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The Journal of Financial Research

 Vol. XLI, No. 1  Pages 91–111  Spring 2018

DO SCANDALS TRIGGER GOVERNANCE CHANGES? EVIDENCE FROM OPTION BACKDATING

Atul Gupta Bentley University

Lalatendu Misra University of Texas at San Antonio

Yilun Shi Independent

Abstract We examine whether firms charged with backdating option grants make discernible changes to board structure and activity and whether such changes help recoup value losses from the revelation of option backdating. We find that these firms increased board size, reduced duality, and increased board independence. In addition, the boards and the compensation committees of these firms experienced significant increases in meeting frequency. We also find that firms in the same sectors that had not been identified as backdating option grants experienced similar changes in board activity and some elements of board structure. Additional analysis reveals that increases in board size, chief excutive officer turnover, and the meeting frequency of the audit committee are related to buy-and-hold abnormal returns in the postscandal period. JEL Classification: G30, J33

I. Introduction Reputational damage resulting from public revelation of corporate misconduct has a significant negative impact on a firm’s stakeholders (e.g., Alexander 1999; Gande and Lewis 2009; Bernile and Jarrell 2009; Karpoff and Lott 1993; Karpoff, Lee, and Martin 2008a, 2008b; Palmrose, Richardson, and Scholz 2004). The likelihood of corporate misconduct is itself strongly related to the presence of financial incentives in the form of option-based compensation and the quality of the firm’s governance systems (e.g., Collins, Gong, and Li 2009; Carver, Cline, and Hoag 2013; Minnick and Zhao 2009). Corporate actions designed to stem the damage and rebuild reputation generally include replacing top executives, improving board independence, and possibly restructuring elements of executive compensation. We contribute to this literature by focusing on firms charged with backdating (BD) stock option grants and asking a series of broad questions. First, do these firms We thank an anonymous associate editor and referee for their helpful comments. Earlier versions of the paper were presented at the Southern Finance Association and the Southwestern Finance Association meetings.

91 © 2018 The Southern Finance Association and the Southwestern Finance Association

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experience discernible changes in board structure and activity in the period following the scandal? We focus on three measures of board structure—board size, independence, and duality—and three measures of board activity—the meeting frequency of the full board, the compensation committee, and the audit committee. Second, are there spillover effects on oversight and governance for other firms in the same industries as those charged with BD? Third, are any such changes transitory and restricted to the year of the scandal or are improvements in board structure and activity observable in later years? Finally, do changes in board structure and activity help reduce the financial damage triggered by the scandal? Our work is similar in spirit to Farber (2005) and Marciukaityte et al. (2006), who examine the effectiveness of governance changes at firms charged with fraud. These firms had weak governance structures in the year preceding the fraud charges but implemented a variety of changes over the next three years that brought their governance characteristics in line with the set of control firms. Farber reports that firms charged with fraud experienced superior stock price performance in the years following the governance changes, but Marciukaityte et al. do not find abnormal stock returns or improvements in operating performance following the changes in corporate governance. The findings of Farber (2005) and Marciukaityte et al. (2006) apply to firms that engaged in fraudulent activities with potentially severe implications for corporate valuation. The BD scandal, in contrast, was primarily a reputational event; the practice did not have significant cash-flow consequences and the revelation of option BD had a relatively small effect on shareholder returns (Bernile and Jarrell 2009). In addition, BD firms constitute a large sample of firms charged with a specific type of misconduct. Using a sample where there is a relatively homogeneous set of charges is useful because both the corporate response to fraud charges and the firm’s ability to recover from the damage may vary with the type of infraction. Our empirical analysis uses a sample of 115 firms that are charged with BD option grants and a matched sample of firms that are not targets of a BD investigation. Consistent with earlier studies (Bernile and Jarrell 2009; Carow et al. 2009; Narayanan, Schipani, and Seyhun 2007), we find a negative and statistically significant price reaction to news of the BD charge. Following the revelation of BD, we find that the sample firms experienced significant increases in board size, board independence, and chief executive officer (CEO) turnover; a significant decline in duality; and significant increases in the meeting frequency of the board and the compensation committee. Our findings suggest that these firms made a concerted effort to address reputational problems by improving oversight procedures in the wake of the BD scandal. Several of the changes in board structure and activity are not restricted to firms charged with BD but are also observed at the set of control firms. In particular, we document significant increases in meeting frequencies for the board and the compensation committee, as well as significant changes in duality and CEO turnover at these firms. Our findings indicate that the revelation of option BD by some firms had a spillover effect on monitoring and governance practices at not just those firms charged with BD but also firms in related sectors that made significant use of option-based compensation.

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In addition to documenting changes in board structure and activity from before (pre-2006) to after (post-2006) the BD scandal, we examine whether these changes occurred in the year of the scandal or persisted in post-2006. We find that relative to the control firms, sample firms had significantly higher meeting frequency for the board as well as the audit and compensation committees in 2006; the significant difference in meeting frequency for sample versus control firms continued into 2007 and for the audit and compensation committees into 2008. In addition, these firms continued to make changes to board size and board independence into 2008, suggesting that at firms charged with BD, changes in board structure and activity were not restricted to the year of the scandal but continued for at least two years beyond that. We then examine whether such governance changes are instituted at all the sample firms or whether the adoption of changes was related to the magnitude of the reputational losses resulting from BD. We find, based on three proxies for the extent of reputational losses, that all the sample firms showed improvements in a variety of governance metrics, including declines in duality, increases in the proportion of independent directors, and higher meeting frequency for the board as well as for the compensation and audit committees. In addition, we show that firms experiencing relatively large reputational losses experienced a statistically significant CEO turnover rate; this is not the case for firms that experienced relatively low reputational damage. Finally, we examine whether the changes in board structure and activity helped reverse the value losses incurred by firms charged with BD option grants. We do this by estimating a market-adjusted buy-and-hold abnormal return (BHAR) for each firm in the 18-month period from January 2007 to June 2008, and regress the BHAR on measures of changes in board structure and activity. We find some weak evidence suggesting that increases in board size and in the meeting frequency of the audit committee are positively related to the BHAR. In contrast, higher levels of CEO turnover are negatively related to the BHAR, presumably because higher CEO turnover may reflect relatively more serious problems with the firm’s governance structure. Our work contributes to the literature on the interaction between governance quality and corporate misbehavior. In particular, although the drivers of corporate misbehavior have been extensively studied in the literature, corporate attempts to rectify the damage have received less attention. Our work fills this gap by providing evidence on ex post changes in governance implemented by firms charged with a particular type of wrongdoing, and the possible spillover that scandals may have on governance practices at similar firms not charged with malfeasance. We also provide evidence on the effectiveness of these changes at rebuilding investor confidence and reversing value losses incurred at the time corporate misbehavior was revealed.

II. Literature and Hypothesis Development The revelation of financial misconduct by corporate executives can have significant negative consequences for corporate stakeholders. Direct costs associated with accounting and legal fees as well as judicial and regulatory sanctions contribute to observed value losses; reputational damage caused by such revelations is another major

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contributor. Karpoff, Lee, and Martin (2008a), for example, examine a sample of 585 firms targeted by the U.S. Securities and Exchange Commission (SEC) for financial misrepresentation and find that these firms lose 38% of their market value when the enforcement action becomes public. In addition, their analysis shows that fully two-thirds of the value losses follow from costs associated with the reputational damage caused by the fraud charges. Several papers document that firms charged with BD option grants experience significant negative abnormal returns of approximately 7% in the period immediately preceding and including the public release of the information (Bernile and Jarrell 2009; Carow et al. 2009; Narayanan, Schipani, and Seyhun 2007). Given that BD had minimal cash-flow implications, these value losses are presumably driven almost entirely by the reputational impact of the revelation of this type of selfdealing behavior. Reputational costs are large presumably because the revelation of financial misconduct increases investor uncertainty about managerial integrity and the board’s ability to monitor self-serving managerial actions. The issue facing the firm is how to repair the reputational damage caused by revelations of financial misconduct. Karpoff, Lee, and Martin, (2008b) indicate that managers who participate in “cooking the books” lose their jobs after the investigation period ends and become much less likely to hold similar positions in the future. In the case of BD, Efendi et al. (2013) document high executive turnover relative to control firms; forced turnover of the CEO or chief financial officer (CFO) takes place in almost one-third of the BD firms. Ertimur, Ferri, and Maber (2012) provide evidence that BD-related directors are less likely to be reelected. Improving governance quality can contribute to rebuilding investor trust and rebuilding reputational quality, both of which could arguably add to firm value. Farber (2005) tracks changes in governance practices at 87 firms charged with fraudulently manipulating their financial statements and finds improvements in board independence, duality, and frequency of audit committee meetings as well as the presence of a financial expert on the audit committee. Farber reports that such changes are unrelated to changes in institutional ownership or analyst following, but finds a positive relation between changes in board independence and BHARs over a three-year period following the fraud charges. Marciukaityte et al. (2006) examine measures of board independence at firms charged with a variety of regulatory violations and find significant improvements in the years following the fraud charges; they do not find improvements in either stock returns or operating performance. In this article, we focus on firms charged with BD option grants and pose several testable hypotheses, as outlined below. Board Structure and Monitoring Activity Did firms experience changes in board structure and activity in the aftermath of the BD allegations? As suggested by Farber (2005) and Marciukaityte et al. (2006), observable improvements in these areas could reassure investors, reduce information risk, and potentially allow the firm to recoup some of the reputational losses associated with the BD allegations. Our proxies for board structure include board size, the incidence of CEO duality, and board independence. Duality is supposed to have a negative impact on the quality of governance whereas board independence is likely to have a positive influence.

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The influence of board size may vary by firm size, and by the operating, technical, or financial complexity of the firm; this makes its impact on governance quality uncertain (Coles, Daniels, and Naveen 2008; Linck, Netter, and Yang 2008). Regarding board activity, Vafeas (1999) documents an increase in board meeting frequency at firms that experience a stock price decline, and an improvement in operating performance following this enhanced level of board activity. Similarly, Xie, Davidson, and DaDalt (2003) find a negative relation between the frequency of audit committee meetings and the level of earnings management; McMullen and Raghunandan (1996) find a similar negative relation between audit committee meeting frequency and the likelihood of financial reporting problems. We include meeting frequency (board, compensation and audit committees) as proxies for changes in monitoring activity, and expect to see an increase in meeting frequency at the sample firms. In addition, the revelation of option BD may have triggered self-examination at firms that were not initially included in the list of firms that backdated option grants. We therefore expect to see heightened meeting frequency at both the sample and control firms. A final interesting question is the extent to which increases in meeting frequency were transitory, and board activity returned to “normal” once the BD issue was examined and resolved. In this event, we expect to observe a spike in meeting frequency in 2006, followed by a decline in 2007 and 2008. Our hypotheses relating to board structure and activity following BD allegations are summarized in Table 1. Drivers of Changes in Board Structure and Activity It seems reasonable to expect that the board would react to charges of option BD by investigating what happened and why. We therefore expect to observe significant increases in the meeting frequency of the board as well as the audit and compensation committees. Changes in board structure may be more complex and difficult to implement, and these costly signals of board commitment may therefore occur only when the magnitude of the reputational loss resulting from BD is relatively large. We use three proxies for the magnitude of the reputational loss. First, we follow Karpoff, Lee, and Martin (2008a) and use the stock price reaction to news of BD allegations as a proxy for the extent of the reputational loss. Our second proxy is the incidence of financial restatements resulting from BD option grants as in Ertimur, Ferri,

TABLE 1. Expected Changes to Board Structure and Activity following Backdating Allegations. Variable Board size CEO duality Proportion of independent directors Meeting frequency Board Audit committee Compensation committee

Expected Change ? Decline Increase Increase Increase Increase

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and Maber (2012). It is possible that the reputational loss varies with whether the news of BD announcement is due to an internal investigation versus an SEC investigation. A priori, it appears plausible that an announcement of an SEC investigation is viewed by investors as a more serious indicator of corporate malfeasance and is thus likely to have a greater reputational impact. We therefore use the presence of an SEC investigation as our third proxy for the magnitude of reputational damage. We expect changes in board structure to be (1) negatively related to the magnitude of the stock price decline upon news of BD allegations, (2) negatively related to the incidence of financial restatements following BD, and (3) larger in cases where there is an SEC investigation into the firm’s option-granting practices. Improvements in corporate governance are likely to be reassuring to investors. But do they help reverse value declines resulting from the reputational impact of BD allegations? We use BHARs for an 18-month period following the changes in corporate governance, presumed to be completed in the year following public revelation of option BD, to proxy for value changes, and we use this proxy examine whether observed changes in value are related to our measures of changes in board structure and activity.

III. Sample Selection and Institutional Background We obtain an initial sample of firms charged with BD stock option grants from the Wall Street Journal’s “Perfect Payday: Option Scoreboard” column of January 10, 2007. Bloomberg News also reported a list of 208 firms involved in BD later in 2007. From both lists, we obtain 150 firms that announced BD in 2006. We then exclude the following cases: (1) firms that were acquired, taken private, or went bankrupt during 2006–2009; (2) firms that merged with other companies or split into multiple companies; and (3) firms with no proxy filings until 2010. Details regarding each of these items are listed in Panel A of Table 2 and result in a final sample of 115 BD firms. As seen in Panel B, BD firms belong to a wide range of industries, but the largest concentrations are in computer services (Standard Industrial Classification [SIC] code 32) and business services (SIC 73). The sample firms usually have multiple BD-related stories during 2006–2008. Many of the first events are internally initiated. Typically, these reviews involve past option-granting practices in response to requests from the board or its subcommittees, or initiated by management. Other trigger events are initiated by outside parties, such as the SEC initiating an informal investigation, subpoena from the U.S. Department of Justice (DOJ), or investor-initiated actions. In terms of timing of announcements, most of the initial announcement dates are clustered in mid-2006, particularly after the Wall Street Journal started listing companies in its option scoreboard in March 2006. After the first trigger event, firms often faced shareholder lawsuits relating to option BD and many eventually restated their financial statements. Moreover, in responding to requests to strengthen their governance structure, many firms took actions that include executive departures and director replacements in relatively short order (Efendi et al. 2013; Ertimur, Ferri, and Maber 2012). The entire investigation, law

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TABLE 2. Sample Summary. Panel A. Sample Reconciliation Description Companies that publicly announced option backdating by 2006 Cases excluded for following reasons: Had announcement date in 2005 Taken private during 2007–2010 Acquired by others during 2007–2010 Merged with other firms during 2007–2010 Went bankrupt during 2007–2010 No proxy filings until 2010 Split into multiple units Others Sample used in the study

152 2 7 15 5 3 2 1 2 115

Panel B. Industry Distribution Industry 13 15 20 28 32 35 36–Computer service 38 39 48 49 50 52 53 56 57 58 59 63 67 73–Business service 80 82 83 87 Total

Observations

% Observations

2 1 3 6 1 10 33 8 1 2 1 3 1 3 3 1 2 2 3 2 21 1 2 1 2 115

1.74 0.87 2.61 5.22 0.87 8.70 28.70 6.96 0.87 1.74 0.87 2.61 0.87 2.61 2.61 0.87 1.74 1.74 2.61 1.74 18.26 0.87 1.74 0.87 1.74 100

enforcement, and restructuring process can last more than two years, particularly if the firm faces charges from a federal agency or faces multiple shareholders lawsuits. Our empirical analysis is based on comparisons of BD firms (sample firms) with a set of comparable firms (control firms) that did not backdate option grants. We use a propensity-score-matching technique to generate this set of control firms. Starting with the universe of all presumed non-BD companies in the Compustat database and our sample cases, we run a logistic regression based on total assets and operating profitability in 2004, and four-digit SIC industry codes; these variables are similar to the metrics used

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in Farber (2005). For each sample firm, we then select a control firm with the closest propensity score—the probability from the logistic regression. If we cannot find a match, we relax the SIC industry code to three or two digits. The use of a matched control sample also mitigates the effects of mandatory meeting and board structure changes following the Sarbanes–Oxley Act (Linck, Netter, and Yang 2009). To ensure that the control firms were not involved in the BD scandal, we check that our control firms are not included in a list of firms being investigated for BD option grants (Glass–Lewis Report, 2007).1 For each firm we get stock price and volume data from the Center for Research in Security Prices (CRSP) database and other financial information from Compustat for 2004–2008. Because all announcements took place in 2006, which was the end of fiscal year 2005, we define 2004–2005 as the pre-BD disclosure period and fiscal years 2007–2008 as the post-BD disclosure period. We search each sample and control firm’s proxy filings during 2004—2008 to collect governance variables, including CEO duality, the percentage of independent directors, and the number of board and subcommittee meetings. For the postperformance BHAR, we obtain the firm’s market-adjusted performance over an 18-month period from January 2007 to June 2008. We present the summary statistics for several characteristics of the sample and control firms in Table 3. We provide mean values of each variable for both sets of firms, for each year from 2004 through 2008. The p-values for tests of differences in mean values are almost universally above .10, indicating no significant differences between the sample and control firms in terms of total assets, sales, market capitalization, return on assets (ROA), and earnings before interest, taxes, depreciation and amortization (EBITDA). These results provide some confidence that the two sets of firms are in fact comparable, and the findings reported are not an artifact of the firms chosen as control firms. IV. Empirical Findings We present findings from a variety of tests motivated by the discussion presented in Section II. We first present findings from an event study centered on the first public announcement relating to option BD, because the estimated abnormal returns are one of our proxies for the magnitude of reputational losses resulting from allegations of BD. Event-Study Results We specify the day the BD-related story first appeared in the news as day 0 in event time and use the market model to estimate daily abnormal returns over days surrounding the arrival of BD-related news. Market model parameters are estimated using daily returns over days t ¼ (200, 40) in event time and the equally weighted CRSP index. Consistent with earlier studies (Bernile and Jarrell 2009; Carow et al. 2009; Narayanan, Schipani, and Seyhun 2007), we find a statistically significant abnormal return of 2.54% over the 3-day period t ¼ (1, þ1) and an abnormal return of 5.54% over the The number of firms investigated for BD option grants is larger than 115; the Glass–Lewis Report (2007) indicates that by March 2007, the number was 257. We make sure that our control firms are not included in this list but cannot say with confidence that none of these firms engaged in option BD. 1

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TABLE 3. Summary Characteristics of Sample and Control Firms. 2004

2005

2006

2007

2008

2,556 2,337 .80

2,881 2,249 .40

3,268 2,453 .33

3,424 2,629 .34

3,577 2,451 .20

3,083 1,754 .16

3,479 1,938 .14

4,078 2,114 .12

4,210 2,229 .11

4,350 2,252 .10

5,378 2,953 .06

6,342 3,464 .06

5,191 3,356 .11

5,433 3,186 .12

3,761 1,827 .07

3.12% 2.64% .81

4.04% 4.10% .97

3.51% 4.52% .54

2.70% 2.01% .72

–3.09% –5.47% .46

12.11% 10.22% .64

14.22% 12.89% .73

11.91% 8.62% .62

12.00% 9.84% .61

10.64% 8.56% .59

Panel A. Total Assets ($million) Sample Control p-value of difference

Panel B, Sales Revenue ($million) Sample Control p-value of difference Panel C. Market Cap ($million) Sample Control p-value of difference Panel D. ROA Sample Control p-value of difference Panel E. EBITDA Sample Control p-value of difference

Note: This table shows measures of size distribution: total assets, sales, and market capitalization in Panels A, B, and C, respectively, for the sample and control firms. We present profitability measures return on assets (ROA) and earnings before interest, taxes, depreciation and amortization (EBITDA) as a percentage of sales in Panels D and E, respectively. p-values for the difference in means are also shown.  Significant at the 10% level.

21-day window t ¼ (19, þ1). The abnormal return for a 41-day period surrounding the event, t ¼ (–20, þ20), is 4.90%. Changes in Board Structure and Activity We employ board size, board independence, and duality as proxies for board structure, as described in Section II. We present summary statistics on each of these variables in Panels A–C of Table 4. We provide mean values of each variable and tests for differences in means between sample and control firms over 2004–2008. Board size, independence, and the incidence of duality are comparable for sample versus control firms over 2004–2007; the differences are not statistically significant, except for 2007 when the difference in board size is weakly significant. In contrast, in 2008 both board size and independence are significantly larger for sample versus control firms; these findings indicate that firms charged with BD option grants made changes in board structure that may be perceived as attempts at improving corporate governance. As seen in Panels D and E of Table 4, BD

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TABLE 4. Summary Measures of Governance Practice of Sample and Control Firms. 2004

2005

2006

2007

2008

7.86 7.77 0.50

8.13 7.95 0.91

8.25 7.96 1.38

8.40 8.02 1.77

8.51 7.96 2.63

6.02 6.32 –1.28

6.28 6.37 –0.38

6.46 6.41 0.34

6.63 6.39 1.08

6.73 6.29 2.20

0.58 0.62 –0.69

0.56 0.57 0.00

0.43 0.50 –1.02

0.44 0.45 –0.25

0.39 0.40 –0.28

0.07 0.07 –0.50

0.08 0.15 –1.91

0.21 0.12 1.85

0.13 0.18 –1.10

0.16 0.17 –0.35

0.08 0.10 –0.49

0.23 0.09 2.88

Panel A. Board Size Sample Control t-stat (sample  control) Panel B. Board Independence Sample Control t-stat (sample  control) Panel C. Duality Sample Control t-stat (sample  control) Panel D. New CEO Sample Control t-stat (sample  control) Panel E. New COB Sample Control t-stat (sample  control)

0.12 0.05 1.83

0.13 0.11 0.42

0.14 0.07 1.81

Panel F. Board Meetings Sample Control t-stat (sample  control)

8.47 7.26 2.11

8.88 7.35 2.73

10.93 8.34 3.44

11.34 8.55 3.91

10.55 8.75 2.87

12.07 8.79 4.68

11.31 8.53 3.74

6.92 5.78 2.23

9.18 6.31 5.40

10.49 9.83 0.77

Panel G. Audit Committee Meetings Sample Control t-stat (sample  control)

9.97 8.59 1.79

9.89 8.67 1.75

Panel H. Compensation Committee Meetings Sample Control t-stat (sample  control)

4.84 4.93 –0.53

5.87 5.72 0.15

8.42 6.71 3.50

Note: We present summary measures of governance practices for sample and control firms across the five-year data period. Board size and board independence are shown in Panels A and B, respectively. Chief executive officer/ chairman of the board (CEO/COB) duality, new CEO, and new COB are shown in Panels C, D, and E, respectively. Meeting statistics of the board, audit committee, and compensation committee are shown in Panels F, G, and H, respectively. t-statistics for the difference in means are also shown.  Significant at the 1% level.  Significant at the 5% level.  Significant at the 10% level.

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firms experienced significantly larger turnover in both the CEO and the COB positions in 2006, the year that news of option BD became public. Board and the committee compositions may also influence governance. We examine various measures of board composition but these do not have much explanatory power in the logit or BHAR regressions.2 Furthermore, there is little variation in the composition of the compensation committees as they typically comprise only independent members consistent with the adoption of such rules by the New York Stock Exchange (NYSE) and Nasdaq in 2003 and incorporation of these requirements by sample firms by the period under study. We present our findings on differences in meeting frequency in Panels F–H of Table 4. Boards of BD firms met more frequently than the boards of control firms, and meeting frequency increased through the entire sample period. Meeting frequency of the audit and compensation committees shows a similar pattern. In particular, audit committees at BD firms met more frequently during each of the five years in the study period. Compensation committees at BD firms met more frequently compared to those at control firms, but the difference is statistically significant only in the years following the scandal. In addition, the significantly higher meeting frequency for the audit and compensation committees continues into 2008, indicating that this form of increased monitoring continues for at least two years after the revelation of option BD. Monitoring changes, as captured by meeting frequency, appear not to be transitory but may reflect an attempt by the board to improve overall governance quality going forward. We show the findings for changes in board structure and activity from pre-2006 to post-2006 in Table 5. As we present in Panels A and B, sample firms experienced significant increases in both board size and board independence, and these increases were significantly larger than for the control firms. In addition, as we show in Panel C, both control and sample firms experienced significant declines in duality, but the differential change is not statistically significant. Similarly, as we show in Panel D, both sample and control firms experienced significantly greater CEO turnover post-2006 relative to pre-2006, but the differential change is not significant. As we show in Panel E, for the sample firms, the CEO turnover in the post-2006 period is numerically two times the turnover during the pre-2006 period (0.14 vs. 0.07). For the control firms, there is also an increase in the CEO turnover during the post-period. The difference-in-difference is, however, not significant. These findings are consistent with our expectation that the BD scandal triggered governance improvements not only at firms charged with BD but also at comparable firms in the same sectors. We present our findings on meeting frequency in Panels F–H of Table 5. As we show in the last column of the table, the board as well as the audit and compensation committees at the sample firms met more frequently than those at the control firms; differences in meeting frequency are statistically significant in five of the six time 2

We obtain director turnover statistics including the number of new directors, the number of directors reelected, and the number of directors who resigned, but do not tabulate these data. For example, the number of new directors on the board of sample firms increased from 0.84 in the pre-2006 period to 1.01 in the post-2006 period and the increase is not statistically significant. Similarly, the number of directors not up for reelection increased from 0.66 to 0.85 in the post-2006 period compared to the previous period.

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TABLE 5. Changes in Governance Practice between the Pre- and Postevent Periods. Sample  Control

t-Stat (Sample  Control)

Sample

Control

8.00 8.45 1.67

7.85 7.99 0.55

0.15 0.46

0.59 1.82 2.08

6.14 6.67 2.17

6.31 6.33 0.13

–0.16 0.33

–0.70 1.36 3.26

Panel A. Board Size Pre-2006 Post-2006 t-stat (post  pre) Panel B. Board Independence Pre-2006 Post-2006 t-stat (post  pre) Panel C. Duality Pre-2006 Post-2006 t-stat (post  pre)

0.57 0.41 –2.52

0.59 0.43 –2.60

–0.02 –0.01

–0.28 –0.21 0.08

0.07 0.14 2.34

0.11 0.18 2.09

–0.03 –0.03

–1.29 –0.98 0.00

0.10 0.13 0.97

0.07 0.09 0.82

0.03 0.04

1.21 1.48 0.22

8.64 10.97 3.98

7.33 9.42 3.49

1.31 1.56

2.77 2.25 0.53

10.22 10.64 0.60

8.62 8.71 0.18

1.59 1.93

2.91 3.03 0.56

5.32 6.61 3.52

0.00 2.19

0.01 4.46 5.03

Panel D. New CEO Pre-2006 Post-2006 t-stat (post  pre) Panel E. New COB Pre-2006 Post-2006 t-stat (post  pre) Panel F. Board Meetings Pre-2006 Post-2006 t-stat (post  pre) Panel G. Audit Committee Meetings Pre-2006 Post-2006 t-stat (post  pre)

Panel H. Compensation Committee Meetings Pre-2006 Post-2006 t-stat (post  pre)

5.32 8.80 7.32

Note: We present summary measures of governance practices for sample and control firms. The pre-period is 2004–2005 and the post-period is 2007–2008. Board size and board independence are shown in Panels A and B, respectively. Chief executive officer/chairman of the board (CEO/COB) duality, new CEO, and new COB are shown in Panels C, D, and E, respectively. Meeting statistics of the board, audit committee, and compensation committee are shown in Panels F, G, and H, respectively. t-statistics for the difference in means are also shown.  Significant at the 1% level.  Significant at the 5% level.  Significant at the 10% level.

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windows. In addition, both sample and control firms experienced statistically significant increases in board and compensation committee meetings from pre-2006 to post-2006. These results, as a whole, indicate that the BD scandal triggered significant increases in meeting frequency and in oversight activities as both sample and control firms made an extra effort to understand and react to the problem. For control firms in particular, the significant increase in meeting frequency for the board and the compensation committee, as well as the significant decline in duality and increase in CEO turnover, indicates that the BD scandal triggered important governance spillovers across a variety of firms. Drivers of Changes in Board Structure and Activity It appears reasonable to expect that the reputational and economic impact of revelations of option BD may vary across firms. As we argue in Section II, any changes in board structure and activity can entail substantial costs, and firms may choose to incur such costs only if the reputational damage caused by BD allegations is substantial. We use three proxies to estimate the magnitude of the reputational damage: (1) declines in the market value of equity over a 41-day window, with the BD announcement date designated as day 0; (2) whether the firm filed earnings restatements in the subsequent period; and (3) whether there was an SEC or other governmental agency investigation into the firm’s option granting practices. We hypothesize that larger declines in equity values, restatement filings, or SEC investigations represent situations with the potential to generate greater reputational damage. We present the findings from this analysis in Table 6. Among the board structure variables, changes in board size and board independence are positive and statistically significant for both subsamples, and differences between the two subsamples are not statistically significant. Thus, it appears that firms responded to the BD event by constituting larger and more independent boards to help respond to and recover from the reputational damages. Such structural changes may provide clear signals of corporate intent to investors and other external parties. Duality declines from pre-2006 to post-2006; the change is negative and statistically significant for the high-reputational-damage subsamples. For the lowreputational-damage subsamples, the change in duality is negative but not statistically significant for two of three measures of reputational change; the difference is statistically significant only for the SEC classification. Overall, our findings suggest that BD firms responded to reputational losses by disentangling the roles of CEO and chairman of the board (COB), thereby providing a higher degree of independence and potentially better oversight to the board. We report our findings on CEO and COB turnover in the next two rows of Table 6. We find that the CEO change indicator is positive and significant only for firms in the high-reputational-loss subsamples. In contrast, the COB change indicator is not significantly different from zero for either the high- or low-reputational-loss subsamples. As we show in the last three rows of Table 6, the revelation of option BD triggered a significant increase in the meeting frequency of the board and of the audit and compensation committees. Board meeting frequency increased for both high- and low-reputational-loss subsamples, and the difference in board meeting frequency

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TABLE 6. Changes in Governance Practice of Sample Firms According to Reputational Loss. Panel A. Reputation Loss 41-day CAR

Board size Board independence Duality CEO change COB change Board meetings Audit committee meetings Compensation committee meetings

Panel B. Financial Restatement

Panel C. SEC Investigation

High Loss (N ¼ 57)

Low Loss (N ¼ 58)

Yes (N ¼ 78)

No (N ¼ 37)

Yes (N ¼ 56)

No (N ¼ 59)

Post–Pre

Post–Pre

Post–Pre

Post–Pre

Post–Pre

Post–Pre

0.59 0.58 –0.19 0.10 0.05 2.26 0.44 3.26

0.33 0.48 –0.12 0.04 0.01 2.41 0.36 3.70

0.44 0.54 –0.20 0.09 0.05 2.83 1.37 4.12

0.49 0.50 –0.06 0.03 –0.01 1.28 –1.64 ,a 2.15 ,b

0.38 0.46 –0.27 0.11 0.04 3.87 1.47 4.62

0.54 0.59 –0.05c 0.03 0.02 0.88 ,d –0.60e 2.41 ,f

Note: We present the impact of the degree of reputational loss on the difference in governance measures across the postevent and preevent periods for the sample firms only. The difference between the mean values for the post- and pre-2006 periods is shown in the Post–Pre columns in each panel. We classify reputational loss three ways: (1) according to higher (lower) than the median value of the 41-day cumulative abnormal return (CAR) loss for the sample firms, (2) whether the sample firm eventually restated the financials, and (3) whether the firm was subjected to U.S. Securities and Exchange (SEC) or Department of Justice (DOJ) investigation regarding backdating. Significance levels of the p-values are indicted next to the mean difference. We test for significance between the High Loss and Low Loss columns and between the Yes and No columns. These differences are not significant except as noted below.  Significant at the 1% level.  Significant at the 5% level.  Significant at the 10% level. a The significance level of the difference in audit committee meetings between restated and not restated cases is 3.01 . b The significance level of the difference in compensation committee meetings between restated and not restated cases is 1.96 . c, d, e, f The significance level of the difference between SEC investigation cases and those without SEC investigation are: duality, 0.21 ; board meetings, 2.98 ; audit committee meetings, 2.07 ; and compensation committee meetings, 2.20 .

between the high- and low-loss subsamples is positive and significant when an SEC investigation is used to proxy for reputational loss. The change in audit committee meeting frequency is not significant in the 41-day cumulative abnormal return (CAR) classification. However, when restatements and SEC investigations are used to proxy for reputational losses, the change in audit committee meeting frequency is positive and significant for firms experiencing high reputational losses, and is negative and significant for firms experiencing low reputational loss. Furthermore, the difference between the high- and low- loss subsamples is positive and statistically significant. We do not have a prior expectation on why audit committee meeting frequency would decline for the low-reputational-loss subsamples. Finally, the meeting frequency of the compensation committee increases for both the high- and low-reputational-loss subsamples. In addition, the difference between the two subsamples is positive and statistically significant when restatements and SEC investigations are used to proxy for reputational loss. Our findings support our expectation that compensation committees of firms suffering greater reputational losses

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TABLE 7. Logistic Regression of Post–Pre Changes in Governance Practices. Logistic Specifications Model 1 D Board size D Board independence D Duality D COB D CEO D Board meetings D Audit committee meetings D Compensation committee meetings Constant x2

Model 2

Model 3

Model 4

–0.047 –0.197 0.253 –0.441 20.98

–0.331 0.608 0.088 –0.053 –0.072 –0.033 –0.039 0.247 –0.502 27.50

–0.352 0.560 0.016 0.019 –0.103 –0.028 –0.001 0.238

–0.393 0.751 –0.174 0.197 0.117

–0.128 13.21

Ordered Logit

33.47

Note: This table presents results of logistic regressions on the changes in governance practices post–pre in models 1–3 for the sample and control firms. The dependent variable is coded 0 for control firms and 1 for sample firms. As a robustness check, we present the results of an ordered logit specification based on reputation loss due to financial restatement in model 4. The dependent variable is coded 0 for control firms, 1 for sample firms that did not restate their financials, and 2 for sample firms that restated their financials. We show the significance levels corresponding to the robust standard errors but do not present the standard errors. COB ¼ chairman of the board; CEO ¼ chief executive officer.  Significant at the 1% level.  Significant at the 5% level.

spent significantly more time addressing possible reasons BD occurred and how to ensure that such activity does not continue going forward. Taken together, the findings reported in the Table 6 permit the following broad conclusions about some of the changes following the revelation of BD. First, board size and board independence increased and duality declined. Second, both changes in duality and CEO turnover were more likely for firms that suffered relatively large reputational losses. Finally, boards and their committees generally experienced greater meeting frequency post-2006. We use a multivariate framework to get a deeper insight into the bivariate findings reported in Table 6. In particular, we use a logistic regression where sample (control) firms are coded as 1 (0) to get additional insight into changes experienced at the sample firms following the BD scandal. The independent variables are changes from pre-2006 to post-2006 for each variable of interest. We present findings from this analysis in the first three columns of Table 7. As seen in the first three specifications, sample firms experienced significantly greater improvements in board independence following the scandal. In addition, these firms had a significantly higher number of compensation committee meetings. We report findings from an ordered logit specification in the last column of Table 7, where control firms are coded as 0, sample firms that did not file restated financial statements are coded as 1, and firms that restated their financials are coded as 2. The ordered logit results in the last column of Table 7 are similar to those for model 3. Using other classifications for reputation loss similar to the classiciations shown in Table 6 yields results that are broadly comparable to those shown in model 4 and are therefore not reported.

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Effectiveness of Changes in Board Structure and Activity Our findings reported earlier indicate that the revelation of option BD triggered systematic changes in board structure and activity both at firms charged with BD and at other firms in related sectors. Did these changes help allay investor concerns about selfserving behavior by management? We examine this question by estimating abnormal stock returns in the period following the governance changes documented above and regressing this return measure on changes in our governance proxies. We measure abnormal stock returns by adjusting monthly stock returns by the CRSP value-weighted market returns. We estimate the BHAR from January 2007 to June 2008. The use of this limited time frame to capture corporate actions and the market response is predicated on the behavior of market returns during the financial crisis starting in the latter part of 2008. From the beginning of 2008 until the end of August, the value-weighted market index had dropped by 4%. The cumulative drop in the following three months was 37%. By the end of 2008, the cumulative decline was 40%, with significant increases in market volatility occurring during the second half of 2008. The limitation imposed by the limited time span used for the BHAR measurement due to the market conditions in 2008 requires us to interpret our tests and results with caution, as the independent variables are measured over a longer postevent period compared to the response variable. We assume that governance changes put in place by 2007 have performance consequences captured by the estimated BHAR. Our analysis of the effectiveness of governance changes in reversing value losses caused by the negative reputational consequences of BD revelations entails estimating difference-in-difference ordinary least sqares (OLS) regressions with the BHAR as the dependent variable. Explanatory variables include the difference-in-difference (DD) changes in board size, board independence, duality, the CEO and COB positions, and changes in meeting frequency for the board as well as the audit and compensation committees. We also control for the possibility of different levels of reputational losses by using dummy variables for restatement, SEC investigations, and the size of the 41-day CAR suffered by the firm.3 The independent and dependent variables are winsorized at 2.5% and 97.5%, respectively, to control the impact of extreme values. We report the findings from these regressions, with the BHAR as the dependent variable, in Table 8. The estimated coefficient for board size is positive and statistically significant, suggesting that the market considers increasing the number of board members as a positive move undertaken by the firm to control the reputational damage caused by BD option grants. Conversely, DD New CEO is negatively related to the BHAR, possibly suggesting that CEO turnover is indicative of the potential extent of damage incurred by firm. The effectiveness of the new CEO is unlikely to be fully incorporated in the market response by the mid-2008.

3

We also estimate BHARs over one-year (2007) and two-year (2007–2008) time spans. These specifications yield insignificant findings and are not tabulated. A possible reason for the lack of significance is that the proxy for value creation is noisy, and the financial crisis in mid-2008 added substantially to this noise.

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TABLE 8. Regression of Postevent BHAR.

DD Board size DD Board independence DD Duality DD COB DD CEO DD Board meetings DD Audit committee meetings DD Compensation committee meetings Restate SEC Loss Constant R2 F-statistic

Model 1

Model 2

Model 3

0.058 –0.041 –0.039 0.018 –0.115 –0.003 0.011 –0.004 –0.046

0.059 –0.044 –0.043 0.018 –0.110 –0.003 0.010 –0.004

0.061 –0.044 –0.039 0.011 –0.113 –0.003 0.010 –0.004

–0.110 0.141 2.49

–0.128 0.138 2.42

–0.028 0.057 –0.168 0.146 2.64

Note: This table shows regression results of the postevent buy-and-hold abnormal return (BHAR) over the 18-month period January 1, 2007 to June 30, 2008. The BHAR is computed by adjusting for the Center for Research in Security Prices (CRSP) value-weighted return. The independent variables are difference-in-difference estimated between the post- and pre-2006 periods, and between the sample and control firms. Restate is a dummy variable that indicates whether the firm eventually restated its financial statements to account for the backdating transaction. SEC is a dummy variable that indicates whether the U.S. Securities and Exchange Commission (SEC) (or Department of Justice [DOJ]) initiated an inquiry or action against the firm relating to the backdating allegations. Loss is a dummy variable that indicates whether the 41-day event window cumulative abnormal return (CAR) for the firms exceeded the median value for the sample. We show the significance levels next to the coefficient estimates. COB ¼ chairman of the board; CEO ¼ chief executive officer.  Significant at the 1% level.  Significant at the 5% level.

The change in the number of meetings of the audit committee is positive and significantly related to the BHAR. Our prior expectations are that the compensation committee’s activities would have increased after the BD event. Earlier tables provide evidence of the increased meeting frequency of both the compensation and audit committees. Overall, the mechanism by which meeting frequency translates to the BHAR is unclear. It is possible that more meetings of the audit committee provide a signal of a corporate intention to investigate, respond to, and fix the BD problem. Other variables, including the dummy variables Restate, SEC, and Loss yield, estimated coefficients that are not statistically significant, and overall findings from the models are broadly similar. We also investigate the relative importance of the meeting versus board composition variables by estimating standardized regressions coefficients corresponding to model 2 reported in Table 8. We do not tabulate these findings but instead provide a discussion of the relative size of the betas corresponding to the three significant variables. The standardized beta for the board size variable is significant and it is numerically the most impactful at 0.35. The standardized beta for the CEO change variable is significant and 0.20, and the standardized beta for the audit committee meeting variable is significant and 0.29. Taken together, the standardized coefficients suggest that board size changes have a stronger impact than the meeting frequency of the audit committee, and the CEO change variable has a weaker impact than the other two variables.

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These findings indicate that improvements in the quality of corporate governance, as captured by structural changes in the board and more frequent audit committee meetings, are positively received by investors and allay their fears about ongoing self-serving behavior by corporate insiders. Changes in the CEO position potentially add to uncertainty and detract from value creation, at least in the short run. Other Corporate Responses to BD The focus of this article is on governance changes instituted by the firms in response to BD as a reputation-damaging event. Firms are likely to use additional mechanisms to respond to such a reputation loss and to minimize the probability of potential recurrence of such events in the future. Such preventive measures may include enhanced auditing and/or making appropriate changes to adjust option-based compensation to executives, thereby reducing the potential for recurrence of such managerial conduct. We provide below some preliminary evidence on these additional activities undertaken by firms in our sample. One measure of the intensity of auditing activities is the total audit fees incurred by the firm. We find that the average audit fees for the sample firms pre-2006 were $2.64 million compared to $1.99 million for the control firms. Post-2006, the average audit fees increased to $3.50 million and $2.49 million, respectively. The $0.86 million post-2006 minus the pre-2006 increase for the sample firms is statistically significant (p-value of .02), whereas the increase of $0.50 million for the control firms is not statistically significant. During both periods, the sample firms incurred higher auditing fees compared to the control firms with a difference of $0.65 million pre-2006 (p-value of .02) and a difference of $1.01 million post-2006 (p-value of .00). It is likely that the enhanced expenditure was due to an audit of earlier option grants that led to the BD. Larger option awards to executives may also create unintended incentives for manipulation such as BD. We examine the fair value of options granted for a subsample composed of approximately 80% of the sample firms. The average fair value of options granted indicates the following. Pre-2006, the sample firms issued an average grant of $11.01 million compared to $9.25 million for the control firms. The difference of $1.76 million is statistically significant at the 5% level, indicating that the sample firms appeared to rely more heavily on option-based compensation. Post-2006, the average size of option grants for the sample firms declined to $8.82 million compared to $8.45 million for the control firms. This difference of $0.37 million between the sample and control firms is not statistically significant post-2006. The decline in option grants from pre-2006 to post-2006 for the sample firms was $2.19 million, significant at the 2% level, whereas the decline of $0.80 million for the control firms was not statistically significant. These findings suggest that the negative press and publicity resulting from the BD scandal led firms to reduce their reliance on option-based compensation. A Postscript: Extent of SEC and DOJ Actions On or immediately following the announcement, media reports in many cases indicated that the SEC and/or the DOJ were scrutinizing the BD actions of these firms. Based on the early information, we identify 56 firms that were rumored to be under SEC scrutiny, 30

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firms under DOJ scrutiny, and 62 firms potentially under either SEC or DOJ investigation. The Glass–Lewis Report (2007) indicates that 82 firms were subject to SEC investigation and 37 firms to DOJ investigation by March 2007. SEC or DOJ investigations into corporate malfeasance would typically be a matter of serious concern for both firms and investors alike. We follow each of our 115 sample firms for the next five years to determine the severity of eventual government actions. We cross-reference each of our sample firms against the Accounting and Auditing Enforcement Releases (AAER) and the Litigation Releases made by the SEC from 2006 to 2011. A total of 11 cases from our sample were covered by SEC AAERs. The time distribution of the AAERs is: 1 case in 2007, 5 cases in 2008, 4 cases in 2009, and 1 case in 2010. There were no BD AAERs in 2011. Eight of the 11 cases were initially coded in our sample at the time of the announcement as potentially subject to SEC investigation and 3 case were not initially so coded. For the 11 cases involving SEC investigation, the average monetary consequence of the settlement was 2.5% (median settlement was 0.3%) of the previously overstated financial results. There were no financial settlements in 3 cases, and in 1 case the settlement exceeded 4%. Firms were held liable in 5 cases, and the CEO or CFO was penalized in 6 cases. Officers were subjected to fines of relatively low magnitude and gave their consent to permanent injunction from further violation of Section 13 (reporting requirements) of the Securities Exchange Act of 1934. There are 37 cases of potential DOJ investigations reported in the Glass–Lewis Report of March 16, 2007. We examine publicly available information on each of these cases January 1, 2006 to January 1, 2010 in the LexisNexis database using various search terms. The DOJ subpoenaed documents and brought cases against executives of some of these firms, but there were no DOJ prosecutions against the sample firms for option BD. The executives of 3 firms—Broadcom, Molex Inc., and Take-Two Interactive—were sentenced to serve time. In addition, the Internal Revenue Service charged an executive of Brooks Automation with tax evasion related to option BD. Two other well-known cases where executives were sentenced were Brocade.com and Comverse Technology, but these firms are not part of our sample. V. Conclusions In 2006, the Wall Street Journal and other media outlets ran a series of stories revealing that a large number of firms had been engaging in self-serving behavior by BD option grants to days when their stock price was low, thus ensuring that the options had a relatively low strike price and were in the money at the time of issue. Several papers have documented the value losses associated with these revelations and explored how BD firms differed from others in terms of governance and compensation structures (Bernile and Jarrell 2009; Carow et al. 2009). The literature also documents abnormal turnover among top executives and board members at firms charged with BD (Efendi et al. 2013). We contribute to this literature by examining the corporate response to losses stemming from BD charges. Rebuilding investor confidence requires improvements in corporate governance and oversight, and we examine changes in variables that proxy for

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governance quality. These variables include the size of the board, board independence, duality, CEO/COB turnover, and meeting frequency for the full board as well as for the compensation and audit committees. Our findings indicate that firms charged with BD option grants did in fact make changes that moved them in the right direction; some of these changes are more pronounced in cases where the reputational losses resulting from the scandal were relatively large. Generally, sample firms enhanced their board sizes and the independence of the board. Firms that suffered the greatest loss to their reputations made more substantive changes to their governance practices, including higher CEO turnover. We use stock returns for a limited period that overlaps the governance changes to explore the effectiveness of these changes at restoring investor confidence. We find that the BHAR is positively related to increases in board size and to the frequency of audit committee meetings, and is negatively related to CEO turnover. Finally, we find that the revelation of option BD triggered observable changes in board structure and activity not just at the firms charged with BD but also at other firms operating in the same sectors. These findings indicate that corporate scandals may have positive spillover effects, in that they trigger board activity that can lead to desirable changes in corporate governance.

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