“Option Backdating, Board Oversight, and Corporate Governance: Evidence from Firms Interlocked with Backdating Investigation Targets” by Cong Wang
The Chinese University of Hong Kong
Veronika Krepely Pool
We provide insight into the nature and contributing factors of the controversial practice of option backdating by analyzing the stock price reactions of firms interlocked through directors with companies under backdating investigation. Our evidence suggests that option backdating is a manifestation of managerial rent extraction and investors hold directors at least partially responsible for it. Specifically, we find that a company's backdating investigation announcement generates significant and negative abnormal stock returns to its interlocked companies. The abnormal returns are more negative when interlocking directors sit on the compensation committee of the backdating investigation target, and less negative when the interlocked companies have stronger corporate governance and higher-quality management in place. These findings indicate that the backdating revelation prompts investors to question the judgment and monitoring ability of directors at the investigation target and to critically reassess the governance quality of the other companies where these directors also hold board seats. We also find that interlocked companies exhibit significantly higher CEO compensation and more aggressive earnings management than do carefully selected control companies, suggesting that the poor judgment and lax monitoring of interlocking directors contribute to other agency problems in addition to option backdating.