A study of companies with abnormally favorable patterns of executive stock option grant timing * Rick Edelson# Scott Whisenant

Bauer College of Business University of Houston August 16, 2009 Abstract We identify, solely on the basis of public grant and stock price data, a sample of companies that are highly likely to have committed backdating. Two-thirds of this sample have not disclosed evidence of backdating, allowing the first study of the economic consequences and characteristics of undisclosed backdaters. Undisclosed backdaters show negative abnormal stock price performance, negative ROA, and abnormal rates of unfavorable stock market delisting events that are as bad as or worse than disclosed backdaters. This suggests that disclosure does not drive the destruction of shareholder wealth, and may mitigate losses, due to backdating. We find that over 500 backdaters remain undisclosed.

JEL Classification: J33, M52 Keywords: Backdating, Corporate governance, Executive stock option grants
Corresponding author: Rick Edelson University of Houston C.T. Bauer College of Business 334 Melcher Hall Houston, TX 77204 phone: 970-531-3748 e-mail: rickedelson@gmail.com
#

The authors are grateful to Rick Aster, Lucian Bebchuk, Randy Heron, Erik Lie, Kiran Parthasarathy and workshop participants at the University of Houston and the Securities and Exchange Commission for helpful comments. All data are available from public sources.

A study of companies with abnormally favorable patterns of executive stock option grant timing 1. Introduction In the discovery paper on the backdating of executive stock option grants, Lie (2005) offers evidence that stock returns on unscheduled option awards to CEOs were abnormally negative before grant dates and abnormally positive afterwards. Lie (2005) and subsequent grant-level studies (e.g., Narayanan and Seyhun 2005, 2008; Heron and Lie, 2006, 2009; Bebchuk et al. 2008a,b; Collins et al. 2009) make persuasive arguments that this indicates that the backdating or ex post facto manipulation of the dates of the grants is widespread. These studies directly aggregate individual grant data, finding that global characteristics such as low market capitalization, high volatility, frequent and valuable options awards, and weak corporate governance are more frequently associated with grants that appear to have been backdated. No attempt is made to first isolate a sample of specific companies that committed backdating and then to study the characteristics of such a sample of companies. Indeed, it has been asserted that public grant and stock price data alone cannot be used to isolate a sample of companies that committed backdating. For example, Lie (2005, 811) concludes: Further, 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. An alternate approach (e.g. Narayanan et al. 2007; Bernile and Jarrell 2009; Armstrong and Larcker 2009) is to study companies that have publicly disclosed reports of backdating. By first isolating known backdaters, these company-level studies are able to directly study the economic consequences associated with backdating. The disclosure process itself, however, can introduce a complex and unquantifiable set of sample biases. Furthermore, studies of companies with disclosures of backdating are inherently unable to distinguish whether economic consequences such as shareholder losses are due to the backdating itself or to a disclosure effect associated with the public announcement of backdating problems. Our paper demonstrates that a reliable sample of companies, with both disclosed and undisclosed backdating activities, can indeed be constructed solely on the basis of publiclyobservable stock price and grant data. By making the first direct comparison of disclosed and undisclosed backdaters, we decouple the interactions between the economic consequences of backdating and those of the disclosure process. At the heart of our approach is a nonparametric test of the null hypothesis that a companys pattern of stock option grants relative to its stock price movement is no more favorable to the recipients than would be expected at a given confidence level. The test, termed the Joint Probability Technique (JPT), reliably measures the joint probability that the entire pattern of independent grants issued by a single company is abnormally favorable to confidence levels below one thousandth of one percent. We apply the JPT to 4,008 companies with sufficient historical data from 1996 through 2007 to extract a sample of 141 companies (3.52 percent of the tested population) that shows abnormally favorable patterns of stock option grants at a very stringent confidence level of p 0.0005 (five-hundredths of one percent). Only about two of these companies (4,008 0.0005 = 2) are expected to be this lucky by chance (Type I error). Based on the extremely low Type I error rate in this sample of 141 companies, we term these companies the High Probability Backdating (HPB) sample. We then further subdivide the HPB sample into two subsamples: the
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49 companies that have disclosed evidence of backdating (the disclosed, or DHPB sample) and the 92 that have not (the undisclosed, or UHPB sample). These two subsamples are the focus of our investigation of the economic consequences of stock option backdating. Bernile and Jarrell (2009) shows that companies that disclose backdating subsequently suffer negative abnormal stock returns. A major contribution of our paper is to extend such analysis by documenting that undisclosed backdaters also show stock price performance at least as bad, if not worse, than disclosed backdaters. We also document that the UHPB sample show poorer accounting rates of return and suffer a higher rate of unfavorable stock market delisting events than both the DHPB sample and a matched control group. These findings suggest that public disclosure is not what drives the destruction of wealth associated with stock option backdating. Indeed, vigorous enforcement and disclosure may ameliorate backdating related losses. Overall, our empirical evidence is not consistent with theories that predict that managerial backdating benefits shareholders (Gao and Mahmudi 2007; Dierker and Hemmer 2008). Our paper also contributes to the literature by characterizing the occurrence and disclosure of stock option backdating. We find that approximately two cases of backdating have gone unreported for each reported case. Overall, it appears that approximately 800 companies engaged in backdating, of which at least 500 are still undisclosed. We also find that higher market capitalization companies within the HPB sample are substantially more likely to have disclosed backdating-related regulatory investigations or restatements than smaller market capitalization companies. This indicates that either regulators detection practices or other discovery processes tend to be biased toward finding large market capitalization companies. The JPT also has potential for applications beyond the company-level test. In this paper, we modify the JPT to perform a managerial-level analysis that reveals that insiders benefit significantly more from backdating than outsiders. We also perform a person-level analysis that shows how this technique can identify individuals who committed backdating across multiple companies. Finally, we note that our joint probability approach can be broadly adapted by financial economists or market regulators to study a wide range of problems for which there is a need to identify a sample of entities (companies or individuals) that repeatedly obtain abnormally favorable outcomes. Possible applications include stock option exercise backdating (e.g., Cai, 2007; Cicero, 2007; Dhaliwal et al. 2009) and various forms of insider trading. To further these ends, we make the SAS code for the JPT available in an appendix. This paper is organized as follows: Section 2 introduces the statistical underpinnings of the JPT. Section 3 discusses the data filtering and reduction using publicly-available data. Section 4 describes how the JPT was applied to produce the HPB sample. Section 5 presents descriptive statistics and characteristics associated with stock option backdating. Section 6 offers evidence on the economic consequences of backdating. Section 7 is a brief concluding discussion of these results. An appendix supplies the SAS code used in this analysis. 2. The Joint Probability Technique The JPT is a non-parametric test of the null hypothesis that a specific pattern of stock option grants, compared with pattern of stock prices surrounding those reported grant dates, is no more favorable to the recipients than would be expected at a given confidence level. First, consider a specific option granted on date tG. One can construct a symmetric 2N+1 day window of trading
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days centered on the grant date where tn = {tG-N, tG-N+1, , tG-1, tG, tG+1, , tG+N-1, tG+N}, and associated closing stock prices are Prn = {PrG-N, PrG-N+1, , PrG-1, PrG, PrG+1, , PrG+N-1, PrG+N}. The exercise price of the grant is assumed to be equal to the closing price on the reported grant date. The option price is ranked within this symmetric 2N+1 day window of trading days centered on the reported grant date to yield rank R {1, 2, ..., 2N+1}. Under the null hypothesis, the grant has an equal probability of receiving any rank within the window. The most favorable grant is the one awarded on the date at which the price was the lowest and the least favorable is that when the price is the highest. The probability of obtaining an option exercise price at least as favorable as that actually obtained is given by p R/(2N+1). Thus the probability of receiving an award at least as favorable as that on the date of the lowest price is p 1/(2N+1), on the date of the second lowest price is p 2/(2N+1), and so on. In case of ties, the average rank is assigned. Note that secular linear trends in the stock price will not affect this statistic because the grant date is the midpoint of the window. 1 Next, consider a series of m = {1, 2, , M} independent option grants issued by a single company, each with probability values (pm ) calculated as above. By the joint probability theorem, the unadjusted joint probability of issuing a series of grants that are at least this favorable is given by the equation: punadjusted pm
m =1 M

(1)

Note that this statistic weights all independent grants equally. This is a conservative approach as managers have stronger incentives to backdate grants for larger amounts. The distribution of this unadjusted joint probability statistic approximates the Uniform Product Distribution (UPD; see Weisstein, 2003) and so must be corrected to yield a proper global probability value. The closed form of the UPD cannot be used for this purpose because pm is not a continuous function but is instead discretely sampled. The adjustment can be made via a Monte Carlo simulation (detailed further in Section 3.2). The resulting probability value directly indicates if the distribution of grant dates relative to the stock price is more favorable to the recipients than would be expected at a specified confidence level. The earliest public disclosure of an award occurs when the Form 4 filing is received at the U.S. Securities and Exchange Commission (SEC). The proper measurement date could be any date between the reported award date and the SEC receipt date. Thus, the window half-width N would ideally be set equal to the lag between the grant date and SEC receipt date. This would maximize the power of the test by matching the potential look-back period to the window halfwidth. Since different grants have different lags, different window sizes would be required for each of the M grants. Unfortunately, this means that implementation would require constructing individual Monte Carlo simulations based on each company and each grant. Since the Monte
1 To see this, initially consider the (unrealistic) case of a stock that always shows a steady monotonic increase in price. If an asymmetric window that starts with the grant date and ends with the receipt date is used, the grant would always have rank=1 even if no backdating occurred. Introducing volatility makes the picture more realistic, and the first grant can no longer be assumed to have rank=1. Still it is clear that the ranking remains biased towards assigning lower rank to the grant date even if there was no backdating. This bias renders the non-parametric statistic unusable. Since we do not know a priori the ratio between the variance contributions from secular drift and volatility, we array the window symmetrically around the grant date. 3

Carlo simulation in this paper involves 1,000,000 trials per independent grant, we see no practical solution to allow for individual company-level Monte Carlo simulations. This means that the real-world implementation of the Monte Carlo simulation imposes adoption of a uniform window size for all grants. This aspect of the technique, in turn, forces a trade-off between the window size and minimum lag allowed, as discussed in the next section. Both parameters, fortunately, can be controlled in the JPT. 3. Sample selection 3.1. Data selection and processing Sample selection begins with Center for Research in Stock Prices database (referred to as CRSP throughout this paper). After excluding foreign companies and REITs, we identify 14,498 U.S. publicly-traded companies that had at least some CRSP data in the period 1996 through 2007. Next, we use CUSIP numbers to match companies that also have data during this period in the Reuters/Thomson Financial Network Insiders database (referred to as TFN throughout this paper) to the CRSP data.2 We then obtain daily stock price data for each grant from CRSP over a 51-day window (the grant date plus 25 trading days on each side, so N = 25 in this analysis). 3 Next we match the grant exercise price to the closing stock price. As has been noted by previous investigators, a large fraction of the grant exercise prices listed in the TFN Insiders database (PrT,t hereafter) do not exactly match the closing price on the listed grant dates as compiled by CRSP (PrC,t). In many cases the exercise price is consistent with the previous days closing price (PrC,t-1), so earlier studies have corrected inconsistent grant date/price information on this basis. In order to accurately capture as many of these events as possible, the following approach was used in the current study: 1) If PrT,t and PrC,t are the same within rounding errors ( 0.1 percent), then PrT,t is set equal to PrC,t for the purposes of ranking. 2) If not, the previous days closing stock price is checked. If PrT,t and PrC,t-1 are the same within rounding errors, then PrT,t is set equal to PrC,t-1 and the grant date is set to the previous day. 3) If neither of these tests are passed, we then test if PrT,t falls between the high (Hi) and low (Lo) of that day (HiC,t and LoC,t , respectively), again allowing for rounding errors. If HiC,t PrT,t LoC,t, PrT,t is set to PrC,t as in step 1. 4) If the third test fails, the process is repeated for the previous day. If HiC,t-1 PrT,t LoC,t1, PrT,t is set to PrC,t-1 and the grant date is set to the previous date as in step 2.

2 Due to the proprietary nature of data obtained from the TFN and CRSP databases, we are unable to report or supply the matching outcome. 3 Different window sizes (e.g., N = 12 and N = 50) were considered but ultimately N = 25 was used because it produced a reasonable amount of sensitivity to abnormally favorable grants (e.g., the probability value of the most favorable grant was < 2 percent, whereas for N = 12 the probability value of the most favorable grant was 4 percent) without being so large as to force the minimum lag to be set so high as to exclude typical look-back periods. 4

5) If a specific grant fails all four tests, the grant is excluded from further analysis. Next we determine the number of trading days between the reported grant date and the date the insider transaction report was received at the SEC. The algorithm assumes that both the reported grant date and SEC receipt date fall on trading days. In practice neither has to be the case, since the SEC can receive information on days the markets are closed (e.g., Good Friday) and, for example, a board of directors could meet and issue grants over the weekend. Whenever the SEC receipt date or reported grant date falls on a non-trading date, we set it to the first subsequent trading date. We require that a minimum lag of 10 trading days separate the reported grant date and the date the SEC marks the report as received. 4 This condition was retained for all further analyses except for estimating the fractional rate of backdating with time (Section 5.4), as that issue involves all grants, not just backdated ones. Consistent with prior studies using public company insider transaction data, we next eliminate individual grants as follows: 5 1) TFN parameter CLEANSE must not equal A or S in order to assure data of adequate quality. TFN uses a proprietary data cleansing process to verify the accuracy and reasonableness of insider reported data by reference to external sources. Data (transaction prices, acquisition/disposition indicators, etc.) that appear erroneous or unreasonable are corrected by substituting information from alternate sources. The two lowest categories (A and S) offer insufficient assurance that the cleansing process was effective. 2) TFN parameter FORMTYPE must be equal to 4" or 5" so that only SEC Form 4 and 5 data are included. Public company insiders are required to use these forms to report changes in their ownership position on an episodic and annual basis, respectively. 3) TFN parameter ACQDISP must be equal to A to indicate that the event was an acquisition or award, instead of a disposition. Option grants are acquisitions on the part of the recipient. 4) TFN parameter TRANCODE must be equal to either A, 8, J or G. These codes are all consistent with the transaction being an acquisition or gift. 5) TFN parameter DERIVATIVE must not equal COM, COM A, COM B, COM C, CVD, CVP, CVS, EQUIV, NTS, PERF, PFD A, PFD B, PFD C, PFD D, PHNTM, SH, STOCK, UTSLP, WT, as these are more likely to indicate stock as opposed to options grants. 6) TFN parameter AMEND must not equal A. This eliminates amended filings, which could be used to try to cover up for backdating after an investigation is started.
4 This choice was made by plotting the fraction of rank=1 grants (i.e., the grants most unlikely to have been achieved given price ranks over the 51 day trading window) as a function of lag. The plot (available from the authors) appears to increase up to approximately 10 lag days and then flatten out. We also note that other minimum lags (e.g., 5, 15, 20, and 25 days) were considered and that a minimum lag of 10 days resulted in the largest final sample of companies with probability values 0.1 percent. In the end, the choice of the minimum lag balances considerations of noise and power of the technique. 5 Many previous studies also filtered on TFN parameters ROLECODE1 through ROLECODE4, for instance restricting study to grants to CEOs (e.g., Lie, 2005, Heron & Lie, 2006, 2009, Bebchuk, Grinstein & Peyer, 2008a). This approach was not utilized in the current paper as our focus is on a company-level test. 5

7) CRSP must indicate non-zero trading volume in the stock for at least 49 of the 51 days in the window. Windows with significantly less than 51 days would reduce the accuracy of the Monte Carlo correction discussed in Section 3.2. 8) All events with SEC receipt dates either before January 1, 1996, or after December 31, 2007, or grant dates before February 3, 1994, were eliminated. TFN did not collect Form 4 and 5 data in a uniform manner prior to 1996. The grants are then sorted by their CRSP company identifier (PERMNO) and by grant date. Following previous studies (e.g., Lie, 2005), we eliminate grants if another grant is awarded within 251, 252, or 253 trading days (indicating 1 year 1 day) either before or after that grant date. The bulk of these repeated grants have been scheduled to occur on the same date each year, so their timing cannot be as easily manipulated. Next, we eliminate grants with non-independent award dates. Companies typically issue multiple grants on the same day to various officers and with different vesting periods. The joint probability analysis presented above requires that all grant dates be independent. Thus grants awarded by a specific company on a common date are not independent and are considered as a single grant on that date, irrespective of differences in the recipient, exercise date, SEC receipt date, or other information (none of these varying terms affects the current analysis). These filters yielded a total of 7,013 companies with adequate CRSP and TFN data and at least one grant with the required characteristics (e.g., unscheduled, independent awards with usable data and lags of at least 10 trading days) . As a last step, we exclude from further analysis companies for which the filtering process yields less than four independent grants during the testing period, as the JPT has insufficient power to perform a meaningful test with so few data. In the end the filters yielded a sample of 4,008 testable companies. 3.2. Monte Carlo simulation As discussed in Section 2, the unadjusted statistic returned by Equation (1) is not a proper probability value but is instead distributed approximately as the UPD. It is not identical because the input Pm factors in Equation (1) are discretely sampled in units of 1/(2N+1) while the UPD is formed by continuous factors that can be arbitrarily close to zero. Thus, normalizing by the UPD would underestimate the significance at the lowest probability values because individual grants can never attain probability values below 1/(2N+1) (or 1.96 percent in this case since N = 25). This means that we cannot use the UPD to obtain an exact analytical solution for the proper probability values. We can, however, use a Monte Carlo simulation to convert this unadjusted statistic to a proper probability value. We implement this as follows: for a company with M independent grant dates, M random numbers are generated from the set {1/(2N+1), 2/(2N+1), , 1} and the product is formed as in Equation (1). This process is repeated for 1,000,000 trials and the resulting list of products is sorted from smallest to largest. This results in a lookup table in which we look up and read out the final, fair-play corrected probability value based on the number of independent grants and the unadjusted probability value statistic (punadjusted; see equation 1). Because the underlying statistic is multiplicative and its distribution follows the UPD, the probability statistic is more sensitive to a small number of highly improbable grants than to a
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larger number of mildly improbable grants. Examination of stock price movements around the grant dates often shows a number of grants that appear to be highly favorable along with a comparable or even larger number that do not appear unusually favorable. Thus, a desirable feature of the technique is that it can detect companies that backdated some, but not all, grant awards. Finally, we note one minor difference between real-world data and the Monte Carlo simulation: actual closing prices on different days can occasionally be tied, while by design this cannot occur in the simulation. Different stocks will exhibit ties with different frequencies, based on factors such as volatility and trading volume. This cannot be compensated for within the simulation. Since ties are assigned the average rank, the effect of ties will be to conservatively lead to higher (less significant) final probability values. This is discussed in more detail in Section 4.7. 4. Application of the Joint Probability Technique to a large public data set 4.1. Company level analysis Figure 1 is a histogram of the measured probability values from the JPT for the 4,008 tested companies. If the null hypothesis is correct for all companies and none had manipulated the timing of their stock option awards, the histogram should be expected to be flat with counts varying randomly around the horizontal dashed line. Instead, a very strong excess in the leftmost (lowest probability value, that is, highest statistical significance) bins is evident. The excess is dominant below a few percent and extends to probability values of approximately 17 percent. The results of the JPT can be used to extract samples of companies that have abnormally favorable patterns of option grant timing at or below a desired confidence level. The composition of samples constructed with various cutoffs is shown in Table 1. In the current paper, we focus most of the analysis on the 0.05 percent cutoff. Figure 1 reveals that the excess is largest in the first five bins of the lower panel, resulting in the sample of interest. The statistics for this sample are highlighted in Table 1. That is, of the 4,008 companies subjected to the JPT, 141 (3.52 percent) have probability values p 0.05 percent. Approximately two companies are expected to be Type I errors. Thus, with a high degree of confidence, we can argue that almost all of these 141 companies appear to have engaged in improper timing of executive stock options. 6 Because of the low Type I error rate, we term the 141 companies as the High Probability Backdating (HPB) sample. Figure 2 presents stock charts for four tested grants made by one of the companies in the HPB sample, KV Pharmaceutical. This figure is included both to illustrate why a manager
6 The analysis in this paper is purely a statistical study. As such, it identifies a sample of companies very likely to have committed stock option backdating. We note that our purely statistical study does not claim to provide categorical or absolute legal proof that any specific company has engaged in backdating. That is, we make no company-specific claims of backdating. The HPB sample is expected to contain about two companies that are actually false positives due to Type I errors. Without additional information, we also cannot know with certainty which companies these are, and thus which are the true positives that have committed backdating. That would require review on an individual basis of the documents underlying the grant authorizations. Additionally, companies may have innocuous explanations of their pattern of grant dates that this study did not consider, or some events could have been labeled incorrectly as option grants in the TFN database. The reader is, therefore, reminded that it would be premature to reach any conclusions about any individual company on the basis of this study alone. 7

(recipient) would engage in backdating and to give the reader a feel for how the JPT is implemented. We choose this particular company because it is a disclosed backdater that has already issued backdating-related restatements of financial statements. 7 We note, however, that all of the HPB companies exhibit similarly abnormally favorable patterns of stock option grants. The JPT indicates that the probability of obtaining a pattern of grants as favorable as that shown in Figure 2 is p 0.0001 percent. Each of the four independent grant dates is the most favorable price within the 51-day testing windows: rank = 1. The technique is designed to detect this characteristic pattern of multiple low-priced (favorable) grants. We note that the technique does not rely on company characteristics such as size, governance proxies, industry group, investigation status, or stock volatility. 8 The incentive to backdate stock options can be seen by the stock price appreciation between the reported grant dates and SEC receipt dates in Figure 2. The KV Pharmaceutical stock options are worth approximately $1.7 million more to the recipients at the putative grant dates than at the SEC receipt dates. 9 4.2. Type I error analysis A Type I error occurs when the null hypothesis is true but is incorrectly rejected. In our analysis, a Type I error occurs when a company identified as a high probability backdater did not actually commit backdating. The formal Type I error rate of the HPB sample (or any sample in Table 1) can be estimated by assuming the null hypothesis is correct, that is, that the timing of stock option grant awards was not manipulated. Under these circumstances one would expect that about 0.05 percent of the 4,008 companies in the HPB sample would have probability values 0.05 percent, by chance. Since 4,008 0.05 percent = 2, we expect about two false positive Type I errors in the HPB sample. Furthermore, the probability that any specific company in the HPB sample is a Type I error can be estimated. This Type I error rate is simply the expected number of Type I errors divided by the number of sample members, 2.0/141 = 1.4 percent. These values are given for the HPB sample and other possible samples in Columns 4 and 6 of Table 1.

http://www.sec.gov/Archives/edgar/data/57055/000106880008000127/kv10k.txt

8 In contrast to our approach that relies purely on public grant and stock price data, concurrent research by Carow et al. (2008) uses a logistic regression to predict the likelihood of an option backdating investigation based on factors such as market capitalization, number of grants, late grants, and minimum grant rank. No error analysis or estimate of Type I error rates is given in that paper so we cannot directly compare their results to ours. However, our discovery of a disclosure bias related to market capitalization (see Section 5.3) appears to render their predictive model problematic. 9 Note that this is the increase in the intrinsic value of the options, that is, simply the difference in price on the two dates multiplied by the number of underlying shares awarded. Other authors have also computed the excess value based on Black-Scholes or binomial tree models, which lead to smaller gains due to the possibility that the grant may end up out of the money (i.e., if the grant expires out of the money, then there is zero realized gain). This difference is not terribly significant, at least in this case, for two reasons: 1) KV Pharmaceuticals stock was above $20 through September 2008, so all options vested by that time were in the money at either price, and 2) KV Pharmaceutical had the (somewhat unusual) policy of typically vesting 10 to 20 percent of the award on the putative grant date (and therefore always in the money if the grant date is backdated to a day when the closing price is lower) and remainder in equal amounts every year for the next 4 or 9 years. As a result, 87 percent of the increase in intrinsic value in these four groups of options was (or could have been) extracted in cash, and the remainder may still be realized before the final option expires in 2015. 8

Finally, we recognize that our chosen and very strict p 0.05 percent cutoff leads to a relatively small sample that may be inadequate for some purposes. One could, however, easily construct a larger sample by invoking a weaker cutoff or a cleaner sample by invoking a stronger cutoff. For instance Table 1 shows that a cutoff of p 10 percent would allow extraction of a very large sample (1,007 observations), but the characteristics of the sample at this cutoff level are undesirable for our analysis of the economic consequences of stock option backdating. For example, the number of false positives is comparable to the number of true positives. The high Type I error rate (about 40 percent) limits the usefulness of such a sample for the purposes of our study. One could envision specific problems for which the most useful samples would have cutoffs between 10 percent and 0.05 percent (the HPB sample cutoff) or even below 0.05 percent. 4.3. Disclosed and undisclosed backdating companies In order to construct a sample of companies with public backdating disclosures, we searched the following sources: (1) Wall Street Journal Options Backdating Scorecard website,10 (2) Compliance Week Investigations & Probes,11 (3) The D & O Library Counting the Options Backdating Lawsuits website,12 (4) Stanford Securities Class Action Clearinghouse,13 (5) various SEC filings, most notably those listed in Spotlight On: Stock Options Backdating website,14 (6) Glass Lewis (2007) Yellow Card Trend Alert: Stock-Option Backdating Scandal, and (7) Audit Analytics. A wide variety of indications were accepted so long as they were related to stock option backdating, including executives convicted, pending civil and criminal complaints (or formal or informal investigations) by the SEC and U.S. Department of Justice (DOJ), formal settlements with the SEC or DOJ, restatements or adjustments to financial statements related to compensation expense, findings of material weaknesses in internal controls around stock option granting practices, as well as internal investigations, or forms of legal actions (e.g., derivative lawsuits) related to stock option granting practices. After removing the duplicates across these sources, we isolated a total of 274 companies that have some public indication of backdating. These are referred to as disclosed backdaters. Of these, 238 have sufficient TFN and CRSP data to be tested with the JPT. Approximately 21 percent (49 of these 238) of the disclosed backdaters are also in the HPB sample of 141 companies. These 49 observations form the Disclosed High Probability Backdating (DHPB) subsample. The remaining 92 companies in the HPB sample have not (to the best of our knowledge) been publicly disclosed as being involved in internal or external investigations or having made restatements related to stock option backdating. As discussed previously, the results of the JPT, nonetheless, indicate a high likelihood that they did in fact engage in backdating. We refer to this subsample as the Undisclosed High Probability Backdating (UHPB) subsample.

10

http://online.wsj.com/public/resources/documents/info-optionsscore06-full.html

11 Compliance Week is a registered mark of Haymarket Media, Inc. (http://www.complianceweek.com/) 12 http://dandodiary.blogspot.com/2006/07/counting-options-backdating-lawsuits.html 13 http://securities.stanford.edu/ 14 http://www.sec.gov/spotlight/optionsbackdating.htm 9

A strong overlap is evident between companies identified as backdaters through various disclosure mechanisms and the JPT, even though these methods are completely independent. If inclusion in either (or both) the HPB sample or 238 known backdaters is random and uncorrelated, we would expect only about 238/4,008 = 6 percent of HPB companies to be in the DHPB sample. The fact that the 35 percent of the HPB sample are disclosed backdaters (see Table 1, column 8) is strong evidence that both methods are effective in identifying backdaters, although neither has close to a 100 percent detection rate. Although not tabulated, the median probability value of the tested and known backdaters is 4.3 percent. In contrast, the median probability value for the remaining sample is 36.3 percent. A test of differences indicates a statistical difference in the distributions between the disclosed and other observations (p-value 0.001).Note also that column 8 of Table 1 shows the fraction of the sample with disclosed backdating issues decreases as the probability value threshold of each sample increases. Again, this is expected if both methods are effective at finding backdaters. 4.4. Type II error analysis A Type II error occurs when the null hypothesis is false but the test incorrectly fails to reject it. In this case, it means failing to include in the sample a company that actually did commit backdating. Type II errors are harder to estimate than Type I errors as assumptions are required about the (typically unknown) distribution of the test statistic across the parent population. The JPT cannot be designed to avoid all Type I and Type II errors. Instead, there is an inherent tradeoff: if one allows fewer Type I errors then one must accept more Type II errors and vice versa. We make two estimates of the Type II error rate, noting that neither is assumption-free. First, consider that the excess in Figure 1 extends to about 17 percent. Although this is not shown in Table 1, a total of 1,341 companies have p 17 percent. By the same argument as Section 4.2, one would expect 4,008 x 17 percent = 681 companies by chance. The excess, 1,341 681 = 660 companies is an estimate of the total number of backdaters in the tested sample. The HPB sample contains 141 companies. Thus the number of backdating companies not identified in the HPB sample is estimated to be 660 141 = 519 companies. The Type II error rate is the number of non-detections divided by the size of the HPB sample, that is, 519/141 = 3.7 Type II errors for every HPB sample member. This estimate only considers the sample of 4,008 companies tested by the JPT, not the larger population of all U.S. publicly-traded companies. The results of Section 4.3 can also be used to form estimates for both populations if one assumes that the distribution of backdating probability values of the disclosed backdaters follows the same distribution as the parent population of backdaters. This technique allows estimation of a Type II error rate relative to both the sample of 4,008 companies tested (as above) as well to the broadest sample of 14,498 U.S. publicly-traded companies which have data in TFN and CRSP in our sample period. In the first case, recall that 49 backdaters out of the 238 tested were identified in the HPB sample, so the number undetected is 238 49 = 189 companies. The Type II error rate is the number of non-detections divided by the size of the sample, that is 189/49 = 3.9 Type II errors for every HPB sample member. It is reassuring that the two estimates for the tested sample of 4,008 companies are similar. Likewise for the parent population of 14,498 companies, 274 are disclosed backdaters, so there are 274 49 = 225 undetected companies. The Type II error rate for the parent population is 225/49 = 4.6 Type II errors for every HPB sample member.
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Finally, we note that Type II error rate for the parent population of 14,498 is only about 19 percent larger than it is for the tested sample of 4,008 even though the former is well over three times as large. This means that the untested sample of 14,498 4,008 = 10,490 companies has a much lower rate of backdating than the tested sample of 4,008 companies. The difference is not unexpected since the untested sample consists of companies that issued fewer than four sets of qualifying, independent executive stock option grants (and often none at all), so the opportunity and motive for backdating would be much lower (or non-existent). This is discussed further in Section 5.2. To summarize the results of Sections 4.2 and 4.4, the conservative fashion in which the JPT is used to extract the HPB sample means that it likely contains about two Type I errors. This high degree of reliability comes at the cost of a small sample size and a large number of Type II errors. 4.5. Application at the level of individual insiders Up to this point, the JPT has been used to test if a companys pattern of stock option grants appears abnormally favorable. In order to demonstrate the potential usefulness of the JPT for other applications, we now modify it to detect abnormally favorable stock option grant patterns at the individual recipient level. The TFN database includes a unique person identifier (PERSONID) for individuals without regard to any company affiliation. The analysis in this section follows that previously described technique up to the point at which the data are sorted on PERMNO and date and each companys non-independent grants (those awarded on the same day but with different recipients or vesting periods) are eliminated. Instead, data are sorted on PERSONID, PERMNO and date, and grants are eliminated only if all three of these variables are non-independent. The unadjusted statistic is then obtained by multiplying probability values for grants accumulated by each individual PERSONID. This unadjusted statistic is then subjected to the same Monte Carlo correction as before. The modified test uses both the same cutoff level (0.05 percent) and required number of grants (four) as the company-level test. A total of 9,536 unique PERSONIDs are tested, yielding a sample of 324 individuals who received abnormally favorable patterns of stock option awards. Of these, 234 are affiliated with at least one of the 141 HPB companies. This indicates that 90 of these recipients of abnormally favorable patterns of options (28 percent) are not associated with any of the companies in the HPB sample. The application of the JPT at the level of individual insiders has two major effects. First, it segregates and distinguishes an individuals grant pattern from that of any company. This modification allows the identification of an individual who received a favorable pattern of grants even if the companys overall pattern was not statistically significant. For example, this could occur when one manager or director in a company backdates grants but other managers and directors do not. Second and even more interestingly, it allows identification of individuals who received an abnormally favorable pattern of grants across multiple companies, even if the overall patterns at some or all of those companies are not statistically significant. An example of the second situation is Richard Scrushy, who received options from both HealthSouth and Caremark. Both companies have disclosed backdating investigations, but Scrushy himself was never charged with backdating, although he was charged with other criminal actions. The JPT yields suggestive but not significant p-values between 0.05 percent
11

and 1 percent for both HealthSouth and Caremark. Each company has at least two grants with rank = 1, but the presence of other less favorably priced grants causes the final statistic for both to exceed our stringent cutoff. When Scrushys grants from both companies are combined, however, the resulting probability value (0.0184 percent) is significantly below our 0.05 percent threshold. This section highlights an alternative application of the JPT. In terms of detecting stock option backdating, both financial economists and market regulators (including audit firms) could have an interest in obtaining evidence about backdating at a level finer than the company level. Although a rigorous analysis of person-level application of the JPT is left to future research, this initial evidence indicates that this modification of the JPT can provide evidence, in this case complementary to the company-level application, of stock option backdating. 4.6. Critique of the Joint Probability Technique With hindsight, it would be straightforward to design a scheme to manipulate grant timing that would thwart detection by this algorithm. Consider the following: first, because the JPT relies on multiple low-probability events, it has little power for companies that have issued only a few option grants. Specifically, companies with less than four independent awards are not tested. Second, grant dates are weighted equally, so a company that issues many small awards on random or unfavorable dates and backdates a few large awards to favorable dates would not be detected.16 Third, a recipient could disguise backdating by either of the methods described in the previous section. Fourth, since errant data in the TFN database are filtered out and ignored, companies could submit SEC forms with incomplete or incorrect information. Although beyond the scope of this introductory paper of the JPT, future research could find ways in which to deal with the majority of these issues. With regard to the last method that could thwart detection of backdating by the application of the JPT, we find evidence of such a case in our sample. One high-profile stock option backdating company, Comverse Technology, apparently submitted false or misleading Form 3 and 4 disclosures.1 7 Because TFN could not reliably cleanse the vast majority of their insider transactions, the filings (and related grants) were not tested as sufficient data did not exist to apply the JPT to that specific company. 4.7. Control testing A control experiment was conducted to provide an independent test of the reliability of the JPT. Using the sample of 4,008 companies previously discussed, we changed option grant dates systematically and reperformed the JPT analysis. That is, for each grant in the tested sample, the TFN grant dates were shifted by a fixed number of days. The entire test was repeated a total of six times for each company, using shifts of 4, 8 and 12 months (84, 168 and 252 trading days, respectively) both forward and backward in time. The JPT was then performed on these new (shifted) grant dates to determine the likelihood that executive stock option grant for each company was more favorable to recipients than expected at the threshold confidence level.

16 Weighting grants by the nominal value of the option or number of underlying shares could not be efficiently implemented within the Monte Carlo simulation. 17 http://www.sec.gov/litigation/litreleases/2006/lr19796.htm 12

The results are shown in Figure 3. The figure shows a significant deficit at p-values below about 40 percent, and a smaller deficit at p-values above approximately 98 percent. This indicates a bias against low p-values. This bias is apparently introduced in the Monte Carlo correction, since the simulated ranked data can never have ties while actual stock price data can have ties (be the same in our 51-day window).18 This is a conservative bias against finding a company has backdated executive stock option grants, and will result in more Type II errors but not more Type I errors. Reflecting the desire to obtain the cleanest possible sample of companies likely to have committed stock option backdating (one with the fewest Type I errors), the conservative bias was retained and no attempt was made to correct for it. 5. Characteristics associated with stock option backdating 5.1. Descriptive statistics Table 2 reports descriptive statistics for the HPB sample. The results are in general agreement with previous work that report (Heron and Lie 2006), for example, that Computers & Related Technology companies (SIC ranges 7370 to 7379, 3570 to 3579 and 3670 to 3679) are over-represented in the HPB sample. Two new results are apparent. First, the percentage of Financial Services companies (SIC range 6000 to 6999) drops from 30 percent of the CRSP population to 9 percent of the tested companies and to only 4 percent of the HPB companies. That is, they are under-represented in the HPB sample. Second, the NASDAQ exchange is also slightly over-represented in the HPB sample, with 71 percent of the HPB sample but only 64 percent of the tested sample and 60 percent of the parent population. 5.2. Backdating rate in U.S. capital markets Because the UHPB and DHPB samples were selected independently of the disclosure effect, we can make a reliable estimate of the number of U.S. publicly-traded companies that committed backdating. We present two ways to estimate this number. First, recall that in Section 4.4, we found that about 660 more companies had p 17 percent than would be expected by chance. This reveals the most direct estimate we can make with the data; however, it only considers the 4,008 companies tested. Since about 10,154 U.S. publicly traded companies were not tested (see Section 3.1.), this estimate of 660 companies should be considered a lower limit. A more comprehensive but also more assumption-dependent estimate can be made from the second estimate of Type II error rates, by comparing size of the DHPB and HPB samples. This analysis assumes that all companies within the disclosed lists committed backdating, and that the distribution of this subsample is representative of the population. The estimated total number of backdaters N is given by N = SD KB / KD, where SD is the total size of the HPB sample, KB is the number of known backdaters, and KD is the number of known backdaters in the HPB sample. Note that the total size of the parent population does not enter into this relation. For the tested sample of 4,008 companies, KB = 238, KD = 49, and SD = 141, yielding N = 685. This estimate is reassuringly similar to the previous estimate. Finally, for the population of 14,498 U.S. publicly-traded companies as previously identified, KB equal 274 observations, while KD and SD remain the same, yielding evidence that approximately 800 companies backdated stock options. Although the backdating rate reported in the current paper is similar to the finding by Bebchuk et al. (2008a), our results on the rate of backdating are significantly lower than claimed in some other studies. For example, Heron and Lie (2009) use average return differences to
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estimate that 29 percent of the 7,774 companies they examine (about 2,270 total) engaged in backdating or similar manipulation of grants during 1996 through 2005. Fried (2008) used a simple scaling to extrapolate these results to the estimated 15,000 publicly-traded U.S. companies, concluding that over 4,000 companies had committed backdating. Bebchuk et al. (2008a) studied CEO options grants in about 6,000 companies and concluded that about 12 percent (720 companies) had committed backdating in the period 1996 through 2005. Fried (2008) similarly extrapolated this result to conclude that almost 2,000 companies backdated CEO grants. The largest part of this disparity comes from the extrapolation of Fried (2008), which incorrectly scaled the results of tests on a sample of companies that issued executive stock option awards to a parent population dominated by companies that issued few or no executive stock option awards. In backdating studies (e.g., Heron and Lie, 2009; Bebchuk et al. 2008a,b and this study), the test sample consists only of those companies that awarded stock options during this period. A large fraction of the untested companies did not award any executive stock option grants, so those companies could not have engaged in backdating. 5.3. A bias in backdating disclosures Figure 4 presents histograms of the companies in the UHPB and DHPB samples as a function of average market capitalization. This shows that lower market capitalization backdaters are less likely to have publicly disclosed that they committed backdating than higher market capitalization backdaters. Of the 18 companies with market capitalizations above $3 billion, 12 (67 percent) are in the DHPB sample, while for the 25 companies with market capitalizations below $100 million, only 3 (12 percent) are in the DHPB sample. A Kolmagorov-Smirnov test confirms that the distributions differ at the 10-6 confidence level (two-sided test). The evidence has implications for studies that focus solely on companies known to be under investigation for backdating (e.g., Bernile and Jarrell, 2009; Narayanan et al. 2007). One obvious concern is that they might overstate the typical size of companies that engaged in backdating. More generally, we note that the relatively low rate of backdating disclosed by small market capitalization companies is due to a bias in the disclosure process, not a greater tendency for large market capitalization companies to commit backdating. This indicates that predicative models that use large market capitalization as a basis for identifying undisclosed backdaters (Carow et al. 2009) will yield an incomplete and biased sample. One could speculate as to why lower market capitalization companies are more likely to escape public scrutiny than their larger counterparts. This could possibly be the result of an informal (or formal) cost-benefit analysis performed by groups that investigate backdating. For instance, law firms may have a stronger incentive to sue large companies, since a lawsuit against a $20 billion company has a much larger potential payoff than one against a $20 million company. Likewise regulators such as the SEC may have determined that the public good is best served by focusing their scarce resources on the largest companies, which could be construed as having harmed the largest number of investors. This would be consistent with the model of high-profile prosecutions studied in Ashwini (2007). Finally, if the underlying rate of backdating is somewhat uniform across companies and if larger companies have better corporate governance, a higher rate of detection and disclosure would be expected for larger companies if better governed companies performed more thorough backdating investigations.
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5.4. The evolution of the rate of backdating In this section, we analyze how the incidence of backdating has changed with time for the HPB sample. Figure 5 shows the fraction of the luckiest grants (those with rank = 1 in the 51day window), binned in six-month periods from 1996 through 2007 and summed across all 141 HPB companies. Grants are assigned on the basis of SEC receipt date, not the putative grant date, because the latter would be irrelevant if backdating occurred. Also, all independent grants are included in this analysis, not just those with lag 10 days. In the absence of improper timing, no more than 1/51 = about 2 percent should have rank = 1. We measure the excess of rank = 1 grants above 2 percent to investigate how backdating (or other improper timing) evolved in the HPB companies. A number of interesting points are evident in Figure 5. First, the rate of backdating shows a broad peak from the middle of 1998 through the end of 2001, with an average of 26 percent having the most favorable grant possible. This implies that for these 141 HPB companies, an excess of 24 percent (26 percent 2 percent = 24 percent) of the grants issued appear to have been backdated or improperly timed during mid-1998 through 2001. In fact, this is a strong lower limit on the level of backdating by these companies because if there happened to be a tie for the best grant in the window, both would be assigned rank = 1.5 and no grant would be included. Also, anecdotal evidence indicates that some executives aimed for lower ranking grants, either because their look-back window was shorter than 26 trading days or because they were trying to avoid scrutiny (e.g., see McWilliams 2007). The second interesting aspect of Figure 5 is the decline in rank = 1 grants in 2002. The Sarbanes-Oxley Section Act of 2002 (SOX), Section 16(a) imposes a 2-day reporting requirement on insider transactions such as stock option awards starting on August 29, 2002 (shown as a vertical dotted line in the figure). The coincidence between these events suggests that this unheralded aspect of SOX may be responsible for greatly reducing option backdating activities. Third, during 2006 and 2007, after the widely-publicized cases of stock option backdating had been disclosed, the HPB companies awarded 255 independent stock option grants, of which 5 had rank = 1. This average of 2 percent is equal to the lower limit expected in the absence of backdating. This indicates that in the current period, for the HPB companies, backdating appears to have been substantially eliminated. 5.5. Which insiders received the most favorable grants? Another important question regards the spread of backdating grants within companies: which insiders took the lead in backdating stock options and how widespread was it within the company? In this section we segregate the data on the basis of the recipients role within the company before applying the JPT, allowing us to determine which types of insiders benefitted the most from backdating. That is, this is a second modification of the JPT presented in this paper. In this case, we investigate how favorable are the grants to that managerial or director level, regardless of the number of individual changes over our sample period. Thus, the test offers empirical evidence that is unique to related studies that focus on a specific managerial level (e.g., CEO in Lie 2005). Insiders are required to indicate their roles on SEC Form 4, and these are tabulated by TFN and reported as parameters ROLECODE1 through ROLECODE4. We use these data to
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determine the recipients position in the company. Seven different insider levels were used: 1) officer, 2) director, 3) CEO, 4) CFO, 5) other officer, 6) inside director, and 7) outside director.19 The results are summarized in Table 3. Because each recipient is classified on multiple levels (e.g., CEO is also an officer), each filing is assigned to between two and four levels.2 0 The number of independent grants tested on each individual level is always less than or equal to the total number of independent grants tested for that company. Thus, for many companies, an insufficient number of independent grants are accumulated to allow application of the JPT. The result is that the total number tested at each level can be less than 141. First, we find that managers do significantly better than directors, and inside directors do better than outside directors. The data indicate the average grant rank for officers (managers) is 9.1, while the average rank for directors is 10.9. A test of differences in distributions yields a pvalue 0.0001, using a Kolmogorov-Smirnov two-sample test. The data also indicate that inside directors have an average grant rank of 8.4, while outsider directors show an average rank of 12.3 (p-value = 0.0003, using K-S test). The greatest difference between mutually-exclusive groups is between all officers (whose pattern of grants is significant in 111 cases) and outside directors (whose pattern is significant in only 27 cases). These result indicates that managers benefit more from backdating than do directors, and inside directors benefit more than outside directors. This in turn seems to argue against the assumption, made by Dierker and Hemmer (2008) that directors are aware of backdating and allow it because they believe it will optimize corporate decision making. Of course, there is a second possibility, outside directors could be aware of the backdating and acquiesce to it, choosing not to be personally enriched. This would, nevertheless, suggest that directors were complicit in the crimes making them de facto accessory without receiving any direct benefit. Thus, the latter explanation seems less likely. We also find that CEOs do not outperform other managerial levels (CFO or other officers).21 The data indicate that, taken as a whole, no single managerial level is the dominant force behind backdating. This suggests that the approach taken in this paper, of studying the entire set of grants awarded by a company, may be more effective than those which restrict study to grants to a single role (e.g., CEO in Lie 2005, Bebchuk 2008a; or directors in Bebchuk 2008b).
19 Any filing that reported any ROLECODE as CEO or P classified the recipient as the CEO. Any filing that reported a ROLECODE as CFO but not CEO or P had the recipient classified as CFO. Any filing with any ROLECODE reported as AV,CI, CO, CT, EVP, GC, O, OB, OP, OS, OT, OX,S, SVP, or VP for which the recipient was not already classified as CEO or CFO was considered to belong to an other officer. Thus all officers (managers) are classified either as CEO, CFO or other officer. Likewise, the recipient of any filing with any ROLECODE as CB, D, DO, H, OD, VC was classified as a director. Finally, all directors were considered to be either inside directors (if they were also classified as an officer) or outside directors (if they were not classified as an officer). Note that this classification is independent of the specific identity of the person filling the role, so for instance if four different individuals served as CEO during the test period, all of their grants would be assigned to CEO. Likewise, if the CFO was promoted to CEO, then the grants awarded before the promotion would be assigned to CFO and those afterwards would be assigned to CEO. 20 So, for instance, the CEO is also Chairman of the Board, that persons grants would be assigned to the officer, director,CEO and inside director categories. 21 Note that the total is less than 100 percent because the pattern of grants to recipient in a narrower classification (e.g., CEO) may or may not be more favorable than those to recipients in the broader classification (e.g., officers). 16

6. Economic consequences associated with backdating This section presents the first comparative analysis of the economic consequences associated with backdating for disclosed backdaters (the DHPB sample) and undisclosed backdaters (the UHPB sample). Three separate tests are presented in Sections 6.1. to 6.3. 6.1. Stock market delisting events In this section we examine the rates of stock market delisting reasons for the HPB, UHPB, and DHPB samples. This requires establishment of a benchmark. Accordingly, we match the HPB to a control sample based on the following criteria obtained from data at the end of fiscal year 1999: (1) three-digit standard industry codes (two-digit if unavailable), and (2) between 70 and 130 percent of the market value of equity of the sample company. We then identify (at most) the four closest observations in years since initial offering (proxied by inclusion date in CRSP database) and select the control company with the highest probability value (lowest likelihood) of backdating obtained from the JPT.22 We use Compustat data in the year before inclusion in the CRSP database beginning with fiscal year 1999 as it offers the only year of some overlap of the entire HPB sample. Table 4 compares the rates and reasons for delistings for the samples and their control groups. Note that mergers and combinations are segregated from what we term unfavorable delisting events. These unfavorable reasons comprise the following: delinquent filings; stock price too low to meet exchange requirements; company request; bankruptcy; stock pricing listing moved to over-the-counter market; insufficient capital, equity, float, or assets; and protection of investors and the public interest. These unfavorable events are generally indicative of poor operating performance or violation of exchange rules, while mergers can have either positive or negative connotations. The most interesting result in Table 4 is that the UHPB sample shows twice the rate of unfavorable delisting events than its control, while the DHPB sample shows no such excess. For the UHPB sample and control, a two-tailed paired test indicates a statistically significant difference at the 5.2 percent level. For tests of the DHPB sample and its control, the test is not statistically significant (p-value > 0.1). For the full sample of 141 companies, the test indicates a p-value of 8.5 percent, suggesting a marginal statistical difference. Based on the tests of the UHPB and DHPB and their respective controls, the marginal difference in the full sample appears to be driven by difference in the UHPB sample relative to its control. 6.2. Analysis of stock market returns In this section we extend the evidence offered by Bernile and Jarrell (2009), who investigate long-term stock price performance for companies disclosing backdating problems, to a test of the stock price performance of both disclosed and undisclosed HPB sample over fiscal years 2005 to 2007. We use four different risk adjustments to produce abnormal stock returns: value- and equal-weighted market indices and a three- and four-factor Fama-French (1993) models. As the sample sizes are small and subject to positive skewness bias, we use median annual buy-andhold abnormal return (BHAR) shown in Barber and Lyon (1996a) to have well-specified test statistics (using Wilcoxon signed-rank tests).
22 We note that substituting market-to-book instead of market capitalization in the matching process leads to similar conclusions. 17

Table 5 reports the results on equal- and value-weighted indices. The twelve-month BHAR are calculated over the 2005, 2006, and 2007 fiscal years, and then accumulated to yield a threeyear cumulative abnormal stock return reported in the table.23 We find that DHPB companies are associated with reliably negative abnormal stock returns of negative 31.73 and 35.89 percent using the equal- and value-weighted indices, respectively. This finding is consistent with Bernile and Jarrell (2009) which uses a sample period that covers the first two years of our sample period. The more interesting empirical evidence offered by this section is that the UHPB sample is also associated with negative 39.46 and 47.49 percent abnormal stock returns using the equaland value-weighted indices, respectively. That is, the undisclosed sample of backdating companies are associated with reliably negative abnormal stock returns that are as large or larger as than those associated with the disclosed sample of backdating companies.24 Thus, the findings indicate that the evidence is not consistent with the view that public disclosure of backdating activities is the primary source of shareholder losses.25 6.3. Analysis of accounting rates of return In this section we calculate the accounting return on assets (ROA, equal to net income [NI in 2007 Compustat] divided by end of period assets [AT in 2007 Compustat data]). This analysis covers the same period as the financial (stock market) return analysis in the previous section. Because the ROA analysis requires an explicit benchmark, we use the matched samples derived in Section 6.1. The results indicate the median value of ROA for the HPB sample is 3.6 percent, while the median ROA for the HPB control sample is 3.7 percent. A Wilcoxon test for two-sample
23 Shumway (1997) reports that performance-related delistings often have missing final returns, which he estimates to be 30 percent. Substituting (potentially) missing performance -related delisting returns with 30 percent does not alter our findings. 24 Ritter (1991) argues that stock price performance can be affected by initial public offerings as companies attempt to go public to take advantage of overvaluation of their stock. Thus, matching on years since initial offering between the treatment and control samples is warranted. Kolmagorov-Smirnov tests indicate no differences in the distributions of all matching characteristics between the HPB and control companies except for the p-value of backdating (as was expected by design) indicating the control company approach achieved the expected results. 25 Kothari and Warner (1996) and Barber and Lyon (1996a,b) discuss the problems associated with long-run abnormal stock return tests. As done in Bernile and Jarrell (2009), we also employ asset pricing models that utilize multiple factors to describe risk: a Fama-French (1993) three- and four-factor model where the fourth factor is momentum (Carhart, 1997). Cross-sectional dependence of returns can be severe when sample companies have event dates close together as calendar-time clustering may result in a cross-correlation of returns across event companies and may result in misspecified test statistics. Therefore, we use a calendar-time approach (see Jaffe 1974; Mandelker 1974) that accounts for this source of bias. In this approach, securities are formed into portfolios at the beginning of each fiscal year. A single regression is run where the dependent variable is the time series of calendar portfolio excess returns and the explanatory variables, in the Fama French (1993) three-factor case, are the returns of the excess market factor, the small-minus-big capitalization factor, and the high-minus low book-tomarket factor. The intercept from the regression represents the mean monthly abnormal return over the fiscal years 2005, 2006, and 2007. Fama (1998) suggests a weighting factor should be used that is based on the number of securities in the portfolio in each calendar month. Accordingly, since we expect variation in the number of securities in each calendar-time portfolio over our sample period, our regressions are based on WLS where we weight the portfolio returns in each calendar month by the number of securities included. We find the intercept is reliably negative in each of the three fiscal years for both the disclosed and undisclosed sample of companies, and three intercepts for the undisclosed observations are as negative as the disclosed company intercepts. Thus, our conclusions are unchanged after considering other risk factors in the pricing models. 18

differences indicates no statistical difference in the distributions of ROA over fiscal years 2005 to 2007 for the HPB sample compared to its control sample. Similarly we test the DHPB sample and the UHPB samples compared to their respective control samples. As in the full sample, the data indicate no statistical difference in the distributions of ROA over fiscal years 2005 to 2007 for the DHPB sample compared to its control sample. In contrast, the median ROA for the UHPB sample is 1.2 percent; however, the median ROA for the undisclosed HPB control sample is 3.6 percent. Tests of differences indicate a statistical difference in the distributions of ROA over fiscal years 2005 to 2007 for the UHPB sample compared to its control sample (p-value = 0.019). Thus we conclude the ROA of the undisclosed sample of backdaters underperforms relative to its control sample, while the ROA of the disclosed sample is consistent with its control. 7. Conclusions This paper introduces the Joint Probability Technique, a methodology that identifies companies that are highly likely to have committed backdating solely on the basis of publiclyobservable grant date and stock price data. We identify 141 companies that apparently committed backdating at a very stringent 0.05 percent confidence level. Of these, 49 have disclosed evidence of backdating and 92 have not. We use this sample of 92 undisclosed backdaters to conduct the first studies of the economic consequences of backdating to undisclosed backdating companies. Over a three-year period that begins when the stock option backdating practices of companies became public, we find that the undisclosed stock option backdating companies perform as poorly, and in some cases worse, than the disclosed backdating companies in terms of both financial (stock market) and accounting (ROA) rates of return. Furthermore, over a longer period (1999 to 2007), the undisclosed sample shows an excess of unfavorable delisting events relative to both its control and the disclosed sample. These results have a number of implications about the economic consequences of backdating. The poor performance along three important metrics of the undisclosed sample relative to both the disclosed and control samples indicates that the disclosure effect is not the primary source of destruction of shareholder wealth in backdating companies. Additionally, the evidence could suggest that the act of uncovering and disclosing stock option backdating activities leads to improvements in management and thereby helps companies that had committed backdating mitigate poor performance. It is claimed (Gao and Mahmudi, 2007; Dierker and Hemmer, 2008) that the backdating of stock options is an efficient contracting process that optimally aligns shareholder and manager incentives. This should lead, ceteris paribus, to above market returns for the full HPB sample. This is not the case, suggesting that backdating does not in fact maximize shareholder value. More generally, recall that the motivation for executive stock option grants is to better align the interests of shareholders and managers. As the evidence suggests the HPB sample underperforms the market, especially in stock price, the results are not consistent with stock options having this desired effect, at least in backdating companies. The fact that we perform the first comparative analysis of disclosed and undisclosed backdaters also allows the first investigation of the disclosure process itself. We find evidence of a clear bias in the disclosure process: small market capitalization companies that backdate are
19

significantly more likely to remain hidden (undisclosed) than their larger counterparts. This may be the result of a cost-benefit analysis by regulators, choosing to investigate companies that caused the most damage to shareholders. It might also indicate that larger companies have better corporate governance and are therefore more likely to uncover and report backdating. On a broader scale, we find that approximately two backdaters remain undisclosed for every one that has been disclosed, leaving a total of more than 500 backdating companies undisclosed. We also modify and apply the JPT to two settings other than the company-level implementation. First, we aggregate data at the individual level. We then are able identify individuals who show statistically significant evidence of backdating, even if the fuller pattern of grants to all insiders in those companies do not exceed our stringent 0.05 percent threshold. Second, we aggregate data within companies and then again by managerial levels. We find that managers receive significantly better patterns of grants than outside directors. This indicates that directors appear to have either been less aware of or benefitted from backdating than managers, again not consistent with the efficient contracting models of Gao and Mahmudi (2007) and Dierker and Hemmer (2008). These results indicate the potential for applications beyond the HPB sample and, in general, stock option backdating. Financial economists may wish to analyze differently-constituted samples to investigate questions such as: how did stock backdating spread? What corporate governance mechanisms appear to fail and succeed in monitoring activities such as stock option backdating? What audit firm characteristics or auditor-client factors are more or less likely to uncover backdating practices? Identification of the hidden backdaters is particularly valuable in this regard. Additionally, the Joint Probability Technique introduced in the paper could be adapted to study a wide range of issues in which the researcher wants to extract a sample of insider transactions that behave in a non-random fashion. Possible applications include stock option exercise backdating and various forms of insider trading. To further these ends, we make the SAS code for the JPT available in an appendix to this paper.

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Appendix: SAS code and users guide to the Joint Probability Technique This appendix supplies the SAS code used in this analysis and a guide to replicate and expand upon the described methodology. To get a broad overview of the logic behind the code, the reader is referred to Sections 2 and 3 of this paper. User supplied libraries and filenames may vary. A.1. Starting the process Running this code requires that the user have access to the CRSP and TFN databases and a SAS license. The user must create four files. The first is a match between CRSP and TFN databases (samp in supplied code). In the paper, the match was done on the basis of eight-digit CUSIP supplied in each database. The second and third files are data tables from CRSP (dsf in supplied code) and TFN (table2" in supplied code). The fourth required file is a Monte Carlo lookup table as described in section 3.2 is required (monte in the supplied code). Once the necessary files are created, a reasonable first run could attempt to (closely) replicate the sample described in the paper. We note that no two realizations of a Monte Carlo lookup file will be the same. Thus, relatively minor differences in adjusted probability values are expected. A.2. Adjustable parameters Once the user has replicated these results to the expected accuracy, the next step could be to vary the input parameters as described in the paper to meet their specific needs. Note that the program gives easy access a rather large number of parameters for this purpose. The main set of user supplied filters (flags on TFN parameters or lags in the supplied code) occurs near the end of the program to allow for easy adjustment with minimal additional run time. Other parameters such as the size of the test window (51 days in the supplied code) must be set earlier in the program. Note also that once the table of companies probability values has been output, the user has a final choice of where to set the sample cutoff: a smaller (more stringent) cutoff will produce a cleaner sample with fewer Type I errors but more Type II errors, while a larger cutoff will produce a larger sample with more Type I errors and fewer Type II errors. Finally, note that for brevity, comments are minimized and various lines of code are sometimes combined into one line. A.3. The Joint Probability Technique SAS code %LET START = 03jan1994'd; %LET STOP = 03jan2008'd; *** step2.samp is match file for crsp and tfn*************; proc sql; create table main.lookupfile2 (index=(secid permno)) as select distinct secid, permno from main.samp where secid and permno between 0 and 99999; quit; * Stock price data cleaning *; proc sql; create table main.crsp1 as select permno, date, abs(bidlo) as lo, abs(askhi) as hi, abs(prc) as price_crsp, cfacpr as adj_crsp, cusip, vol, permco, shrout from crsp.dsf where date between (&START.) and (&STOP.) and permno is not null order by permno, date; quit; ******* to read in insider transcation data from THOMSON (TFN) **********;
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data main.table2 (drop=i index=(secid)); set tfn.table2 (drop=acqdisp_ar address1 address2 cdate city cnum country cusip2 cusip6 cusipx dcn derivheld derivheld_adj fdate industry maintdate num_deriv ownership phone sector seqnum sigdate sprice state trancode_ar trandate_ar zipcode tdate sprice_adj num_deriv_adj); if secid = subid{i, 1} then secid = subid{i, 2}; end; if missing(xprice) then delete; if amend = A then delete; if acqdisp = D then delete; run; * DANO is sequential trading day number, created using General Electric data, PERMNO 12060, to find trading days *; proc sql; create table work.datelist as select distinct date from main.crsp1 where permno = 12060; create table work.trandate as select distinct trandate as date from main.table2 where date between (&START.) and (&STOP.); create table work.secdate as select distinct secdate as date from main.table2 where date between (&START.) and (&STOP.); quit; ******* DANO is a consecutive trading day count variable ***; data main.dates (keep=date dano index=(date dano)) main.alldates (keep=date dano index=(date)); retain count 0; merge work.datelist (in=p) work.trandate work.secdate; by date; if p then do; count + 1; dano = count; output main.dates; end; else dano = count + 1; output main.alldates; run; * Combine stock price data with dates, SEC ID, and day-before prices *; proc sql; create table work.mergedata2 (index=(pdno=(permno dano))) as select c.*, d.dano, l.secid from main.crsp1 c, main.dates d, main.lookupfile2 l where c.date = d.date and c.permno=l.permno order by c.permno, d.dano; create table main.crspdata (index=(pdno=(permno dano) permno dano secid)) as select m.*, y.vol as vol_lag, y.price_crsp as price_lag, y.hi as hi_lag, y.lo as lo_lag, case when m.adj_crsp and m.vol then m.price_crsp/m.adj_crsp else . end as adjprice from work.mergedata2 m left join work.mergedata2 y on m.permno=y.permno and m.dano - 1 = y.dano order by m.permno, m.dano; quit; proc sql; create table step1.tfnmasterdata (index=(pdg=(permno danog) permno secid)) as select t.*, g.dano as danog, s.dano as danos, l.permno from main.table2 t, main.dates g, main.dates s, main.lookupfile2 l where t.trandate = g.date and t.secdate = s.date and t.secid = l.secid order by permno, danog; quit; data step1.flags; merge main.crspdata (in=aa drop=cusip secid permco adjprice) step1.tfnmasterdata (in=bb rename=(danog=dano)); by permno dano; if aa and bb; danog = dano; agdano=dano; flag = 1; if (( lo_lag*0.999 <= xprice <= hi_lag*1.001 ) and ( vol_lag > 0)) then flag = 5; if (( lo*0.999 <= xprice <= hi*1.001 ) and ( vol > 0)) then flag = 4; if (( price_lag*0.999 <= xprice <= price_lag*1.001 ) and ( vol_lag > 0)) then flag = 3; if (( price_crsp*0.999 <= xprice <= price_crsp*1.001 ) and ( vol > 0)) then flag = 2; if ( abs( flag - 4) = 1 ) then do; agdano = agdano - 1; end;
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if ( flag > 1 ) then flag = 0; flag = flag*4; run; proc sql; create table step1.uniques2 as select distinct permno, agdano from step1.flags where agdano is not null; quit; run; data work.range1; set step1.uniques2; length p $ 3; do pp = 1 to 51; dano = agdano + 26 - pp; p = P || put(pp, z2.); output; end; run; proc sql; create table work.range2 as select u.permno, u.agdano, u.dano, u.p, c.adjprice as prices from work.range1 u, main.crspdata c where u.permno = c.permno and u.dano = c.dano order by permno, agdano, p; quit; data step1.prices (keep=permno agdano prices p); set work.range2; run; proc rank data=step1.prices out=step1.ranks ties=mean; by permno agdano; var prices; ranks rankprc; run; data step1.ranksfull; set step1.ranks (where=(rankprc is not null)); by permno agdano; run; data work.num (keep=permno agdano count) work.t1 (drop=count); set step1.ranksfull; by permno agdano; if first.agdano then count = 0; count + 1; if p = P26' then output work.t1; if last.agdano then output work.num; run; data step1.rankdata; merge work.t1 (in=a) work.num (in=b); by permno agdano; if a and b; if count then pvalue = rankprc/count; run; proc sort data=step1.flags; by permno agdano; run; data step1.m11; merge step1.rankdata (in=a) step1.flags (in=b); by permno agdano; if a and b; run; proc sort data=step1.m11; by permno agdano; run; data step1.fulldata; set step1.m11 ; lag = danos - agdano; if count < 49 then flag = flag + 8; if lag < 10 then flag = flag + 16; if amend = A then flag = flag + 32; if acqdisp in (D, 9', ) then flag = flag + 64; if trancode notin (A, 8', J, G) then flag = flag + 128; if formtype notin (4', 5') then flag = flag + 256; if cleanse in (A, S) then flag = flag + 512; if danog lt 505 then flag = flag + 1024; ** day 505 indicates Jan 1, 1996*; if derivative in (COM, COM B, COM C, COM A, CVP, WT, UTSLP, NTS, CVD, CVS, PFD A, PFD B, PFD C, PFD D, EQUIV, PERF, SH, STOCK, PHNTM) then flag = flag + 2048; run; proc sort data=step1.fulldata; by permno agdano flag; run; proc sql; create table work.ak1 as select distinct permno, agdano from step1.fulldata; quit; data work.ak2 (keep=permno ydano); set work.ak1; do incr = -253, -252, -251, 251, 252, 253; ydano = agdano + incr; output; end; run; proc sql; create table work.ak3 as select distinct permno, ydano from work.ak2; create table work.ak4 as select a.permno, a.agdano from work.ak1 a, work.ak3 y where a.permno = y.permno and a.agdano = y.ydano order by permno, agdano; quit; data step1.flagdates; merge step1.fulldata (in=a) work.ak4 (in=b); by permno agdano; if a; if b then flag = flag + 4096; run; data step1.newflag2; set step1.flagdates; by permno agdano flag; if not first.flag and flag = 0 then flag = flag + 1; run; data step1.flagzero (keep=pvalue rankprc count permno ticker cname secdate trandate danos danog lag amend cleanse formtype trancode acqdisp derivative secid agdano flag xdate shares); set step1.newflag2 (where=(flag = 0)); run;
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proc sort data=step1.flagzero; by permno; run; data work.p2; set step1.flagzero (keep=permno); by permno; if first.permno then num_grants = 0; num_grants + 1; if last.permno then output; run; data work.p3; merge work.p2 step1.flagzero; by permno; format holdproduct e15.; retain holdproduct; if first.permno then holdproduct = 1; holdproduct = holdproduct*pvalue; if last.permno then output; run; proc sort data=work.p3 out=step1.pvdata; by descending num_grants; run; ******** do the monte carlo pvalue correction ***********; data step1.finaldata1; set step1.pvdata; keep num_grants permno holdproduct ticker cname lag secid rankprc; run; ********** supply file and library for your monte carlo adjustment ****; data main.monte2; set main.monte; lstat=lag1(_stat); if _count=1 then lstat=0; if lstat=. then lstat = 0; if _count=1000000 then _stat=1; statdiff=(_stat-lstat); format lstat _stat statdiff e15.; proc sort nodups; by descending n descending _count; proc sort nodupkeys; by descending n _stat lstat; run; proc sql; create view joined_view as select v1.holdproduct, v1.permno, v1.num_grants, v2.n, v2._stat, v2._count, v2.lstat, v2.statdiff from step1.finaldata1 v1, main.monte2 v2 where ((v1.num_grants = v2.n) and (v1.holdproduct le v2._stat) and (v1.holdproduct gt v2.lstat)); quit; run; data step1.joined; set joined_view; pval_co=_count/1000000; proc sort nodups; by permno _count; run; proc sort data=step1.finaldata1; by permno; run; data step1.sample; merge step1.joined step1.finaldata1; by permno; drop statdiff holdproduct lstat _stat n _count lag; proc sort; by pval_co num_grants; run;

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TABLE 1 Summary of the Joint Probability Technique results (1) Sample Cutoff 0.001% 0.005% 0.010% 0.050%a 0.100% 0.500% 1.000% 5.000% 10.000% 50.000% 100.000%b (2) Sample Size 41 56 76 141 169 289 368 723 1,007 2,524 4,008 (3) Percent 1.02% 1.40% 1.90% 3.52% 4.22% 7.21% 9.18% 18.04% 25.12% 62.97% 100.00% (4) Type 1 Errors 0.0 0.2 0.4 2.0 4.0 20.0 40.1 200.4 400.8 2,004.0 4,008.0 (5) Excess 41.0 55.8 75.6 139.0 165.0 269.0 327.9 522.6 606.2 520.0 0.0 (6) (7) (8) Type 1 Number Fraction Error Rate Disclosed Disclosed 0.1% 0.4% 0.5% 1.4% 2.4% 6.9% 10.9% 27.7% 39.9% 79.4% 100.0% 21 27 31 49 53 74 86 123 143 207 238 51% 48% 41% 35% 31% 26% 23% 17% 14% 8% 6%

The table provides sample sizes and error rates for various probability value cutoffs. (1) The column shows various levels of the Joint Probability Technique probability measure, adjusted as discussed in the paper, that a company backdated stock option awards. The cutoffs, chosen by the user, are the lower bound of each possible sample. (2) The number of companies in each sample, given the choice of sample cutoff. For example, 141 companies have p-value 0.05 percent (the HPB sample). (3) The size of each sample as a percentage of the entire initial (i.e, tested) sample (4,008 companies). (4) The expected number of Type I errors in each sample, computed as the sample cutoff multiplied by the total sample. For example, in the HPB sample, a total of 4,008 0.05 percent = 2 companies would be expected to be the Type I error rate. (5) The excess of apparent real detections in each sample. For example, in the HPB sample, 141 2 = 139 companies would be expected to be real detections, that is, companies that one can reliably say backdated stock options. (6) The expected Type I error rate, that is, the expected likelihood that any individual company in the sample is misidentified. For the HPB sample, the error rate is (2/141) = 1.4 percent, indicating that each company in the HPB sample has a 1.4 percent likelihood of being incorrectly included (misidentified). (7) The number of companies for which substantial indications of backdating have been publicly disclosed. For the HPB sample, the number of observations equals 49. These 49 companies form the DHPB (disclosed high probability backdating) sample. (8) The fraction of companies for which restatements due to backdating have been publicly disclosed. For the DHPB sample, the fraction is (49/141) = 35 percent. a The row, highlighted in the table, refers to sources with p 0.05 percent. These observations are the High Probability Backdating (HPB) sample discussed throughout the paper. b The bottom row, included for completeness, gives the values for the full test sample of 4,008 companies.
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TABLE 2 Descriptive statistics Panel A: Industry Analysis CRSP Full Sample N % 228 1.6% 312 2.2% 425 2.9% 217 1.5% 585 4.0% 441 3.0% 2,263 15.6% 1,842 12.8% 716 4.9% 326 2.2% 1,292 8.9% 4,274 29.5% 1,577 10.9% 14,498 100.0% Tested Sample N 53 61 136 59 279 113 717 1,002 202 75 431 364 516 4,008 % 1.3% 1.5% 3.3% 1.5% 7.0% 2.8% 17.9% 25.0% 5.0% 1.9% 10.8% 9.1% 12.9% 100.0% HPB Sample N % 3 2.1% 1 0.7% 2 1.4% 1 0.7% 4 2.8% 1 0.7% 24 17.0% 62 44.0% 5 3.6% 0 0.0% 15 10.6% 5 3.6% 18 12.8% 141 100.0%

Industry Mining & Construction Agriculture, Food & Tobacco Textiles, Printing & Publishing Chemicals Pharmaceuticals Extractive Durable Manufacturers Computers Transportation Utilities Retail Financial Services Services TOTALS Panel B: Exchange Listings

Exchange NYSE AMEX NASDAQ Other TOTALS

CRSP Full Sample N % 3,726 25.7% 1,827 12.6% 8,694 60.0% 251 1.7% 14,498 100.0%

Tested Sample N 1,273 187 2,546 2 4,008 % 31.8% 4.7% 63.5% 0.0% 100.0%

HPB Sample N % 38 27.0% 3 2.1% 100 70.9% 0 0.0% 141 100.0%

Industry membership is determined by SIC classifications as follows: agriculture/food (0100-0999) mining & construction (1000-1999, excluding 1300-1399), food (0100-0999, 2000-2111), textiles & printing/publishing (2200-2799), chemicals (2800-2824, 2840-2899), pharmaceuticals (2830-2836), extractive (2900-2999, 1300-1399), durable manufacturers (3000-3999, excluding 3570-3579 and 36703679), computers (7370-7379, 3570-3579, 3670-3679), transportation (4000-4899), utilities (4900-4999), retail (5000-5999), financial services (6000-6999), and services (7000-8999, excluding 7370-7379). CRSP Population represents the 14,498 U.S. publicly-traded companies that have at least some CRSP data in the period 1997 through 2007. The Tested Sample consists of those companies with at least four independent grants that cleared the filters used for the test. The HPB Sample is defined as the High Probability Sample of 141 observations at the cutoff level of 0.05 percent (as shown in Table 1).
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TABLE 3 Managerial/Director level tests (1) Managerial Level All Levels Officers Directors CEOs CFOs Other Officers Inside Directors Outside Directors (2) Companies Tested 141 133 115 76 68 114 76 68 (3) p 0.05% N % 141 111 57 38 33 82 39 27 100% 83% 50% 50% 49% 72% 51% 40% (4) Independent Grants 1,493 1,204 935 559 494 960 583 518 (5) Average Grant Rank 10.6 9.1 10.9 8.1 7.9 8.8 8.4 12.3

This table summarizes the distribution of abnormally favorable grants among different types of insiders for the 141 HPB companies. (1) The first column gives the recipients role, based on ROLECODE1-4, as taken from SEC Form 4s and compiled in the TFN database. Eight managerial levels were examined: 1) all recipients, 2) officer (any member of levels 4-6), 3) director, 4) CEO, 5) CFO, 6) other officer, 7) inside director (any member of both levels 2 and 3), and 8) outside director (any member of level 3 who is not in level 2). (2) The second column gives the number of companies with sufficient data to apply the Joint Probability Technique at each level. For each company, each insider level has a smaller number of independent grants than the total number of independent grants. That means this total can be less than 141, the total number of HPB companies. For instance, the officers of 133 of the HPB companies had sufficient grants that met the Joint Probability Test criteria, but the officers of the other 8 companies had fewer than the four grants required for the test. (3) The third and fourth columns give the number and percentage of times the patterns of grants were significant at the cutoff used in this paper (0.05 percent). (4) The fifth column gives the number of independent grants made at each managerial level and used for computing the average grant rank. (5) The sixth column gives the average rank of the grants obtained by recipients at each level.

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TABLE 4 Analysis of stock market delisting eventsa HPB Sample Sample Control N % N % 31 22% 38 27% 72 51% 141 100% 16 11% 25 18% 100 71% 141 100% DHPB Sample (1) Sample Control N % N % 4 8% 5 10% 40 82% 49 100% 4 8% 9 18% 36 74% 49 100% UHPB Sample (2) Sample Control N % N % 27 29% 33 36% 32 35% 92 100% 12 13% 16 17% 64 50% 92 100%

Reason for Delisting Mergers & Combinations Total Unfavorable Delisting Events Active Companies Total
a

The table gives the statistics and reasons for delisting for the full HPB and control sample, as well as for two subsamples and their control companies: (1) the disclosed DHPB and its control sample, and (2) the undisclosed UHPB and its control sample. Delisting reasons are obtained from CRSP. For the full sample and the two subsamples, the number of observations and the percentage of the total are shown for the specific sample and its control sample. The reasons given for the unfavorable stock market delisting events are the following: delinquent filings; stock price too low to meet exchange requirements; company request; bankruptcy; stock pricing listing moved to over-the-counter market; insufficient capital, equity, float, or assets; or protection of investors and the public interest.

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TABLE 5 Stock price performance results from high probability backdating (HPB) companies Period Analysis: Buy-and-Hold Abnormal Stock Returns 2005 2006 2007 2005 to 2007 HPB Sample Equal Value 10.23 11.97 8.85 31.05 8.38 11.25 15.31 34.94 DHPB Sample Equal Value 13.14 18.37 0.22 31.73 10.93 15.13 9.83 35.89 UHPB Sample Equal Value 8.40 6.82 24.24 39.46 6.99 7.54 32.96 47.49

The table reports risk-adjusted buy-and-hold abnormal stock returns (BHAR) over three 12-month periods: 2005 to 2007. The company-year observations are HPB (n = 261), DHPB (n = 134), and UHPB (n = 127). The table reports median BHARs using both equal- and value-weighted market-adjusted indices to produce the abnormal returns. The reported values are estimated over each fiscal year and accumulated across the three fiscal years to yield the three-year cumulative abnormal stock return. BHARs that appear in boldface indicate that the null hypothesis, Median (BHAR) = 0, can be rejected at a 10%.

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FIGURE 1 Histograms of measured likelihood of backdating

Histograms showing the probability values for the 4,008 companies tested by the Joint Probability Technique. Note the different scales on each panel. The top panel shows coarse binning of 1 percent bin width over the full range and the bottom shows finer binning of 0.01 percent width for just the lowest 1 percent (the leftmost bin in the top panel). The dashed horizontal lines correspond to the number expected in each bin if the null hypothesis was correct, 40 companies per bin in the upper panel and 0.4 companies per bin in the lower panel. Note the strong excesses at lowest probability values. The lower panel shows that 141 companies have p-value 0.05 percent (sum of the lowest five bins).

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FIGURE 2 Stock price charts for KV Pharmaceuticals

The four stock price charts represent four independent (and tested in the current paper) grants issued by KV Pharmaceutical. Circle/cross symbols mark the dates the forms were received by the SEC and Xs mark the putative grant dates. All four grant dates are the most favorable possible within the 51-day testing windows (denoted by dashed vertical lines). The Joint Probability Technique, which returned a probability value p 10-6 for this company, is designed to detect just this sort of abnormally favorable pattern of option awards relative to the stock price movement. This type of pattern is seen repeatedly within the HPB sample. The last two grants marked Non-Compliant exceeded the SOX 2-day reporting requirement in effect at the time.

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FIGURE 3 Control test results

This plot shows the results of application of this technique to data with the dates scrambled. A bias against low p-values appears due to the fact that ties can affect the real data but not the Monte Carlo simulated data. Note that this is a conservative effect; it can only increase p-value, and thus cannot cause the strong excesses seen at low p-values in Fig. 1. The dashed line represents the value that would be expected if there were no bias.

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FIGURE 4 Stock market capitalization for the disclosed and undisclosed High Probability Backdating (HPB) samples

Histograms of market capitalization for the 141 companies in the HPB sample, partitioned into the 49 observations that have disclosed backdating (the DHPB sample; top panel) and the 92 observations that have not yet made any such disclosures (the UHPB sample; bottom panel). Note that larger market capitalization companies are more likely to have been charged or restated earnings due to backdating than smaller companies. The Kolagorov-Smirnov test indicates the two distributions are different at a confidence level of 10-6.

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FIGURE 5 Backdating rates surrounding enactment of the Sarbanes-Oxley two-day rule

The figure represent the fraction of rank = 1 grants binned in half-year intervals for the HPB sample. This includes all grants, even those with lags < 10 days. The horizontal dashed line shows the fraction that would be expected in the absence of backdating (approximately 2 percent). The dotted vertical line refers to August 29, 2002, the date the SOX 2-day reporting requirement went into effect. The solid line is a one-year boxcar average. Note the fraction of the most favorable possible grants averages 26 percent (with large scatter) for mid-1998 through 2001, then shows a precipitous decrease in 2002. Over the last two years studied, the level was 2 percent, which is fully consistent with no backdating.

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