Executive Stock Option Exercises: Good Timing or Backdating?

Abstract

Using a large sample of executive stock option exercises by the CEOs of U.S. firms during 1997-2005, I identify three popular exercise mechanisms with different backdating incentives. A cash exercise offers an incentive to exercise at a lower stock price, a stock exercise offers an incentive to exercise at a higher stock price, and a cashless exercise offers little opportunity for backdating. Given the different directions of incentive effects, it becomes critical to separate the three types of option exercises. Empirical results show that for cash exercises the average abnormal stock return is significantly negative before the reported exercise date and significantly positive afterwards. In contrast, stock exercises have the opposite stock return pattern. The market return follows similar but weaker patterns. I estimate that prior to the Sarbanes-Oxley Act (SOX) around one out of eight cash exercises and one out of twenty stock exercises were backdated or otherwise manipulated. Finally, all return patterns become weaker after SOX shortens the reporting period.