New study from Professor Lie on option backdating finds high percentage of price manipulation likely

News Brief
July 17, 2006

By: Cydney Posner

Attached below are copies of materials from Professor Erik Lie of the University of Iowa, whose study of option backdating triggered much of the examination of the option dating practices (or witch hunt, depending on your point of view) that we have seen recently. I've also attached a copy of his just-released second study, to be published inthe Journal of Financial Economics, "What fraction of stock option grants to top executives have been backdated or manipulated?" In the study, Lie and another professor examined the stock price pattern surrounding option grants (i.e., the pattern that companies' stock returns were abnormally high immediately after executive stock option grants and abnormally low in the period leading up to the grants) made before and after August 29, 2002, the effective date of the SEC requirement that Forms 4 report option grants within two business days. His hypothesis was that, if the stock price pattern were attributable to backdating, the price pattern should diminish following implementation of the new regulation. His study did indeed support his hypothesis, finding that the stock price pattern became much less evident once the new regulation became effective. Specifically, the study found that the magnitude of the average abnormal return during the week before the grants is roughly six times larger, and during the period after the grants is roughly five times larger, for the period between 1/1/2000 and 8/28/2002 than for the period between 8/29/2002 and 11/30/2004.

The new analysis looked at unscheduled grants (defined as those that did not occur within one day of the one-year anniversary of the prior year’s grant date) to CEOs at almost 8,000 companies. The new analysis estimated that 23% of unscheduled, at-the-money grants to top executives dated between 1996 and August 2002 were backdated or otherwise manipulated. This fraction was roughly cut in half once the new Form 4 requirement took effect. Furthermore, where grants were reported within one day of the grant date, the study found no discernible abnormal stock return pattern. However, for grants that were reported late, the prevalence of backdating in his study was roughly the same as before August 2002. He also found that some backdating occurs with grants that are timely reported, but the benefit was more modest, given that only a two-day price spread would be implicated. The study also found that the prevalence of backdating was greater among technology companies, small companies and companies with high stock-price volatility. Finally, the study estimates that almost 30% of companies that granted options to top executives between 1996 and 2005 engaged in some form of option price manipulation.

The study recommends that, to eliminate backdating, the Form 4 deadline needs to be accelerated to same-day, or at least next-day reporting. In addition, the SEC must enforce the requirements.