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Option Backdating and Board Interlocks

By Harvard Law School Program on Corporate Governance

(Editor?s Note: This post comes from John Bizjak of Portland State University, Michael Lemmon of the University of Utah and Hong Kong University of Science and Technology, and Ryan Whitby of Texas Tech University)

In our forthcoming Review of Financial Studies paper Option Backdating and Board Interlocks, we examine the role of board connections in explaining how the controversial practice of backdating employee stock options spread to a large number of firms across a wide range of industries. Given that the practice was not publicly disclosed, it is unlikely that it originated independently in each firm. We focus on the role that director interlocks played in contributing to the spread of backdating since the board of directors has primary authority over the level and structure of executive compensation, including determination of the amount and timing of option grants.

We find strong evidence that board interlocks are related to the spread of backdating. We find that a firm is more likely to begin backdating option grants if the firm has a director who is a board member of another firm that previously backdated its stock options. Our results are both statistically and economically significant. The increase in the likelihood that a firm begins to backdate stock options that can be explained by having a board member who is interlocked to a previously identified backdating firm is approximately one-third of the unconditional probability of backdating in our sample. We also find that a firm is more likely to begin to backdate option awards if directors concurrently receive a stock option grant.

In addition, we identify several other firm and governance characteristics that are associated with the adoption of option backdating. Firms with higher stock-price volatility are more likely to start to backdate options, which is consistent with the fact that higher stock-price variation provides more opportunities to backdate options. A firm is also more likely to begin to backdate, the greater the stock and option holdings of the CEO and when the CEO is younger. Finally, we find that commonalities in firms? auditors and geographic location also help to explain the initiation of backdating. The fact that commonality in auditor choice and geographic location is associated with the initiation of backdating suggests that other linkages between firms beyond those created through board interlocks may also play a role in facilitating the spread of this practice. In contrast to some earlier research, we find little evidence that other measures of the quality of corporate governance, such as institutional ownership, board size, board independence, and whether the CEO is also the chair of the board, are systematically related to the incidence of backdating.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on November 29, 1999 (boomark / email).