Predicting SEC fraud: Look for CEOs with in-the-money stock options

by Kurt Schulzke

Since August 2010, the DJIA is up 2,300 points or roughly 23 percent.  How much of the rise is real and how much is due hidden financial reporting “irregularities”?  What is the best predictor of financial statement fraud?

SEC whistleblowers take note: A 2007 study* found “that CEOs with substantial amounts of in-the-money options are more likely to issue financial statements with non-GAAP accounting irregularities. ”  The study found other contributing factors include interest coverage debt covenants, new debt or equity raises, and CEOs serving as board chair.

Remarkably, the study found that while CEOs at the studied firms exercised some of their in-the-money options, they sold only a small portion.  The authors suggest that this anomaly may be due to (a) “the sheer size of option holdings [making] it difficult to sell without depressing market prices,” (b) “investors closely monitor[ing] CEO trading,” (c) “CEOs may have been optimistic that future share prices [would] be even higher,” (d) CEOs’ undisclosed use of “derivatives [like put options] to offset any future decline in the stock price,” or (e) borrowing against the options by some CEOs like Bernie Ebbers and Ken Lay.

* Jap Efendia, Anup Srivastavab and Edward P. Swanson, “Why do corporate managers misstate financial statements? The role of option compensation and other factors,” Journal of Financial Economics (September 2007).

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