By Dr. Renzo Comolli, Dr. Branko Jovanovic, Dr. Patrick Conroy and Erik Stettler
Misconceptions about Backdating and Probability
In this article, we explain why:
- some patterns of option grants that may appear extremely unlikely are actually very likely;
- the calculations presented in the March 18, 2006 Wall Street Journal article can be misleading; and
- factors that were disregarded in published probability calculations may be especially important when estimating the likelihood of grants for specific companies.
Allegations of Backdating
Allegations of backdating typically involve a claim of practice by which companies look back to past stock prices and record option grants on a date prior to the actual date of the grants— a date in which the stock price was low.
According to these allegations, companies were motivated by two goals. The first goal was to report granting options with a strike price equal to the stock price on the day of the grant— a goal motivated by accounting and taxation rules.1 The second goal was to grant options to provide remuneration to the employees who receive them—one way to increase the value of the options to the employees is to grant them with a strike price lower than the stock price of the day in which the grant is issued.2 In finance parlance, according to the allegation, these companies granted options that were "at the money" on paper, while, in fact, the options were "in the money."3
What the Academics Are Saying About Stock Price Patterns around Grant Dates
Aggregate Patterns
The academic literature so far has focused on aggregate patterns across publicly traded companies, not on individual companies. The academic literature on backdating is designed to detect whether the aggregate pattern of stock price movement close to grant dates is inconsistent with an assumed benchmark, not whether an individual company has engaged in backdating. The benchmark that the academic literature has assumed, sometimes explicitly, sometimes implicitly, is that grants were made on a random day. This benchmark is analogous to saying that the grant date is determined by a process similar to that used to select the winning number in the Powerball lottery or to toss a coin. That is, the company randomly picks from trading days when selecting the day of the option grant, regardless of past prices or expectation of future prices.
Different authors have indeed investigated option grant timing and have found varying results (see table in the appendix for details).
Lie (2005) finds that, in the aggregate, stock prices tend to decline prior to grant dates and increase immediately after grant dates. Lie speculates that the explanation for this price pattern lies in backdating. Other authors who have investigated stock price movements around option grants find results that in part correspond to and are in part at odds with Lie’s findings. These other works propose a different explanation for their findings: insiders manipulate information releases around the grant dates, a practice sometimes referred to as springloading. The academic articles do not, and could not, given the methodologies that they use, find proof of backdating, springloading or similar practices; they find, or claim to find, aggregate price patterns that are consistent with those practices being adopted by at least some companies.
Currently Available Academic Literature on Option Timing Does Not Disentangle Legal from Illegal Practices
Current academic literature uses methodologies that are not designed to determine whether an individual company has engaged in backdating. They are designed to detect aggregate patterns, but do not directly analyze specific companies. To our knowledge, no published academic study has addressed the likelihood of grants of specific companies. As one of the academic authors explains, his analysis "is designed to uncover evidence of retroactive timing in the aggregate, and might be useless in identifying exactly which firms engage in such activities" Lie (2005).
The Probability of Grants
What Is the Benchmark to Determine Whether a Grant Is Likely or Unlikely?
The assumption made by academic articles and popular press that, in the absence of backdating, a company would randomly grant options throughout the year (according to the Powerball method) is problematic. Rather than randomly granting options, companies may be more likely to grant options on days in which they perceive their stock to be undervalued. This could lead to a pattern where the price increases after grants would be better than random even in the absence of backdating. Similarly, one would expect to find a price pattern different from random in cases where a company offers employees a bonus paid in option grants if certain production deadlines are reached and announced to the public. These possibilities apply both to the study of aggregate patterns and to the study of individual companies; we return to this topic on page 6.
Some Patterns of Options Grants That May Appear Very Unlikely Are Actually Very Likely
On March 18, 2006, the Wall Street Journal published an article entitled "The Perfect Payday" singling out seven companies that according to the Journal exhibited "wildly improbable option-grant patterns." Yet some grant patterns that may appear extremely unlikely at first sight are actually very likely and should be expected.
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