Stock options may help firms hide fraud

Everyone knows that crime pays, and there will always be businesses that succumb to the temptation to commit fraud. But it’s not just the perpetrators who can make money from financial misdeeds, according to research by Associate Professor Andrew Call.

Rank-and-file employees at corrupt firms consistently get more stock options than do employees at companies that follow the straight-and-narrow. Among misreporting firms, employees at misreporting firms are offered more stock options during the fraud period than either before the fraud began or after it is over.

If you think that sounds like hush money, you’re probably right. Though it’s impossible to prove direct causation, there are high correlations between financial wrongdoing and employee options grants, Associate Professor of Accountancy Andrew Call says in his paper, “Rank and File Employees and the Discovery of Misreporting: The Role of Stock Options,” published in the Journal of Accounting and Economics.

Call, working with Professor’s Shivaram Rajgopal at Columbia University and Simi Kedia at Rutgers University reviewed the records of 663 firms subject to class action litigation from 1996 to 2011 and examined at their stock option behavior.

“The idea is if regulators give whistleblowers a financial incentive to come forward, do firms try to circumvent these incentives by keeping whistleblowers quiet?” Call says.

He and his colleagues looked at firms accused of wrongdoing during three periods: before, during, and after their alleged violations. They found companies issued 14 percent more options during the period of accused misbehavior than they had previously. After the fraud had stopped, the rate of stock option issuance dropped 32 percent.

“They ramped up, then fell back down,” Call says. “It’s circumstantial evidence, but it’s consistent with the hypothesis.”

Firms accused of malfeasance also granted more stock options than a control group of firms not accused of misdeeds.

 

Effective tactic

“The second question was whether this kind of tactic deters whistleblowing,” Call says.

His research found that firms giving employees more stock options were less likely to be exposed by a whistleblower. Companies without a whistleblower granted 78 percent more stock options than those where an employee squawked about wrongdoing.

“The more options you give to your staff, the less likely it is that one of them will blow the whistle,” Call says.

For the study, Call considered only stock options given to rank-and-file employees, as opposed to executive stock options. “Typically, whistleblowers are not senior executives, but mid-level managers or below — the rank and file,” Call says.

Of course, employers don’t have to rely on options to keep workers quiet — they can also hand out raises, bonuses, perks, gifts, and other incentives. But stock options offer a couple of unique advantages: First, their value is dependent on the company’s stock price, and exposing wrongdoing causes a company’s stock to sink. Second, they cannot all be cashed in immediately before blowing the whistle, as employees often have to wait two to four years before their options vest and they can realize the gains.

“All the more reason for you to keep your mouth shut,” Call says. “If it were just shares of stock, you could sell while the price is high, then blow the whistle. With options, they’re keeping you financially married to the firm, intertwined with the well-being of the company’s stock.”

 

The fish that get away

Of course, many firms that are cheating don’t get caught. There’s no way to find out about their malfeasance, but Call took a theoretical peek by examining short selling.

Short sellers are investors who bet against a firm, predicting its stock price will fall. They do so for many reasons — the price-to-earnings ratio may appear too high, or the company may have taken on too much debt, made a dubious acquisition, or lost customers to a competitor. Those are all legitimate reasons to sell short.

But investors in-the-know might also bet against a company if they’ve heard bad rumors about its conduct and believe prosecution is inevitable when its deeds come to light.

Call examined companies with strong business fundamentals but high volumes of short selling. “We argue that with abnormal short selling activity, there’s an increased probability that some violation is going on,” he says.

Perhaps not surprisingly, these firms granted more employee stock options than other firms.

 

To tell or not to tell

An interesting question raised by Call’s research is why whistleblowers expose some businesses over others. After all, stock options are nice, but successful whistleblowers can get paid much more.

As part of the whistleblowing provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the government has awarded a total of $111 million to 34 whistleblowers. Though rewards traditionally have not been significant, they have increased in recent years. The largest award given as part of Dodd-Frank was $30 million, awarded in September 2014. The tipster would have gotten even more if he hadn’t delayed reporting the fraud.

Another informant who reported a tax fraud — outside of the SEC’s jurisdiction — got a whopping $104 million award, though he also spent two-and-a-half years in prison for his role in the scheme.

But despite the possibility of significant gains, no one likes being labeled a snitch. It can also be bad for your career.

“Blowing the whistle is a very costly thing to do professionally. You get blacklisted and often subjected to demotions or pay cuts,” Call says. Legally, you can’t get fired for reporting misdeeds, but the firm could fire you for other reasons. “It’s hard to prove the underlying motivation,” he explains.

 

Tightening the screws

Call’s work depicts fraud as a cat-and-mouse game, with the feds rewarding those who expose it and companies paying those who don’t. But momentum appears to be swinging toward the feds.

The government has always had whistleblower programs for people who report abuses against federal agencies, whether it’s tax evasion or Medicare fraud. But those programs don’t affect most of corporate America.

A change came in 2002, after scandals at Enron Corp., WorldCom, and Tyco led to the passage of the Sarbanes-Oxley Act, which aimed to protect investors from financial fraud. The law implemented stricter financial reporting standards and required public companies to set up hotlines their employees could call to report misdeeds anonymously.

In 2010, Congress passed the Dodd-Frank Act with the aim of protecting investors further, as well as dealing with the “too big to fail” problem that made the recession of 2007-2009 so severe. Among many other things, Dodd-Frank established monetary rewards for people who expose financial fraud, offering them 10 to 30 percent of the penalty levied against a company successfully prosecuted for wrongdoing. Whistleblowers can remain anonymous even to the government, interacting with the feds and collecting awards through lawyers.

The SEC took action against 1,133 companies between 1979 and 2012, and more than half of the enforcements occurred after Sarbanes-Oxley passed, Call’s research found. Dodd-Frank is likely to raise prosecutions further.

Nevertheless, fraud will never be completely rooted out. “You can only try to discourage and detect it,” Call says. “But I’m encouraged by the provisions that have passed. They’re influencing other countries to adopt similar laws.”