Research Magazine 2006

Study reveals executives profit by manipulating stock repricings

stock ticker

High-level corporate executives make money—lots of money. What accounting Associate Professor Chandra Subramaniam wants to know is whether their good fortune stems strictly from superior business practices. Occasionally it seems that profits on executive stock options come with the taint of insider information.

Options give the recipient the right to buy stock in the future at today’s price. If an executive receives stock options at an exercise price of $10 per share, and at some time in the future when she’s fully vested in the company the stock is worth $50 per share, she could buy at the first price and sell at the second, making a tidy profit.

All perfectly legal.

“Options motivate you to help the stock price increase,” Dr. Subramaniam said. “Options are good because they provide appropriate incentives for managers and align their incentives with the shareholders.”

But what if the stock price goes south? If an executive received options to buy stock at $50 per share and the value was $10 when it came time to sell, those options would be “under water.” In this situation, companies sometimes cancel the options and issue new ones at market price.

In this, as in all market transactions, timing is everything, and that’s where Subramaniam has detected a little hanky-panky.

Along with two co-researchers, he studied 236 firms that repriced their stock options between 1992 and 1997, and he discovered a sophisticated method of manipulating the market.

“What we wondered was, ‘Are the repricings or resettings being timed for the benefit of the managers?’ ”

In a recent paper published in the Journal of Finance, the researchers laid out their findings. In several cases, the repricing was timed fortuitously—suspiciously so.

Firms determine the best timing based on their earnings reports. Numerous firms in the study with a poor report waited until after it came out to reprice their stock. A poor report historically equals lower stock prices, and thus a cheaper exercise price for option holders.

The idea is that later, when the stock is sold, the price will have risen. Careful timing works if the earnings report looks good as well. In that case, the repricing happens before the report comes out when the stock price has dipped to its lowest point. Once the report is made public, the price increases, granting instant equity to the options holder.

Earnings reports are public information; the dates of stock repricings are not. The date of a repricing is not made public until several months after the event. Managers who manipulate the timing buy low and sell high—a surefire recipe for profit.

“We found that, on average, the effect of repricing options benefits managers by half a million dollars,” Subramaniam said. “Carefully timing the repricing gets them another half a million.”

Only about 5 percent of firms reprice each year.

The Journal of Finance nominated the researchers’ work for the Brattle Prize, a prestigious honor in the world of academic finance, and it has attracted the attention of the federal Securities and Exchange Commission.

Investor groups like the Investor Relations Responsibility Center and Legg Mason Capital Management requested copies of the paper.

“They have also used sections of the paper in various reports they’ve made to institutional investors,” said Subramaniam, who plans to further investigate the questionable practice.

With all this expertise in the machinations of the market, how do Subramaniam’s own investments fare?

“I don’t invest,” he said. “I find the vagaries of the stock market too much to handle.”

— Sherry W. Neaves