Backdating of executive stock options: comparing financial and nonfinancial industries

The 2008-2009 subprime mortgage crisis in the USA caused bankruptcies and closures of many financial institutions. Yet many CEOs of US financial institutions were awarded huge bonuses and pay packages despite the economic collapse, suggesting that their incomes were not in conjunction with those of the shareholders, indicating a serious agency problem. This issue raises the question as to whether stock option backdating, another example of an agency problem, was as prevalent as slack lending policies among these financial institutions. This paper aims to compare the relative magnitude of executive option backdating in financial and nonfinancial firms.

Using a sample of CEO stock option grants from 1995 to 2006, obtained from ExecuComp, the authors employ an event study around the grant dates of executive options. The authors compare the abnormal price movements between financial and nonfinancial firms.

The abnormal negative stock returns were found before the award dates for both groups of firms. The after-event abnormal returns of both groups of firms, however, show different trends. For nonfinancial firms, there is an immediate turnaround of the abnormal return movement right after the grants; that is, the price increases, indicating the occurrence of significant backdating events. For financial firms, however, there is no significant price rebound after the grant date. In fact, the price continued to decline throughout the after-event period.

The result shows that nonfinancial firms demonstrate significantly more option backdating behavior than financial firms.

The findings suggest that previous findings on prevalent backdating among all public listed firms are only partially correct. This paper shows that backdating behavior found in previous studies is indeed driven by nonfinancial firms. This unexpected finding contradicts the initial prediction of authors that option backdating may be more likely among financial firms.

Based on previous research, the authors recognize that generally the official grant dates of firms must have been set retroactively, as shown by Lie (2005). The findings, however, show that financial firms demonstrate only partial backdating behavior. This study opens a path for future research to further discover why financial firms exhibit less backdating behavior compared with nonfinancial firms, and if option backdating is not an issue for financial firms, why the share prices of these firms decline significantly prior to the grant date.