Options Study Becomes Required Reading
By Steve Stecklow
30 May 2006
The Wall Street Journal
(Copyright (c) 2006, Dow Jones & Company, Inc.)
Iowa City, Iowa -- ERIK LIE had become accustomed to bored looks when discussing his academic research, which has addressed such weighty questions as, "which provides a stronger earnings signal in big corporate share buybacks, a Dutch auction or a fixed-price offering?"
"Most people find most of the stuff I do very obscure," says the 37-year-old Norwegian, who teaches finance at the University of Iowa.
Not any more. The unassuming academic, who first came to the U.S. as a student in 1988, suddenly has become a minor celebrity in the financial world, thanks to a paper he published last year. It suggested companies might be backdating stock-option grant dates to enrich their senior executives. The study didn't name any firms, but it drew regulators' interest and proved prescient. In recent weeks, a growing options scandal has led to announcements of earnings restatements, resignations and expanding federal probes. About 20 companies are under the microscope of the Justice Department, the Securities and Exchange Commission or both.
From his modest, narrow office at this state university's business school, Dr. Lie (pronounced LEE) is now inundated with phone calls from hedge-fund managers, class-action attorneys, journalists and the SEC, all seeking his expertise.
The concept, he says, is "relatively simple": Companies routinely issue stock options as an incentive for executives to improve their firms' performance and share prices. The options usually give executives the right to buy shares later at the price of the stock on the date of the grant. The higher the share price goes, the more valuable the options.
But if option grants are backdated to times when shares are especially low, their potential for profit increases. Granting an option at below-market value without disclosing the discount could violate securities laws, and lead to accounting and tax troubles, as well as possible fraud charges.
For years, academics who study corporate finance were aware of a statistical pattern that showed share prices often rose quickly after options were granted -- a paper by David Yermack, an associate professor of finance at New York University's Stern School of Business, documented the phenomenon about a decade ago. He and other researchers speculated the rise might be due to corporate executives who knew that good news was on the horizon and made sure options were granted beforehand. Some researchers even explored whether positive announcements were being delayed to make options more valuable.
Dr. Lie says he had run out of ideas in his research about share buybacks, which had preoccupied his time for years; it had been the subject of his doctoral dissertation at Purdue University in West Lafayette, Ind. He switched his focus to executive compensation and began trying to prove his hunch that option grants prompted executives to take on more risk, like increased debt, to boost their businesses. But he couldn't document it.
"It seems so often in research you try out an idea and it doesn't quite work," he says. "In this case, it didn't work."
So he turned to the timing of option grants. Dr. Lie was aware of Dr. Yermack's study, which was based on a sampling of option grants in the early 1990s. Dr. Lie collected a much larger sample that included data up until 2002.
He examined options that weren't granted the same date every year and found a striking pattern in which prices fell before the grant date, and rose soon afterward. He also discovered that the stock market as a whole also often rose following option grants at certain companies. "I said, `look, it's uncanny how good these executives must be at predicting what will happen with future stock prices," he says. He began to wonder "that maybe it wasn't so uncanny."
Calling his hypothesis "novel," he wrote a paper entitled "On the Timing of CEO Stock Option Awards" that suggested that "at least some of the awards are timed retroactively."
"The results are provocative and might cause some investors to cry foul," he wrote. The paper was published a year ago in a journal called "Management Science." He and another researcher, Randall A. Heron, have since completed a forthcoming, follow-up study that looked at a 2002 change in regulatory law that now requires companies to report option grants within 48 hours. The study found that when companies reported options the same day they were granted, there was no pattern of share prices quickly rising. But the pattern continued when companies delayed reporting option grants.
Dr. Lie first discussed his backdating theory with other academics about two years ago and initially was met with skepticism. "I didn't believe it at first," says Dr. Yermack. "The whole idea was so sinister." Denise Jones, an accounting professor at the College of William & Mary in Williamsburg, Va., where Dr. Lie taught until two years ago, recalls that when he gave a presentation on his work, it generated only "the typical amount of discussion."
"In a lot of finance work, you find statistical anomalies," she says.
Dr. Lie says he sent a copy to the SEC in 2004 and later received an acknowledgement stating it was interesting. He says he has since spoken to the agency but can't discuss the nature of the conversations.
Dr. Lie's paper cited no companies that might be backdating; it wasn't until a page-one article in The Wall Street Journal in March, which used statistical analysis to identify a half-dozen companies with highly suspicious grant practices, that the scandal gained wide public attention.
Dr. Lie says he tried to contact a few companies to ask about the dates they granted options but he couldn't get past their secretaries, and gave up. His paper concludes, "Although I show aggregate evidence that retroactive timing occurs, it is difficult, if not impossible, to prove that such timing takes place in individual cases."
He and other academics say it's not their job to name names; they're more interested in statistical trends. "We are not the police, we are not the SEC," says M. P. Narayanan, professor of finance at the University of Michigan in Ann Arbor, who has also studied options timing.
Dr. Lie, who grew up in Porsgrunn, a small town south of Oslo on Norway's southern coast, says he first became interested in numbers as a child, an interest he credits to his father, a construction engineer. After starting college in Norway, Dr. Lie transferred to the University of Oregon to study finance, courtesy of a Norwegian government grant.
After returning to Norway to serve in the Navy, he came back to the U.S. to work on his Ph.D. at Purdue. There he met his wife, Heidi, a native Iowan with some Norwegian heritage who was in the same program; they have two young children.
Two years ago, Dr. Lie and his wife moved to Iowa from Virginia to be closer to her family. As an associate professor who teaches three classes, Dr. Lie earns about $180,000 a year. He says he has turned down recent offers to assist hedge funds in finding companies that may have engaged in backdating. "I don't see that as my job," he says. He says he may, however, agree to become an expert witness for attorneys pursuing class-action lawsuits.
Because of the backdating scandal, Dr. Yermack says Dr. Lie's future research will receive far more attention than it has in the past.
"I found the problem and he's the guy who came up with the explanation for the puzzle," Dr. Yermack says. "To be perfectly blunt about it, I didn't have as much imagination as Erik did to think about backdating."