Speculating on backdating

We've had a lot of studies now about stock price effects of backdating. Stocks clearly react negatively. The question is why.

I have suggested several times -- e.g., here, here and here -- that the answer could have much more to do with concerns about press coverage and over-criminalization of agency costs than to price inflation due to bad accounting.

So far the data on stock market effects has failed to address why stocks are declining. But today's WSJ has some interesting anecdotes.

For the scores of companies swept up in the options-backdating scandal, repercussions have included financial restatements, regulatory investigations and executive resignations. In what would ordinarily seem like bearish news, however, there may be some buying opportunities. A number of bets have paid off as many stocks have dipped on adverse disclosures about possible backdating, only to bounce back within weeks, days -- or even hours. * * *

Gartmore Small Cap Fund had nearly a 30% return last year partly because it purchased stocks when they fell on backdating news, says Charles Purcell, senior portfolio manager of the $937 million fund. "The underlying businesses were the same, and we were going to get past this eventually," he says. "It's taking advantage of the 'groupthink.' "

About one of his investments, Foundry Networks, which plummeted 10% on backdating news and then went back up, Purcell says, "In hindsight, it looked like free money." Apple fell 2.9% after the initial report of irregularities but was way up not long afterward. The article observes that "investors are recognizing that the degree of wrongdoing -- if there is any -- covers a wide spectrum."

So what is happening? The market may be discounting the likelihood of management turmoil or litigation expense that might occur in the future. Or it may be measuring the reputational loss that the media could end up inflicting. At least some of the latter, as I've written at length in prior posts, is clearly out of proportion to the actual level of wrongdoing.

One possibility is that the market is systematically overestimating the fallout from backdating.  I'm at least a little skeptical of behavioral finance theories (see my Fraud on a Noisy Market). But it's clearly the case that the market is not strong-form efficient minute by minute. The well-known availability heuristic may be working off the media hysteria on backdating. If so, the WSJ article indicates that the market is adjusting as investors see a buying opportunity. In other words, the press may be creating short-term inefficiency rather than performing its ideal role of informing the market.

In any event, I'm glad to see that at least somebody is getting rich off of backdating.

Comments

[K. Williams]

But this is the exact same argument you reject when it comes to the event studies that try to measure how the stock market reacted to Sarbanes-Oxley news.

In Zheng's study, for instance -- the one that produced that $1.4 trillion number people are so fond of tossing about -- three-quarters of that supposed $1.4 trillion loss came in a single week in July (July 18-23). But a week after the market dipped so steeply, it had more than recovered all its losses, so that the S&P was actually higher on July 31 than it had been on July 17. That seems to demonstrate, convincingly, that the market overreacted, and then quickly (much more quickly than it has in the case of backdating) reconsidered. Yet you persist in citing the Zheng study as evidence for the ill effects of Sarbox.

[Larry E. Ribstein]

The Zheng study indicates a real effect of SOX -- and therefore one you couldn't make money off of (unless you had inside information of what Congress was going to do). Of course stock prices fluctuate with real events -- SOX on the downside, economy on the upside. If the backdating prices were press overreaction, you might make money by arbitraging them. And even if the market reacted efficiently, it might be reacting to the excesses of the criminal justice system (just like stocks reacted to SOX) rather than to underlying harm from backdating.

[K. Williams]

The Zheng study did not indicate a real effect. Setting aside her peculiar definition of "event" -- three-quarters of the decline she attributes to SOX came after the law had been passed by both the Senate and the House -- there is no plausible definition of market efficiency that says that the market on July 23 was convinced Sarbox was going to be a $1.4 trillion disaster but on July 31 was convinced it was going to have no impact on equity prices. But that is precisely what Zheng's definition of "real effect" amounts to.

[Larry E. Ribstein]

I don't plan to continue this tiresome discussion about the Zhang study (I think we should at least get the name spelling right), which has been going around in circles for a year now. I would recommend that open-minded readers of these comments look at Zhang's discussion of the assumptions underlying her date selection. As noted in my SOX book (at p. 83) Zhang looks at market moves on three critical days (not just the market on July 23 as you suggest). This date selection is consistent with Romano's detailed political analysis of the act's passage. Other studies look at dates after which the market had almost surely adjusted to SOX and was reacting to other developments.