If options backdating is impossible in Israel, why do the charts look like this? - Haaretz

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Fri., September 28, 2007 ,

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If options backdating is impossible in Israel, why do the charts look like this?

By Sarit Menahem

In a week we'll know how much Dudi Wiessman means to pay Zeev Kalimi as the new CEO of Blue Square Israel. His terms of employment include stock options, convertible into 3 percent of the retailer's stock.

Stock options for the talent is normal, but the allocation is usually done after he starts the job. The hasty announcement of his windfall, just as Blue Square stock was dropping like a stone down a well, makes one wonder.

Blue Square stock tanked because it started a pricing war between supermarket chains a week before it announced the stock options for Kalimi. One can't say whether the 21 percent tumble in Blue Square's share price a week before the announcement is what impelled Wiessman to give Kalimi the options at this time, but what's clear is that Kalimi's future looks rosy. All Blue Square stock has to do is return to its pre-pricing war level for Kalimi to gain some NIS 30 million.

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It is wonderful how some managers and directors seem able to predict slumps in a company's share price. That is what induced Eric Lie at the University of Iowa to publish a breakthrough paper two years ago: "On the Timing of CEO Stock Option Awards." It's still reverberating on Wall Street and it triggered a shake up that has some management talent doing time.

Simply, the lower the share price at the date of a stock option award, the more the recipient of the options stands to make.

Lie set out to check whether stock option awards influence a CEO's appetite for risk. But a pattern he noticed between slumps in share price and option awards caught his eye. Some managers seemed to have supernatural talent at predicting when the company's share price would sink. Or, perhaps it was not supernatural at all: they were cheating, Lie realized, and coined the phrase "backdating". The errant CEOs would look at the share price's history, chose a convenient date and write a letter allocating stock options dated back to that convenient day.

The Wall Street Journal called it "the perfect payday" in March 2006, and by now officers at more than 160 companies have been questioned. Several Israeli companies were implicated, including Mercury Interactive, Zoran Semiconductor and Comverse, whose CEO, Kobi Alexander, colorfully fled the long arm of the FBI to Namibia, where he holds court, so to speak, while deflecting American extradition efforts.

Lie wasn't the first to study share prices around stock option allocation dates, but most researchers figured the companies were looking ahead (not behind): that they were choosing allocation dates that corresponded with some event likely to lower the share price in the future.

Adir Ben-Ezri studies economics at the Open University. He decided to take a look-see around the Tel Aviv arena, and made some pretty impressive findings. In a paper under the tutelage of Dr. Rimona Peles, Ben-Ezri writes that backdating is impossible here: the law here requires companies to advise the Israel Securities Authority within 24 hours of a stock options award. A company can't just up and say "two months ago we allocated x options to y." Even so, executives get stock options at mighty convenient low points in share price. How?

Ben-Ezri looked at 53 companies listed on the TA-100 index from 2000 to 2006. His findings were statistically significant: in the days before stock options awards, a company's share price slumped, reaching a nadir the day before the board decision on the award, and rebounding the day after.

How did they do it? Ben-Ezri's paper is about the phenomenon, not the wherefore, but he does speculate: "Even if regulation in Israel is effective at preventing backdating, it isn't effective in preventing timing games," he writes.

Ben-Ezri used "event study methodology," based on checking for unusual behavior by a share price compared with what its behavior was predicted to be by market models.

His event horizon was 14 days. Ben-Ezri calculated predicted returns for each share 20 days before the board decision on an options award and 20 days afterward. He then subtracted the predicted returns from actual returns for each company, and created the composite chart of average behavior of share prices around the event window, shown here. Share price dipped before awards and rose afterward, he found.

Specifically, he found that from 20 to 6 days before the award, share prices outperformed the model by 0.62 percent, on average. But five days before the award, the trend reversed, resulting in underperformance of 1.53 percent, on average. The share price reached its lowest point exactly on the day before the announcement, and in the following 20 days, the accrued yield deviation upward reached 3.57 percent.

Surprising, given that backdating is impossible in Israel, Ben-Ezri observes. Yet something looks mighty unnatural and the statistical significance of his finding means it's no coincidence. It stands out less in the case of a given company, but when all the companies are taken together, it screams.

Take Nice Systems, he says. On January 8, 2001, the board announced stock option awards on January 4, based on the closing share price of January 3. The share price was at its lowest point in a long time. A few days before, though, Nice had issued a serious earnings warning, which sent its share price down 60 percent, Ben-Ezri says.

The company did not back-date, he stresses, but the timing of the award appears more than coincidental. Note that Nice is dual-listed in Tel Aviv and Nasdaq, so it isn't required to release individual announcements about option awards. It does have to report total option awards in its annual financial statement, and to calculate the average strike price. Other awards it made cannot therefore be checked.

Then there's Israel Chemicals, which on January 30, 2003, announced its board had OK'd an options award the week before, at a strike price 7 percent below the stock's closing price on January 22, 2003.

Again we see, from the chart, that they pinpointed a nadir in the stock and since then, ICL stock has done strongly.

As for HOT, on January 30, 2001, its board allocated options at a strike price of NIS 49, which was 85 percent of HOT's share price on the day of the board meeting. Again it proved to be a very low point in the company's stock.

Ben-Ezri postulates that the ones who best know the company's business and its cycle are the management and board: they can predict, with some accuracy, when the share price is likely to slump or climb (though stock markets are notoriously balky). "But the sharp U-turn on the day before the board meeting shows that if it's coincidence, the combined ability of the manager is categorically supernatural," he said.

Not backdating, but what about fore-dating? Dating a board meeting for a week before a known event likely to send the share price south? Surprises can happen but any CEO can predict what the market's reaction to a major announcement is likely to be. Managers can also try to skew share prices by whipping up a fuss: summoning investors or analysts for a conference, for example. Or they can withhold negative information for a time.

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