The University of Iowa is Ground Zero for the research on the stock option scandal:
Arrow from the heartland wounds corporate America
University of Iowa professor's study exposed a scandal in the granting of stock options to executives
By James P. Miller
Tribune staff reporter
December 3, 2006
IOWA CITY -- Erik Lie is teaching the theoretical ins and outs of debt workouts and Chapter 11 bankruptcy to a class of University of Iowa undergraduates.
Rocking slightly from side to side, the slim, bespectacled finance professor explains to the class about the Altman Z-score, a statistical method that correlates eight variables to predict the likelihood a company will go bust.
Despite his obvious enthusiasm for the subject, some students begin to show signs of restlessness.
Lie moves to lighten things up.
"Who can tell me what people call it when a company files for Chapter 11 a second time?" he asks.
"The informal term. Remember?"
There is a muttered response.
"Right. Chapter 22," says Lie cheerfully.
It is a long way from this college town on the banks of the Iowa River to the Manhattan towers that house Wall Street's power brokers or the Washington offices of the nation's securities-law regulators.
As unlikely as it may seem, however, this placid Corn Belt locale, and more specifically academic research conducted by the mild-mannered professor, is at the epicenter of a still-widening backdating scandal that has trashed the careers of some of the nation's leading corporate executives, tainted corporate reputations from coast to coast and spurred federal officials to launch a criminal investigation.
Through some inspired number crunching conducted largely in his tiny campus office, Lie (pronounced Lee) came up with data that provide near-ironclad proof that hundreds, and most likely thousands, of U.S. corporations have been secretly manipulating the dates on the stock options they grant to their executives.
By doing so, those companies perverted what was intended to be a performance-based incentive plan into a shower of free money for top-level corporate officials.
The findings have been nothing short of a coup. Before Lie's work, few people had even suspected such behavior was taking place.
Once word of his study migrated from the realm of academia to the financial world, however, Lie's startling research generated the kind of profound, wrenching impact that only a genuinely fresh perspective can create: Companies have been forced to restate financial results from past years, powerful chief executives and board members have been forced to step down, shareholder lawsuits have blossomed like flowers, lawmakers have convened hearings, and the Securities and Exchange Commission is pursuing an investigation.
Although the financial reverberations have been substantial for corporate America and may yield big legal settlements, for Lie there's been no significant financial windfall from the groundbreaking work he did. In fact, his life hasn't changed much at all. Even his students don't seem all that aware of his prominent role in kicking up the biggest corporate scandal in years.
And that's just fine with Lie, who never sought the spotlight.
"I like my life here in Iowa City. I like doing research," said the Norway native, whose speech retains a marked Scandinavian cadence, though he has lived in the U.S. for nearly 20 years.
For Lie, the outsize response to his research has been occasionally flattering, often tiresome, and ultimately beside the point.
He has been interviewed on TV, heard his work publicly praised by the head of the SEC and the head of a Senate committee and been featured in newspaper stories in the U.S. and Britain.
Reporters phone him frequently to ask simplistic questions. Plaintiff attorneys phone him to discuss the fine points of options backdating or to ask if he'll serve as an expert witness.
The experience has been "surreal" at times, he said, but notes, "My life, it hasn't really changed that much beyond the extra time I spend talking on the phone."
Lie caused a rare convergence between the research-for-the-sake-of-knowledge world of academia and the more earthbound, let's-make-a-deal environment of corporate finance.
In the course of his studies, Lie has in the past brought the tools of statistics and probability to bear on such real-world hot buttons as share-repurchase plans, stock offerings and hostile takeovers. His findings appear in scholarly publications such as the Journal of Financial and Quantitative Analysis and the Review of Financial Studies, which aren't well read on Wall Street.
In fact, his most explosive statistical work, a second study that showed how pervasive the scamming actually was, almost didn't see the light of day because the first academic journal that looked at the work turned it down, saying it was too far-fetched.
They were wrong.
Erik Lie came to America in 1988 to attend the University of Oregon in Eugene. He liked the school, the nearby mountains and Eugene's laid-back West Coast style. After serving a two-year hitch in the Norwegian Navy, Lie returned to Oregon and completed his master's degree, then moved on to pursue his doctorate at Purdue University.
In 1996, the new PhD went to the College of William & Mary in Williamsburg, Va. He married his wife, Heidi, also a professor, while there, and the two have co-authored studies.
Lie's wife's has relatives in Iowa, and in 2004 the couple accepted positions at the University of Iowa. It's a nice place to raise their two children, ages 7 and 5 years old.
Lie enjoys research, likes the process of finding a question and figuring out a methodology that will yield good data, and he generally publishes a couple of papers each year.
A source of riches
It's not surprising that his attention would turn to stock options. During the 1990s, their use soared, and the multimillion-dollar profits from exercising options became the biggest element of many executives' pay, far outstripping their hefty salaries.
Options are the right to buy stock in a company at a fixed price, known as the strike price. When corporations hand out options to executives, they generally set the strike price at whatever price the company's stock closes at on the day the options are issued.
Because their options become more valuable as the company's stock price rises, executives will have an incentive to drive profits higher, the theory goes.
With options putting huge sums into executives' pockets, questions about the issue had been raised. A decade previously, New York University professor David Yermack had examined options data from 1992 through 1994 and found suspicious statistical evidence: Many companies' shares moved significantly higher soon after executives were granted options.
Yermack and others hypothesized at the time that when the executives at such companies knew good news was on the way, they saw to it that they received their options before the information was released. Some people called the suspected maneuver "springloading."
Why bother? On a grant of 125,000 options, even a modest $2-a-share upward move in the stock's price generates a quarter-million-dollar profit, and a $4 bump provides a quick half a million.
Lie's interest in options initially focused on a different question: whether big options holdings spurred executives to take bigger risks. When that inquiry didn't bear fruit, he reopened the question of stock-option-grant timing, using a detailed database gathered during the go-go years of 1999 through 2002.
Yermack is a "brilliant guy" who "did wonderful work," said Lie, "but he didn't have the later data."
What Lie found, after lengthy study, was a statistical pattern in which a company's shares often fell soon before options were granted, then rose soon after. Even more interesting, he determined that the broad stock market rose after many companies issued options to executives.
Springloading suspicions were based on the idea that executives might be aware of pending, company-specific events. But if they were consistently succeeding in predicting the entire stock market's movements, the implication was much darker.
In a May 2005 paper titled "On the timing of CEO stock option awards," Lie spelled it out. Other factors might be at work, he said, but the simplest explanation for the fact that options were being granted at such fortunate times is that companies were backdating the grants. In other words, choosing a date when the stock was cheap and calling that the issuing date.
That eliminates the entire idea of option as incentive, however. Critics have compared the practice with being allowed to bet on a horse race after the results were printed in the newspaper.
Regulations in those days allowed for plenty of slack in the reporting of options awards, Lie points out, so it wasn't much of a challenge to select a lucrative date from the past. That loophole has since been closed.
Lie thought his findings were worth sharing with the Securities and Exchange Commission, and they were interested. SEC officials "stayed in touch" as months passed but didn't tell Lie much about what, if anything, they intended to do with the information.
Other than that, Lie recalls, after the first study was published, "for a long time nothing happened."
Interest from newspaper
Lie dug back into the data, this time in partnership with Indiana University professor Randall Heron, who he knew from his days at Purdue. That research showed the practice has been widespread.
When the two authors brought the work to a scholarly journal, however, the journal would not publish it.
"They said, `How can this be happening in thousands of companies and not be widely known?'" Lie said. "How come this hasn't leaked to the press?"
The second journal was much more receptive but asked that the statistically based work be bolstered with some concrete, anecdotal evidence.
While the two were seeking such material, the Wall Street Journal reported that the SEC brought a backdating lawsuit against softwaremaker Mercury Interactive Corp. Lie believes the SEC was influenced by his paper to take action. Glad for the evidence he'd been seeking, he contacted the reporter and told him that his research indicated that thousands of U.S. companies may have backdated option grants over the years.
The Journal reporter asked for more information, and Lie said he "reluctantly" provided the paper with some of his still-to-be-published data. (His second paper, with Heron, is due to appear soon).
"I do research. I wasn't interested in pointing out specific companies," Lie said. "I'm not an investigative reporter."
The Wall Street Journal has plenty of such reporters, however. After three months of investigation, the paper, citing Lie's work, broke the story that backdating was prevalent.
The article examined several companies' options procedures in detail. It noted, for example, that UnitedHealth Group Inc. CEO William McGuire had received options in 1999 on the very day that the company's shares hit their low point for the entire year. The same thing happened in the years 1997 and 2000, the story pointed out. (McGuire would later resign, and a federal judge recently froze options he holds that are valued at well over $1 billion).
The story spawned a firestorm of controversy, a Department of Justice investigation and a host of admissions from companies that suddenly had discovered "irregularities' in their options practices.
Lie became the most talked-about finance professor in America.
It was "very awkward for me," he said. "I kind of like to live a normal, anonymous life."
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