Last modified: Monday, June 19, 2006
Kelley School of Business-Indianapolis professor helps uncover major investor fraud
FOR IMMEDIATE RELEASE
June 19, 2006
INDIANAPOLIS, Ind -- At Indiana University's Kelley School of Business, faculty pride themselves on emphasizing real-life, relevant business trends in their research and teaching. Professor Randall Heron took this philosophy to the extreme recently when his research led to an ongoing investigation of investor fraud at companies across the nation.
Heron, an associate professor of finance at Kelley-Indianapolis, did research with Erik Lie of the University of Iowa that revealed that many companies were "backdating" stock option grants for corporate executives. Backdating allows executives to choose the time at which stock options are granted, even if the date is days or even months in the past. This enables the executives to lock in lower purchase prices and benefit from stock price increases that have already occurred.
In their study forthcoming in the Journal of Financial Economics, Heron and Lie examined the stock price behavior around executive stock option grants both before and after the Sarbanes-Oxley Act (SOX) changed the reporting requirements for option grants. Prior to the regulatory change, implemented on Aug. 29, 2002, option grants to executives did not have to be reported until 45 days after the close of the company's fiscal year. Beginning on that date, option grants are to be reported to the Securities and Exchange Commission within two days of the grant decision.
Heron and Lie found that a pattern of significant stock price declines leading up to executive option grants followed by significant stock price increases following the grants, which was present prior to the regulatory change, disappeared for firms that filed their option grants with the SEC within one day of the grant decision in the post-SOX period. They also found that roughly one-fifth of the option grants made since the regulatory change were not reported to the SEC within the two-day requirement.
On average, these late filers saw the value of their stock decline by more than 3 percent in the 30 days prior to their option grants, and rise more than 7 percent in the 30 days following the declared option grant date. The re-emergence of such a favorable stock price pattern for late filers suggests that, even after SOX, many companies continued the practice of backdating option grant dates for executives to boost the value of their stock options. They were found to have attempted to disguise the practice from investors and regulators by filing late.
Although there is an ongoing debate regarding whether the backdating of stock options is illegal, many companies are getting into trouble because they are not accounting for the backdated option grants correctly for both financial reporting and tax purposes.
When option grants are backdated to obtain lower, more favorable exercise prices for executives, the companies were required -- for financial reporting purposes -- to report the spread between the declared exercise price and the market price of the stock on the day the grant decision was made as a compensation expense. This lowered reported earnings as a result. Many companies were not reporting the grants correctly and as a result were misleading investors by overstating earnings.
"The SEC has taken the position that this erroneous reporting represents financial fraud and is investigating numerous companies who will likely, in addition to possibly paying penalties, be forced to restate their earnings," Heron said.
Companies are also getting into trouble because their failure to account for backdated options correctly has shielded corporate income from taxation and thus lowered corporate tax bills. This has prompted lawmakers and the Internal Revenue Service to pursue fines, the repayment of taxes and other legal actions against several companies and their executives.
"Stock options are supposed to provide incentives for executives to work to improve the firm's future performance," Heron said. "However, backdating stock options so that they are already in-the-money and disguising the practice can be compared to letting executives bet on a game where they already know the final score."
The investigations triggered by Heron and Lie have been featured in the Wall Street Journal, Business Week, Fortune, U.S. News & World Report and The Economist, with coverage in other national business publications forthcoming. SEC officials report that the commission likely will issue new rules requiring companies to report to investors the exact dates on which options were issued, and at what prices. The SEC and federal prosecutors are now pursuing action against at least 35 companies, including large insurer UnitedHealth Group.
The IU Kelley School of Business has been a leader in American business education for more than 80 years. With an enrollment of 3,716 undergraduate and over 1,000 graduate students, it is among the premier business schools in the country, with both the undergraduate and graduate programs ranked among the best in the United States. Kelley's Indianapolis campus, based at IUPUI, is home to the school's Evening MBA and Master of Professional Accountancy programs and a full-time undergraduate program. Learn more at https://www.kelley.iupui.edu.