Option Backdating and Board Interlocks

Abstract

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. 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. Our analysis provides new insight into how boards function and therolethattheyplayinprovidingmanagerialoversightanddeterminingcorporatestrategy. (JEL G30, G32, G38, J33) There is now considerable evidence suggesting that a large number of firms in theUnitedStateshaveengagedinthepracticeofbackdatingstockoptiongrants awarded to their executives. The practice of backdating involves the board of directors “looking back” in time to select favorable dates to grant stock option awards (e.g., when the stock price was at its lowest). By looking back in this manner,firms can make it appear that the option award was granted at an earlier date and at a lower exercise price compared to the actual date the award was approved. Heron and Lie (2006) estimate that 18.9% of unscheduled at-themoney option grants to top executives during the 1996‐2005 period exhibit evidence of backdating or manipulation, with the majority occurring before the implementation of the Sarbanes-Oxley Act (SOX) in August of 2002. 1 At the firm level, they suggest that nearly 30% of firms manipulated option