When the dot-com bubble of the late 1990s sent stock prices soaring, something else soared, too: CEOs’ perceptions of their net wealth. That theory alone may explain a large part of the psychology and behavior of why some corporate managers allowed their accounting books to get cooked.

On March 10, 2000, the dot-com bubble burst abruptly and as a result many firms had to issue accounting restatements well into the next decade. Let’s face it, a lot of people lost a lot of money, and not just the CEOs who watched large portions of their own stock holdings in their own companies vaporize. Let’s also not forget the chasm of broken trust that opened between the business community and the public.

So what happened? Did the CEOs transmogrify into greed-poisoned crooks? That answer may satisfy our human desire for a villain, but that is not exactly how things played out, says Anup Srivastava, an assistant professor of accounting information and management at the Kellogg School of Management.

While most firms were not guilty of accounting irregularities or criminal activity, a few were. Srivastava and Jap Efendi, an assistant professor at University of Texas at Arlington, and Edward P. Swanson, a professor at Texas A&M, dug into the problem of overvaluation of firms’ equity, and they developed several reasons why CEOs may have overseen the release of false or misleading financial statements. At the heart of the matter was a confluence of CEO compensation structuring with a little idea (holding large implications) about how very large incentives can cause normally law-abiding citizens to step outside the law’s bounds.

Taking Risks
Srivastava explains that in 2005, Harvard professor emeritus and noted financial economist Michael C. Jensen wrote a paper titled “Agency costs of overvalued equity,” which was published in the journal Financial Management. “In this paper, Jensen argues that managers are normal human beings but when the stakes are very high, normal human beings begin making extremely risky decisions,” Srivastava says. “Our paper examining the overvaluation of a firm’s equity during the dot-com years is the only paper that has tested his theory.”

When Srivastava says a firm is overvalued, he is referring to extreme situations where the stock may be worth 100 to 1,000 percent of its fundamental value. When this happens, the firm’s fundamentals cannot justify the stock price and so managers begin to “do things.”

Decisions based on overvalued equity are not good for society because they lead to a loss of wealth.

“They start taking extreme risks. They make acquisitions and play with their accounting numbers,” Srivastava explains. “This is very destructive to society. Decisions based on overvalued equity are not good for society because they lead to a loss of wealth.”

Srivastava says that an important trend in CEO compensation over the past two decades has been an increasing emphasis placed on company stock options. When this collides with market overvaluation, CEOs may find that their in-the-money stock options balloon into the stratosphere to nearly one hundred times the value of their salary.

“Let’s say their in-the-money stock options are worth a billion dollars now,” Srivastava says. “They may start to think, ‘I’m a billionaire.’” By confusing their overinflated stock options with their net wealth, these CEOs begin to make riskier and riskier decisions, perhaps to preserve their perceived wealth. It is a fragile zone to live within; a 10 percent decline in their company’s stock price could spell out a 50 percent decline in their net wealth.

“In this scenario, they will do anything and everything to keep the stock values high,” Srivastava says. But this motivation may also extend beyond their own personal gain; they may want to maintain the status quo by not liquidating their holdings as to avoid attention from the Securities and Exchange Commission or their investors regarding the overvaluation problem.

“What we highlight in our paper is the fact that when equity is overvalued, and overvaluation in equity results in large in-the-money options for managers, then managers have incentives to take very risky accounting decisions,” Srivastava says.

Show Me the Money
The researchers used ninety-five sample firms—pinpointed from a Government Accountability Office (GAO) database of companies that restated a previously issued financial statement—and compared these to ninety-five control firms that had not issued restatements but were matched in terms of size, industry, and asset values. They then examined the firms that announced a restatement between January 1, 2001, and June 30, 2002, for accounting errors in prior years, extending back to April 1995. (Firms often announce a restatement one to two years after the year being restated, e.g., a restatement announced in January 2001 could be for the accounting year 1999 or 2000.) The team used press releases and annual reports to discover the exact year of the misstatement, a detail the GAO database lacks.

For example, say an Internet company called WidgetTechs tanked in the 2000 bust and announced a restatement of its accounts later. Srivastava and his team basically poked through records to find WidgetTechs’ historic stock prices and its compensation package. Then they dissected this data to look for trends that associated aspects of compensation to time points right before, during, and after accounting irregularities, or criminal activity, was said to have occurred.

By doing this, Srivastava and his colleagues found that the best predictors of accounting misstatements turned out to be in-the-money values of stock options held by CEOs. To illuminate the magnitude of in-the-money option holdings, they found the average holdings for CEOs at restating firms was approximately $50 million, which greatly exceeded the average of $9 million at matched firms that did not announce a restatement. Stated another way, the CEOs of restating firms held options with in-the-money value that was forty-six times their salary, compared with options six times the salary of CEOs in control firms.

The team then parsed the restating firms into two main categories based on accounting issue classifications assigned by the GAO—non-malfeasance and malfeasance—that describe the degree of seriousness of the firm’s accounting error. (A malfeasance category correlates to fraudulent behavior or an SEC-induced restatement, while a non-malfeasance category correlates to a non-criminal, less serious issue or irregularity.)

The researchers found that the in-the-money value of options for CEOs at restating firms with evidence of accounting malfeasance was even higher, averaging approximately $130 million (compared to an average of $50 million for all restating firms).

One of the study’s key insights centered on the degree to which options were in-the-money. The analysis detected no difference between the value or number of options issued by restatement and control firms to their CEOs. In other words, the larger in-the-money values of restatement firms were not due to the number of options held but the degree to which the firm’s stock options were in-the-money. Within both the restating firms and the control firms, the research team analyzed CEO compensation to look for predictors that a firm would issue a restatement. They tested the base salary, bonus, options grant, in-the-money stock options, restricted stock grants, and restricted stock holdings. The only statistically significant variable turned out to be in-the-money options.

Srivastava and his colleagues scrutinized this further to estimate the thresholds of in-the-money options where the probability that a firm would issue a restatement later increased significantly. Again, using WidgetTechs as an example, imagine that its CEO’s in-the-money options in 1999 were twenty-one times the value of his or her base salary. When ranked against the other firms in the study, this would place the firm in the eightieth percentile—smack in the danger zone, where any increase in in-the-money value would dramatically increase the probability that the firm will have to issue a restatement. If the in-the-money options to salary ratio had landed in the ninetieth percentile—where in-the-money options were fifty-three times the salary value—then WidgetTechs would be 43 percent more likely to issue a restatement. If that ratio had risen further to the ninety-fifth percentile—where in-the-money options were a whopping 136 times the salary value—then the restatement probability leaps to 56 percent.

Figure 1. Increase in restatement probability as the value of CEO in-the-money options increase

“The point is that when things go extreme, then the probability jumps up,” Srivastava summarizes. But some people refuted that in-the-money options value could balloon as high as 136 times salary. Reviewers of the paper wanted concrete examples. “Normally in our research, we never name firms,” Srivastava says. “But we had to give a table with the firms and the value of their CEOs’ in-the-money stock options because people disbelieved us that it could be so high.”

Leading their list was JDS Uniphase, whose CEO held $1,278,017,054 in in-the-money stock options. Yes, that’s $1.28 billion. Coming in second was Freemarkets, whose in-the-money stock options totaled $751,140,000.

A Crystal-Clear Pattern
Perhaps the most convincing part of this research is apparent in a table that follows the movement of CEOs’ in-the-money options ratio to salary across time for both the sample and control firms. The researchers pinpointed the years when fraudulent activity or accounting irregularities actually occurred, then looked at the firms’ market values and the value of the CEOs’ in-the-money options in the preceding year to figure out what, if anything, the CEOs might have been motivated to protect in accordance with Jensen’s theory of overvalued equity.

Remember, the timeline of events was as follows: overvalued equity resulted in large in-the-money options for CEOs, managers then misstated accounts in an effort to keep stock prices high, and then accounting improprieties were admitted a few years later via announcements of an accounting restatement. In this scenario, the relevant point at which incentives could have led to irregularities was the year immediately before the misstated year. If the equity or in-the-money value was really overvalued, those values should have declined from that point onwards.

Srivastava and his colleagues tested the same data at three time points in addition to the point immediately before the misstated year: the end of the year when the anomalies occurred, the end of the year when a restatement was announced, and one year after the year in which the restatement was announced. What emerged was a crystal-clear pattern in both the malfeasance and non-malfeasance categorized firms where CEOs’ ratio of in-the-money stock options to salary declined dramatically over time, like a balloon deflating, from 46.2 times to 25.4 times to 15.3 times to 10.8 times.

“This table clearly demonstrates something was overvalued and it was corrected over time,” Srivastava explains. “We’re talking very big numbers here.”

Big indeed. Firms that were guilty of accounting malfeasance found their CEOs’ options-to-salary ratio declining from an average high of 99 to 12.7 over that period, halving nearly every year. That is, their in-the-money options were 99 times the value of their salary, declining to 12.7 times the value of their salary over time. Firms with accounting irregularities but no malfeasance saw their CEOs’ ratio decline less steeply from an average of 22.9 to 9.9. Clearly, the market had overvalued the equity of these firms. Astute observers might reason that this decline occurred because CEOs liquidated their stock options and cashed out on a large scale. But the researchers ruled this out and determined that CEOs did not exercise their options in time. “It is possible that CEOs left much of this potential wealth on the table when the market bubble burst,” Srivastava suggests.

The team also found that the market-adjusted value of the top-ten firms, ranked by the largest in-the-money options to salary ratios, fell nearly 11 percent in the five days after their announcement of a restatement. This is compared to a 4 percent average fall for the restating firms that had less serious accounting problems. Firms guilty of malfeasance experienced market-adjusted value dips of 7.2 percent, compared to nearly half that rate for the restating firms not guilty of malfeasance.

“All of this shows us that if you think that in-the-money options led to criminal behavior, and the criminal behavior is measured by the extent of malfeasance in the accounting re-statement, we find evidence consistent with that,” Srivastava concludes.

Lessons Learned
The biggest take-home message that Srivastava and his team found is that if a CEO holds very large in-the-money stock options, achieved largely because of overvaluation in his or her firm’s equity, then that firm is at a greater risk of fraudulent accounting. This risk increases dramatically once the CEO’s ratio of in-the-money-options to salary base crosses above the eightieth percentile of comparable firms.

So what does all this boil down to for a board committee that structures compensation? “If the stakes are extra high, just be cautious,” Srivastava advises. “Of course, it helps if the CEO is not also the board chair.”


Related reading on Kellogg Insight

Suspiciously Short: CEOs with stock options may purposely miss earnings targets

When Executives Sell: The influence of wealth diversification on contracting schemes