Backdating and the endowment effect

A press release for an article, Devers, Wiseman and Holmes, The Effects of Endowment and Loss Aversion in Managerial Stock Option Valuation, in the February/March issue of the Academy of Management Journal describes a study in which 94 executives enrolled in an MBA program, mostly full-time managers in for-profit businesses who had received stock options, were asked to value stock options they owned in two different scenarios. One group was told they were entitled to 100 stock options in each of several publicly traded subsidiaries, for which they could accept cash payments. Another group was told they had earned a cash bonus that the board wanted them to convert to stock options in the subs and were asked how many options they required. All participants were given details of firm performance over the relevant period.

Black-Scholes values averaged $25.84. The valuations of the group asked to set a cash price averaged $36.38, while the valuations of the group asked to buy stock options with their bonuses averaged $22.75. So the executives estimated the value of the options they had at 60% more than options they would have to pay for, and substantially more than the actual value under the most widely accepted valuation method.

The press release says:

[The authors] believe that the new findings provide insight into one type of activity that has only recently come to light -- namely, the backdating of executive stock options. Says Wiseman: "A puzzle about backdating is why companies need to resort to it at all: if the idea is to enhance an options grant, why not just dole out more options instead of resorting to the backdating subterfuge? But, if executives are as inclined as our findings suggest to equate their stock options with wealth (even though it may be years before they can be cashed in), then options that are already in the money when granted are likely to have considerably more psychological impact than those which are merely at the money."

Does this sound familiar? Holman Jenkins gave this explanation for backdating last August (see my post), when just about every other business journalist was screeching about executive greed.

So it seems there really were business reasons for the backdating that did not involve overpaying executives. Indeed, the study reported above suggests that companies can use in-the-money options to get away with paying executives less than if they used straight cash.

Yes, there were accounting errors, but were they material? 

Was backdating a signal of general corporate corruption?  Then how explain the Apple phenomenon?

As we get broader and deeper knowledge of backdating, and learn more about the institutional and economic background of backdating, the standard journalist story (other than Holman Jenkins) of greed and thievery gets less obvious. What I think we're going to find when the smoke finally clears is a bunch of routine accounting misstatements, some ruined executive careers and, of course, a Pulitzer Prize.

Comments

[Bruce Brumberg]

This is an interesting study and runs counter to others studies I have read that show executives at companies undervalue stock options. See "Employees' Perceived Value of Their Stock Option Holdings: How Training Affects the Cost-Value Gap" abstract of study at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=906020.

From my own experience with http://www.mystockoptions.com, a provider a web-based educational content and tools on employee stock plans, executives and employees undervalue their stock options. Real world proof of this is that too many options are exercised early in their term when it makes better sense to wait to exercise later in term, assuming stock price appreciation.

In this study above you mention and from my reading of the press release on it, the MBA students/executives were provided with education/training on the value of the stock options. Once that happens, then they see the upside value in the stock options and how their gains increase much greater than the stock price increase. Too few companies provide much education or tools to help employees/executives see the update and thus motivational value of employee stock options or restricted stock.

Also, there is difference between between having the grant already which is "compensation", and being ask to buy the options which takes on the status of an "investment". One idea for granting stock options is to have executives pay something for them, which is not common in the US.

I understand the need for new studies to look for tie to explain backdating, which happened for many reasons and takes on many forms. I am not certain that I see the link here to explaining why backdating happened and why it was allowed to happened. All things being equal, most people would rather have options that are discounted than "at-the-money." The question for me is in how many of these backdating cases did the executives and employees know the grants were "misdated" and know it was in violation of their company's stock plan (plus not properly disclosed/accounted for)?

Bruce Brumberg,Editor
http://www.mystockoptions.co

[Kevin]

There is no question that employee stock options are worth less than the Black-Scholes model indicates. They are subject to numerous conditions (e.g. vesting schedule, exercise limitations, forfeiture upon termination, etc.), all of which are deleterious to their value and none of which are assumed in Black-Scholes. I read a McKinsey study on this a few years ago and they said the options are really worth about half of the Black-Scholes value.

In this light, both the buyers and sellers in the DW&H study materially overestimate their compensation when it takes the form of stock options. You'd think the people supposedly looking out for the good of John Q Shareholder would love this, if you thought they were actually looking out for the good of John Q Shareholder at all.