K issued on December 13, 2006.
Baker became CFO of ZipRealty in December 2008. He earned over $2 million in 2006 and 2007 with Monster, but only $425,843 and $445,885 with ZipRealty in 2008 and 2009. His earnings at would not return to 2007 levels until he became CFO of Yelp.com more than a decade later (2018), when he earned $3.3 million. Further, press reports speculated that backdating played a role and noted “the management shake-up comes after Monster filed restated financials in December to include charges related to an investigation into its stock-option granting” (Associated Press 2007).
Studies (Bereskin and Smith 2014; Ertimur et al. 2012) do not find higher turnover rates among new directors. The difference is attributable to the identification of backdating firms. Studies examine all firms implicated in backdating, such as those facing SEC investigations. As noted in section 4, if we include all firms implicated in backdating, we no longer find a statistically higher rate of turnover among new independent directors.
In particular, we examine 1) the language of the press release, 2) the age of the executive, 3) how long it took the executive to obtain subsequent employment, and 4) whether the subsequent position and salary is comparable forced turnover, similar to prior studies (Efendi et al. 2013; Huson et al. 2001).
See SEC release number 34–87457 “Amendments to Exemptions from the Proxy Rules for Proxy Voting Advice” issued on November 5, 2019.
For example, in 2003, an executive director sued ISS alleging that statements in a report were defamatory when ISS sided against him in a contested director election (Vitale v. ISS, 8:03-cv-01737-PMJ, Dist. of Maryland, July 12, 2003.) More recently, former SEC commissioner Paul Atkins, who served during the post-period of our study, encouraged firms to challenge adverse ISS recommendations through litigation when based on incorrect information (Orol 2014).
See https://www.issgovernance.com/about/about-iss/#1570776311994-db534a1e-7bb2 (accessed January 2020).
Dou (2017) demonstrates that directors who leave immediately after a negative event (such as those in our sample) are often most accountable. Therefore, director departures captured in our sample are less likely to be voluntarily initiated by a non-involved party than the typical director departure.
We focus on independent directors, as they played an important role in determining how the firm would respond to inferences of backdating. New regulations gave independent directors a stronger voice in corporate governance just as the backdating scandal began unfolding. The Sarbanes Oxley Act of 2002 requires that all members of the audit committee be independent, and the NYSE and Nasdaq adopted new rules requiring that a majority of directors on the board be independent.
Audit Analytics categorizes three types of restatements related to stock options: “deferred, stock-based options backdating only,” “deferred, stock-based and/or executive comp issues,” and “deferred, stock-based SFAS 123 only.” We reviewed the disclosures of all three types issued between November 2005 and December 2007 and included them in our sample if the description suggested evidence of backdating (as opposed to other issues, such as incorrectly estimating the Black-Scholes model). We also reviewed any restatements in the Glass Lewis list that were not captured by this search and include them if they indicate that the firm backdated.
For example, Efendi et al. (2013) find 141 backdating firms, Ertimur et al. (2012) find 186, and Bernile and Jarrell (2009) find 129. Our study differs in that we capture only firms that restated as opposed to disclosing an investigation or admitting to nonmaterial backdating, and we impose additional data restrictions. Our sample would include 171 backdating firms if we were to eliminate these data restrictions and use a more inclusive definition of backdating, consistent with these studies.
Although the rule change took effect in August, we remove all directors who joined the board in 2002, as the proxy statement often documents the year the director joined and not the specific date.
See ISS’s website: https://www.issgovernance.com/about/about-iss/#1570776311994-db534a1e-7bb2 (accessed January 2020).
November 2005 was the publication date of the first article in The Wall Street Journal (also covered by other mainstream publication outlets such as CFO.com) documenting the backdating scandal. Arguably, the more famous Wall Street Journal article (“Perfect Payday”) triggered the backdating scandal four months later in March 2006 (Forelle and Bandler 2006). However, we chose the earlier date to capture any penalties that might be attributable to backdating. See Appendix 1 for a timeline.
To ensure that our methodology for identifying forced turnover is consistent with prior research, we obtained executive turnover data from one of the authors of Efendi et al. (2013) and compared our assessment with theirs. Our assessment was the same for 30 of the 37 CEOs and 33 of the 44 CFOs who overlapped both samples. Of the seven CEO differences, two were attributable to the fact that we identify turnover over a longer horizon. Of the remaining five differences, two weakened the inferences we draw (i.e., we do not identify restating executives as having forced turned over, whereas Efendi et al. (2013) do). Of the eleven CFO differences, eight were attributable to a different horizon, and all three remaining differences weakened the inferences we draw.
Alternatively, we could include the backdating likelihood and materiality ratio in the propensity-matching model. However, we find that the coefficient on backdating likelihood variable in this model is statistically significant but negative. Therefore, including this variable biases the model toward selecting matching firms that are less likely to have backdated. Further, the materiality ratio in this model is not statistically significant. If we do not limit suspect firms to those with a higher materiality ratio, we find that the materiality ratio of the matched suspect firms is much lower than that of the restating firms.
This is likely because restating firms are the most serious cases of backdating, whereas the backdating sample of Ertimur et al. (2012) includes all firms associated with backdating.
Ertimur et al. (2012) and Bereskin and Smith (2014) do not find a statistically higher rate of turnover among new directors at firms implicated in backdating. The difference is attributable to the fact that we examine the most serious cases of backdating (involving a restatement), whereas these studies examine all firms implicated in backdating, and because our control sample includes suspect firms. In untabulated results, if we estimate Eq. 2 and examine all firms implicated in backdating, we find that the coefficient on the implicated indicator is 5.91 but not statistically significant (T-stat = 1.62).
The turnover (forced turnover) rates for CEOs reported by Efendi et al. (2013) for backdating and control firms are 29.8% (24.1%) and 6.4% (5.0%) respectively. The same rates for the CFO sample are 34.8% (24.8%) and 19.9% (7.8%).
The forced turnover rate of new CEOs at restatement firms resembles the rates reported by Efendi et al. (2013) of backdating firms (24.1%), although they do not examine new executives separately.
In particular, Efendi et al. (2013) find a 22.2% decline in the proportion of CEO compensation consisting of option grants post backdating and a 0.1% decline in the change in the number of grants issued to backdating CEOs. The first result is higher than our estimate of 8.9%, perhaps attributable to a different sample composition, while the second result is the same.
This window length approximates the 45 calendar days allotted to firms to file the Form 4 with the SEC after granting stock options. Further, while some firms did issue backdating restatements for periods beyond this date, Heron and Lie (2007) show that option returns patterns indicative of backdating dramatically declined after August 2002.
Even minor backdating errors could be seen as material because they indicate “particularly egregious circumstances such as self-dealing or misappropriation by management,” which are material, regardless of error size (ASC 250–10-S99). Consistent with this, Bernile and Jarrell (2009) document significant abnormal negative returns upon the announcement of backdating.
We test alternative thresholds for the likelihood of backdating (90% and 99%) and materiality (10% and 15% of net income) and find very similar results.
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Acknowledgments
We thank several anonymous independent directors and SEC personnel, Bill Baber, Dirk Black, Matt Cain, Liz Demers, Yonca Ertimur (discussant), Rich Evans, Marc Lipson, Elena Loutskina, Luann Lynch, Pedro Matos, Scott Taub and workshop participants at the Utah Winter Accounting Conference, the 2017 University of North Carolina PhD Symposium, the 2017 Darden Accounting Winter Camp, the Mason School of Business at the College of William and Mary, the Robert H. Smith School of Business at the University of Maryland, the McDonough School of Business at Georgetown University, and the Securities and Exchange Commission for helpful comments. We especially thank the authors of Efendi et al. (2013) for graciously providing data on forced executive turnover, and the Darden Graduate School of Business and the Law School at the University of Virginia, which provided research support. All errors are our own.
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Appendices
Appendix 1
Timeline of Events (Not Drawn to Scale)
Appendix 2: Methodology for identifying suspect backdating firms
To determine the likelihood that a particular option grant was backdated, we compute the return on the underlying stock in the 20 trading days before and after the grant and estimate the return “reversal” as the post-grant change in price minus the pre-grant change.Footnote 25 For each firm, we compute the firm’s decile of monthly stock price volatility, relative to the sample, and compute the reversal for 1000,000 hypothetical grant dates of a firm in the same volatility decile by randomly drawing from the CRSP Daily Stock Price database over the same period as our sample of option grants. We match the grant to the randomly generated sample of hypothetical grant dates with the same volatility decile and compute the proportion of hypothetical grants with lower reversal. This gives a volatility-controlled estimate of the likelihood that a grant on a randomly chosen date would have reversal at least as large as the observed reversal of the grant.
We then compute a firm-year estimate of the likelihood of having backdated by aggregating the grant-level estimates to the firm-year level. This aggregation is important, given variation in grants across firms. We select the grant with the highest probability of backdating and correct for the family-wise error rate, which accounts for the fact that firms issuing many grants are more likely to randomly issue one with a high probability of backdating (Sidak 1967). To do so, we calculate the firm likelihood of backdating as follows.
where FirmYearProb is the firm-year probability of backdating, GrantProb is the highest grant-level probability the firm issued during any year as estimated as described above, and NGrants are the number of grants issued by the firm for that year. While other estimates are possible (such as aggregating the firm-level estimate across all grants with a high probability of backdating), this is a conservative estimate, as it only accounts for the grant with the highest probability and assumes the rest are not backdated. We identify a firm to be suspect backdating if the firm-level probability exceeds 95% in any year.
In addition to estimating the likelihood of backdating, we also account for the materiality of the backdating in our tests to capture a sample of firms that appear to be the most egregious backdaters.Footnote 26 Consistent with practitioner discussions (Vorhies 2005) and empirical evidence on restatement thresholds (Acito et al. 2009), we consider a grant to be materially backdated if the difference between the strike price on the grant date and the strike price on our estimated measurement date multiplied by the number of grants exceeds 5% of annual income.
To operationalize this measure, we compare the stock price on the date the grant was issued with the median stock price over a 60 calendar-day window centered on the grant date. The difference between these stock prices reflects the compensation expense the firm should have recognized over the vesting period for one grant if the stock price on the actual measurement date were the median price over the window. We then multiply this by the number of grants issued and compare it to the benchmark threshold of 5% of yearly income less special items or non-operating items, following Vorhies (2005) and consistent with the finding that net income is the appropriate materiality benchmark. If the expense exceeds the threshold, we identify the grant as material. We create a ratio of yearly materiality (aggregating the materiality of all backdated grants) scaled by annual income less special items or non-operating items and select the highest value to use as a control in firm-level regressions.Footnote 27
To ensure that our results do not depend on this method of identifying suspect backdating firms, we also follow Bebchuk et al. (2010) and identify backdating firms using a more easily implementable measure: whether firms issued a grant at the lowest price of the month. Results are consistent with prior tests. New directors at firms that issued grants in this fashion (but did not restate) faced lower penalties than new directors at restating firms.
While this methodology captures the essence of the possible error’s size, relative to the firm’s operations, it is subject to the following three limitations. First, this method assumes the median stock price over the 60-day window reflects the stock price on the measurement date. Our estimation of materiality will vary from the actual error to the degree that these prices diverge. Second, we do not account for the income tax effects, although these are likely immaterial. Bernile and Jarrell (2009) examine backdating restatements and find that one-third report higher taxes, while the median restatement reduced taxes by a negligible amount (0.09% of market value). Third, APB 25 requires amortizing the expense over the vesting period, while our methodology compares the expense to one year of income. We do so because, although the accounting errors arose upon the issuance of the grants from 1996 to 2002, the errors were not disclosed until the 2005–2007 period. Thus, the magnitude of the error to incorporate into the current period financials would have reflected the aggregate amount of the error that should have already been expensed over the entire period between the grant date and the current period (Table 8).
Appendix 3
Appendix 4: Illustration of ISS withholding recommendation
To illustrate why ISS recommended withholding votes against new directors, note the case of Thomas Golonski and Richard Crouch, who ran for election as directors of Black Box Corporation in 2007.
In providing a recommendation for this election, ISS explained its policy of evaluating companies involved in backdating as follows.
In cases where a company has practiced options backdating or is facing backdating allegations, ISS may recommend shareholders withhold votes from the Compensation Committee members who oversaw the questionable options grant practices or from current compensation committee members who fail to respond to the issue proactively. In determining our vote recommendation, ISS will analyze, on a case-by-case basis, the severity of the practices and the subsequent corrective actions taken by the company. Our analysis will be based on several factors, including, but not limited to: (i) Reason and motive for the options backdating issue, such as inadvertent vs. deliberate grant date changes; (ii) Length of time of options backdating; (iii) Size of restatement or adjustment due to options backdating; (iv) Corrective actions taken by the board or compensation committee, such as canceling or repricing backdated options, or recoupment of option gains on backdated grants; and (v) Adoption of a grant policy that prohibits backdating, and creation of a fixed grant schedule or window period for equity grants going forward (Institutional Shareholder Services 2007, p. 11).
ISS also noted that the board took a variety of corrective measures.
With regard to corrective actions taken by the board, we note that Messrs. Andrews, Golonski, McAndrew, and Greig agreed voluntarily to reprice their outstanding misdated options. Additionally, the company's former CEO's outstanding options were cancelled upon his resignation. However, there have been no broad-based repricing, cancellation, or recoupment initiatives instituted by the board. The company discloses that it has implemented additional procedures to the process for approving stock option grants that are focused on formalized documentation of appropriate approvals and determination of grant terms to employees and directors. However, the actual procedures have not been specified in the company's public disclosures. It is unclear if the new procedures provide for a fixed grant schedule, window period for future grants, or express prohibition of backdating (page 11).
Finally, ISS noted that Thomas Golonski had been a member of the board since 2003 and Richard Crouch since 2004. ISS also noted “the most egregious [backdating] period was from 1994 to 2001,” indicating that neither Golonski nor Crouch were present during that time. ISS pointed out that other directors (Andrews and Greig) “were both members of the compensation committee during the most egregious backdating period” (page 12). Despite the actions the board took and the fact that Golonski and Crouch were not present when the egregious backdating occurred, ISS recommended against voting for Golonski and Crouch for “failure to adequately remediate the option grant issues at the company” (page 12). Perhaps as a result of this recommendation, the votes withheld for Golonski and Crouch rose 20% from the prior election.
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Curtis, Q.D., Hopkins, J.J. Career concerns for revealing misreporting. Rev Account Stud 27, 1–34 (2022). https://doi.org/10.1007/s11142-021-09599-4
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DOI: https://doi.org/10.1007/s11142-021-09599-4
Keywords
- Corporate governance
- Executive turnover
- Board of directors
- Director labor market
- Shareholder voting
- Financial restatements