The opportunity costs of the backdating scandal

Larry Ribstein —  25 July 2011

I have blogged extensively about the waste and injustice of the overblown backdating scandal.  (The posts are collected in Ideoblog’s executive compensation archive).  Now we have an accounting of the opportunity costs of the SEC’s pursuit of this so-called scandal.  Here’s the abstract of Choi, Pritchard and Wiechman, Scandal Enforcement at the SEC: Salience and the Arc of the Option Backdating Investigations:

We study the impact of scandal-driven media scrutiny on the SEC’s allocation of enforcement resources. We focus on the SEC’s investigations of option backdating in the wake of numerous media articles on the practice of backdating. We find that as the level of media scrutiny of option backdating increased, the SEC shifted its mix of investigations significantly toward backdating investigations and away from investigations involving other accounting issues. We test the hypothesis that SEC pursued more marginal investigations into backdating as the media frenzy surrounding the practice persisted at the expense of pursuing more egregious accounting issues that did not involve backdating. Our event study of stock market reactions to the initial disclosure of backdating investigations shows that those reactions declined over our sample period. We also find that later backdating investigations are less likely to target individuals and less likely to accompanied by a parallel criminal investigation. Looking at the consequences of the SEC’s backdating investigations, later investigations were more likely to be terminated or produce no monetary penalties. We find that the magnitude of the option backdating accounting errors diminished over time relative to other accounting errors that attracted SEC investigations.

And the conclusion:

Our study shows that the backdating investigations crowded out alternative investigative possibilities. Moreover, it is reasonable to conclude that the investigations foregone were likely to have more substantial impact than the backdating investigations that were pursued. We find that the stock market reaction to backdating investigations declined over time as the scandal progressed. The SEC was less likely to include individuals in its investigations, and federal prosecutors were less inclined to pursue criminal investigations. We also find that the consequences of the SEC’s backdating investigations declined as the scandal wore on. The SEC was more likely to terminate later investigations, and the SEC was more likely to come away with no monetary penalty.

The most plausible explanation for this decline in the consequences of the SEC’s backdating investigations is case selection. We find that the SEC‘s backdating investigations focused on smaller accounting errors later in the cycle of investigations. Smaller cases produced smaller consequences. Our conclusions hold whether we focus on just accounting investigations as our baseline of comparison, which we argue is the most similar comparator, or the expanded set of all SEC investigations of public companies. The SEC is an independent agency, but its independence from the executive branch does not mean that it is independent from political currents. The SEC’s response to the option backdating shows that it is not immune to the political imperative to “do something” in response to newspaper headlines. We cannot know which accounting investigations were not pursued because the SEC was occupied with backdating, but our analysis makes clear that the opportunity cost of the backdating scandal investigations.

And the SEC’s opportunity costs are only part of the opportunity-cost story. Consider what the WSJ missed as it pursued its Pulitzer for backdating.

Larry Ribstein

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Professor of Law, University of Illinois College of Law