The effectiveness of existing corporate governance mechanisms in disciplining board directors previously involved in stock option backdating has been questioned, typically by regulators. But increased board turnover related to the rising number of directors resigning or not being renominated following the disclosure of their involvement in backdating practices indicates that the mechanisms are working.
The authors assert that shareholders do not wait for the next election of the board to replace directors who have endorsed the backdating of stock options granted to themselves or to other executives. Specifically, significant board turnover takes place much earlier—namely, shortly after the disclosure—and proves to be as severe as the degree of direct involvement of board directors in such malpractice. As a result, regulatory reforms introduced to replace incumbent directors with new board nominees at the late stage of shareholder elections will likely have little success in empowering board governance processes.
How Is This Research Useful to Practitioners?
In terms of evaluating shareholder power in the context of cases of option backdating, the authors come up with four conclusions. First, disclosure of backdating leads to increased board turnover, which is predominantly a result of the resignation of the involved directors or their failure to be renominated rather than being voted down by shareholders. Second, inside directors usually leave the company as a result of enforced resignation, whereas independent directors are simply not renominated at the end of their tenure. Third, the larger the amount of the accounting restatement in the aftermath of the backdating and the more involved the director is in the compensation committee, the higher the probability of losing his or her seat on the board following the revelation of the backdating. Fourth, in the corporate executive market, directors who were more associated with backdating end up with fewer directorships two years after the disclosure, whereas any new directorships acquired are at less prestigious companies that are smaller in size, revenue, and total compensation allotted for outside directors.
From an investor’s perspective, it is reasonable to expect that, all things being equal, a company that backdated stock options is significantly less attractive than another company that did not. Event studies have shown significant negative returns for company stocks immediately following the disclosure of backdating. For this reason, investment professionals should conduct a “background check” on companies to identify those that are prone to such corporate misconduct.
According to the authors, companies that are more likely to engage in backdating are characterized by weak corporate governance systems that fail to preemptively deter their directors from backdating stock options. Their view is that effectively disciplining directors engaged in backdating can be enforced by shareholders or by the wider competitive market of directorships. Discipline should be sufficient to discourage directors from such deviating corporate behavior and thereby protect investors from negative earnings restatements and negative stock returns.
How Did the Authors Conduct This Research?
The authors use the list of 102 companies that was published in the Wall Street Journal in early 2006 after the companies were implicated in backdating. They gather information from the companies’ proxies regarding the composition of their boards, membership of directors on their compensation committees, and the scope of parallel directorships in other companies.
The authors run statistical regressions to identify the main determinants of the change in board departure rates before and after the disclosure of backdating. Departure is defined as immediate resignation, failure to be renominated for a board position, or outright loss in the elections. In addition, a multinomial logit regression is used to find the components of the probability of departure taking place in any one of the three ways. In almost all cases, the magnitude of the backdating seems to have a significant influence on the level of board turnover and mostly on the intensity of resignations by inside directors. Finally, the tests are extended by using large-sample data from RiskMetrics. The majority of initial results produced with the use of the hand-collected sample are proved to be robust by the inclusion of a large control sample.
The announcement that a company is engaging in backdating increases board turnover in the form of resignations for inside directors and the failure to be renominated for independent board directors, which are both associated with shareholder activism. The results of the authors’ research imply that public companies should be characterized by a corporate culture that takes shareholders seriously. Investors who are mostly short horizon oriented tend to understate the importance of corporate culture and ethics on the grounds that their value will be capitalized only in the long term. Nevertheless, recent experience with episodes of option backdating suggests that corporate governance and corporate culture can also have a big impact in the short term.