1. Guilty until Proven Innocent: The Economic Consequences of the Initiation and the Outcome of Internal Investigations of Option Backdating Discussion CAPANA Conference July 2010

2. V-shaped Return Pattern

3. Progression of the Literature V-shaped returns pattern around stock option grants (Yermack, 1997) Attributed to timing of stock option grants via opportunistic voluntary disclosures (Aboody and Kasznik, 2000; Chauvin and Shenoy, 2001) Based on sample of “unscheduled” option grants: V-shaped pattern attributed to option backdating (i.e., options granted ex post on a day when price was low) – Lie (2005) and Heron and Lie (2007)

4. Backdating Investigations Firms lost around 8% of market cap over announcement window (Narayanan et al., 2006) Potential benefits to executives were miniscule ($600k per firm) Puzzle: Challenges the agency problems (or managerial opportunism) motivation for backdating Gao and Mahmudi (2008): alternative motivation – efficient contracting hypothesis: –Use subsequent minus prior CARS over a 10-day window around option grants as proxy for backdating. –Find: Better corporate governance associated with more backdating; backdating associated negatively with CEO’s cash compensation and positively with executive pay-performance sensitivity. –Conclude: backdating reduces compensation cost and increases managerial incentives.

5. Li, Elayan and Meyer (2009) Also examines motivations for backdating, using a sample of firms with internal investigations of backdating Proxy = alleged back-dating Examine alternative motivations: managerial opportunism versus economic benefits (employee retention, incentives, and morale)

6. Market Reaction Test Interesting Results: Negative returns on announcement of initiation of investigation More negative for intentional backdating firms (-5.2% versus -1.6%) Announcement of outcome of investigation: –Insignificant return for intentional backdating firms –Significant positive returns for unintentional and no- backdating firms

7. Motivations for Backdating Managerial Opportunism variables: –FV of options to total compensation of top 5 executives –% shares & options owned by top 5 executives Economic Benefits variables (employee retention and morale): –Pay-performance sensitivity (PPS) of option grants –% of options granted to non-executive employees Findings: –Managerial incentives, weak corporate governance, internal control deficiencies, PPS of options, % of options to non- executives associated with higher likelihood of backdating Find support for both managerial opportunism and economic benefits motivations

8. Comments Interpretation of on average results Is managerial opportunism more associated with intentional backdating firms and economic benefits with unintentional or no backdating firms? Useful to examine motivations based on the outcome of the investigation

9. Comments (continued) Univariate results (Table 2) suggest no difference between intentional and unintentional/no backdating firms in relation to variables proxying for either of the two motivations – problematic! Suggestions: –Consider corporate governance and internal control weakness as indirect proxies of managerial opportunism –Improve proxies capturing both motivations – Currently-used proxies may simply be capturing the reward and incentive structures of option-granting firms Refine proxies by estimating “abnormal” measures or industry- adjusted measures (e.g., abnormal option compensation as a % of total compensation, similar to Core and Guay, JAE 1999)

10. Reasons for negative market response to announcement of investigation Variables: –Managerial opportunism variables –Economic benefits variables –Media bias (% of articles on backdating) –Investigation outcome uncertainty (resignation/termination of management, number of lawsuits filed, self-initiated investigation vs. SEC/DOJ initiated, financial leverage Find: No relation between CAR and managerial opportunism and economic benefits variables; weak corporate governance, high outcome uncertainty, and high media coverage associated with more negative CARs.

11. Comments Strong corporate governance associated with higher returns – does not seem like the market is changing its beliefs about firms with strong corporate governance as hypothesized by authors?? Why is the market response not consistent with managerial opportunism and economic benefits motivations? –Univariate analysis (Table 4) suggests that the market has the ability to predict the outcome of the investigation – but outcomes are unable to differentiate motivations (Table 2), hence it is not surprising that motivations do not explain the market reaction! Suggestions: –Need to obtain better proxies capturing managerial opportunism and economic benefits –Include control firms in the market reaction analysis – may be outcomes can better differentiate motivations relative to control firms? –Or, Include control for self-selection of backdating (inverse Mills ratio from first-stage regression?)

12. Additional Comments May be interesting to see what variables drive the market reaction on the investigation outcome announcement?? –Is the return reversal for unintentional/no backdating firms stronger when the initial reaction was caused by media hype? –Is there really a media “bias”? Or, are intentional backdating firms correctly given more negative publicity?

13. Concluding Remarks Interesting paper New insights using investigation outcomes Definitely worth reading

14. Thank You!