"Altruistica": Seeking a return to full financial disclosure and regulatory oversight. A financial market analysis blog for "entertainment purposes" only by an experienced CFA seeking new hedge fund engagements for investment writing and analysis. The author has experience investing internationally, running a hedge fund, making angel investments, and helping launch five startup companies. Investors should do their own due diligence.

21 January 2007

Why Backdating Equals a Criminal Windfall

Broadcom TRIPLES its executive stock option ("ESO") charge to $2.2BILLION! And the stock soars 7% on that sanguine news. Options issues to purchase 240 MILLION Shares. UFB!

Stock option errors result in $2.22B charge for Broadcom
Broadcom Corp. will take charges of $2.22 billion to correct accounting flaws related to misdated stock option grants. The restatement of financial statements from 1998 to 2005 with the Securities and Exchange Commission completes the company's investigation into the stock-option grants. The restatement is the largest so far among companies that have looked into its grant practices. According to the company, the charge so large because the company issued options to purchase nearly 240 million shares to employees from June 1998, the time of the company's initial stock offering, through May 2003, "a period of unprecedented market volatility."

ESOs are usually granted at-the-money, i.e., the exercise price of the options is set to equal the market price of the underlying stock on the grant date. Because the option value is higher if the exercise price is lower, executives prefer to be granted options when the stock price is at its lowest. Backdating allows executives to choose a past date when the market price was particularly low, thereby inflating the value of the options.

An example illustrates the potential benefit of backdating to the recipient. The Wall Street Journal (see discussion of article below) pointed out a CEO option grant dated October 1998. The number of shares subject to option was 250,000 and the exercise price was $30 (the trough in the stock price graph below.) Given a year-end price of $85, the intrinsic value of the options at the end of the year was ($85-$30) x 250,000 = $13,750,000. In comparison, had the options been granted at the year-end price when the decision to grant to options actually might have been made, the year-end intrinsic value would have been zero.

Funny, this article details how options backdating awareness has existed since 2003 or earlier, if you believe Wal-mart insiders.
David Yermack of NYU was the first researcher to document some peculiar stock price patterns around ESO grants. In particular, he found that stock prices tend to increase shortly after the grants. He attributed most of this pattern to grant timing, whereby executives would be granted options before predicted price increases. This pioneering study was published in the Journal of Finance in 1997, and is definitely worth reading.

In a study that I started in 2003 and disseminated in the first half of 2004 and that was published in Management Science in May 2005 (available at, I found that stock prices also tend to decrease before the grants. Furthermore, the pre-and post-grant price pattern has intensified over time (see graph below). By the end of the 1990s, the aggregate price pattern had become so pronounced that I thought there was more to the story than just grants being timed before corporate insiders predicted stock prices to increase. This made me think about the possibility that some of the grants had been backdated. I further found that the overall stock market performed worse than what is normal immediately before the grants and better than what is normal immediately after the grants. Unless corporate insiders can predict short-term movements in the stock market, my results provided further evidence in support of the backdating explanation.


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