Options Backdating: The Statistics of Luck

08 March 2007
By Dr. Patrick Conroy et al.

As options backdating continues to come under scrutiny by federal investigators, auditors, investors, the media, and the plaintiffs' bar, among others, a new NERA paper sheds light on the limited extent to which academic literature on options timing may be used to draw direct conclusions about specific company practices. The authors explain that the scope of current academic literature on backdating has been limited to methodologies designed to detect aggregate patterns, rather than analyze specific companies. Because of this, these studies do not disentangle legal from illegal practices, according to the authors.

The NERA paper also examines many misconceptions currently circulating about the statistical calculations that have been used in connection with backdating -- including some used in the March 18, 2006 Wall Street Journal article, "The Perfect Payday."

Among other findings, the authors show that:

  • Some grant patterns that may at first appear extremely unlikely are actually likely
  • The Wall Street Journal article did not account for the vast number of directors and officers (D&O) in the US who receive options grants. With such a large number of D&O, it is a near certainty that some of them would receive most of their grants on days when the stock price was particularly low, even in absence of any illegal practices
  • Factors that were disregarded in published probability calculations may be especially important when estimating the likelihood of option grants for specific companies

This is the third installment of the NERA Insights: Options Backdating Series, a series of papers dedicated to the analysis of options backdating. All papers in the series include an updated, detailed table summarizing the companies that have been identified for potentially improper option-granting practices. Part I, Options Backdating: A Primer, provides an introduction to the properties of options as a financial instrument and how these properties relate to the practice of backdating. Part II, Options Backdating: Accounting, Tax, and Economics, provides an overview of the potential accounting, tax, and economic consequences stemming from the practice of backdating. The next topic in the series will offer an in-depth examination of related company statistics. To learn more about NERA Insights: Options Backdating Series, please contact Dr. Conroy.