It’s been a decade since scores of corporations became embroiled in the “dating game” scandals over backdated CEO stock options, and most people thought that reforms in the aftermath ended the problem years ago.
But a recent paper, coauthored by Robert M. Daines of Stanford University, has unearthed a new and potentially more sinister version of the scheme — call it Dating Game 2.0 — that replaced the original. Daines is the Pritzker Professor of Law and Business at Stanford Law School and a senior faculty member at the Arthur and Toni Rembe Rock Center on Corporate Governance, which is a joint initiative of the law school and Stanford Graduate School of Business.
Under Dating Game 1.0, a company would surreptitiously backdate its grants of stock options to coincide with recent dips in its share price. If the stock had recently climbed from $10 to $12, the company would backdate the stock options so that executives could still get the shares at $10. A CEO who got options to buy 100,000 shares — which was common — could turn around and resell them for an immediate risk-free profit of $200,000.
Revelations about backdating came to light in 2006 and sparked outrage on many fronts. Federal prosecutors filed criminal charges against more than a hundred executives, convicting 12 and sending five to prison. Companies and executives paid out almost $1 billion in fines and civil settlements. William McGuire, a former CEO at UnitedHealth Group, paid $468 million in civil fines and restitution to his company.
Under pressure from regulators, the media, and investor groups, most companies adopted reforms that seemed to stop the game. One key reform: Companies began scheduling their upcoming option grants well in advance and on immovable dates. On top of that, regulators ordered all companies to disclose all of their option grants within two days of when they occurred.
Manipulating Stock Prices
In Dating Game 2.0, however, many top executives appear to be reaping the same kinds of windfalls with a new variant on the original scam. Instead of manipulating the dates of option grants to match a dip in the stock price, companies appear to be manipulating the stock price itself so that it’s low on the predetermined option date and higher right afterward.
“I was surprised, because it sounded too cynical at first,” says Daines, who teamed up with Grant R. McQueen and Robert J. Schonlau at Brigham Young University. “But we tested for all kinds of benign explanations and none of them fit the data. The unusual stock patterns happen so often, and they exactly fit with the self-interest of the CEOs and senior executives. Either the CEOs are incredibly lucky or they are manipulating stock prices.”
Daines and his colleagues found a remarkable telltale V-shaped pattern in stock prices when they analyzed 1,500 companies that granted options. On average, share prices dipped markedly in the 90 days before a grant and quickly began rebounding immediately afterward.
In effect, this pattern allows top executives to buy low and sell high. It’s not quite as risk-free as the original scheme, but it comes close. And it doesn’t appear to be a coincidence. Indeed, the researchers identify several techniques by which companies appear to nudge share prices in the directions they want.
A $100,000 “Round Trip”
Using conservative assumptions, Daines and his colleagues estimate that the new maneuvering provides an average extra payout of just over $100,000 per CEO. That’s above and beyond their salaries and the official value of their options.
In the 90 days before the option grant, the average stock generated what analysts call an “abnormal negative return” of 1.9% — that’s a return 1.9% below those on shares of comparable companies during that same period. In the 90 days after the option grant, however, the average stock generated an abnormal positive return of 1.1%. Overall, the researchers estimate, the “round trip” from the temporary dip through the rebound produced an abnormal positive return of about 2%.
Coincidence? Not likely, says Daines. The V pattern turns out to get stronger at companies where CEOs have both more incentive and more opportunity to manipulate share prices.
The V was deeper, for example, at companies that awarded above-average numbers of stock options and where top executives had more to gain. It was especially deep, however, at companies that were also hard to value and where company announcements and “guidance” could have a big impact on investor expectations. Think here of a fast-growing technology company, where it’s difficult to predict the exact pace of future growth and where the statements of top management can significantly influence investor expectations.
At those companies, the shares had on average abnormal low returns of minus 3.5% before the options were granted and abnormal high returns of 3.4% in the months right after. That’s a huge and timely swing for seemingly random fluctuations.
The Art of the Well-Timed Disclosure
So how did CEOs manage to manipulate stock prices so adroitly?
Daines and his colleagues find evidence of several techniques, many of them tied to when companies decide to disclose important new information. In “bullet-dodging,” a company temporarily depresses its stock price by releasing negative information before the option-grant date. In “spring-loading,” a firm holds back on positive information until after the option date. Sometimes, of course, a company can do both things in the same cycle.
The researchers found concrete evidence for both bullet-dodging and spring-loading in corporate “8-K” disclosures, which companies are required to file when important new developments occur between regular quarterly reports. At companies that issued lots of stock options, the disclosures before an option grant were more likely than not to drive shares down and those that came after an option date were more likely to send prices up. The same pattern showed up with company-issued “guidance” about upcoming earnings and with accounting decisions that effectively shift profits from one quarter to the next. Last but not least, the researchers found evidence that some companies were even massaging actual earnings, such as by increasing R&D costs before an option grant or delaying strategic investments until afterward.
Again, Daines says, it’s hard to see this as a coincidence. If the “bad news” before an option grant is genuine, you would expect the stock to continue to do poorly after the options are awarded. But that isn’t the case. More often than not, the researchers found, the pre-grant bad news was followed by higher returns.
Even Worse Than the “Dating Game”?
“This might actually be worse than the original backdating scandal,” Daines says. “The original scandal was bad because it suggested that executives might be overpaid, but this distorts stock prices for months. This gives executives an incentive to delay good projects, and that’s bad because you typically want to make good investments as soon as you can.”
All of this raises a troubling question: If Dating Game 2.0 stemmed directly from the reforms adopted to stop Dating Game 1.0, is there a real solution?
“One of my takeaways from this is that it’s really hard to get things right in aligning the incentives of executives and shareholders,” Daines says. “We’re getting better and better at it, but it’s easier to complain about problems than to get things right.”