They say that one should not look a gift horse in the mouth. We decided to go against this proverb and look carefully in the mouth of one such gift horse. After all, we still remember from high school reading that in addition to the shirt of Nessus, the Trojan horse as being not such a tantalizing gift. In this blog, we examine corporate executives’ gifts of common stocks to see they resemble the shirt of Nessus or the Trojan horse.
We find that corporate executives’ gifts of stock while not quite poisonous, do have a dark side. We find that executives exploit a legal loophole to backdate their gifts. In addition they appear to be spring-loading good news, and bullet-dodging bad news with their gifts. Overall, stock prices rise abnormally about 6% during the one-year period before the gift date and they fall abnormally by about 5% during the one year after the gift date. Our bottom line advice to recipients of these common stock gifts to get rid of this gift horse as soon as possible.
Let’s explain the terminology first. Backdating refers to the practice of fraudulently picking a date in the past when the stock price was higher than today as the gift date.[1] The higher the stock price, the bigger is the charitable donation, and the bigger is the tax-deduction that comes with it. Other games involve spring-loading and bullet-dodging. Spring-loading refers to the practice of accelerating the release of good news so that stock prices rise before the gift date. The preceding rise in stock price when the good news is announced immediately increases the value of the gift and thereby the tax-deduction. Bullet-dodging refers to the practice of delaying the release of bad news so that stock price declines after the option grant date and not before. The subsequent decline in stock price ensures that the value of the gift and thus the tax-deduction is not hurt by the bad news.
Unlike previous studies that use very limited sample of firms or very limited time periods, we investigate these motivations for the timing of gifts by utilizing a comprehensive database that includes all gifts of common stock where executives gift the stock of their own firms, in all publicly listed firms in the United States. Our data covers all reported gifts of common stock and contains over 200,000 observations. The total volume of gifts contained in our dataset is approximately 9.5 billion shares, with a dollar value of approximately $300 billion. Consequently, our findings are general and apply to all executives’ gifts of their firm’s stock. Given the large dollar volume of gifts covered and the comprehensive nature of the study, our findings are important from legal, economic, as well as public policy perspectives.
Overall, we find that gifts are well-timed over the time period of 1986-2014. Stock prices rise abnormally about 6% during the one-year period before the gift date and they fall abnormally by about 5% during the one year after the gift date. We find this pattern is stronger for late-reported gifts, which is consistent with the fraudulent backdating hypothesis. We also find that almost two-thirds of gifts are reported late, taking advantage of an exception in the Sarbanes-Oxley Act of 2002 (SOX),[2] further contributing to the lax regulatory conditions that make it easy to manipulate the timing of gifts. We suggest policy recommendations that should improve the compliance of gifts with the requirements of SOX as well as general anti-fraud provisions of federal securities laws.
Our finding that executives’ gifts are well-timed also has economic and policy implications for the federal tax laws. Under U.S. tax law, the donor of gifts of stock to public or private charitable foundations may obtain a personal income tax deduction for the market value of the shares while simultaneously avoiding the capital gains tax that would be due if the shares were sold.[3] Furthermore, although open market sales of stock are undoubtedly within the purview of federal insider trading law, whether stock gifts to charity are so constrained is an unresolved question.[4] These loopholes create an opportunity for exploitation: empirical evidence suggest that corporate insiders use their access to inside information to time their stock donations prior to price declines, increasing their federal income tax deductions.[5]
Taxpayers are hurt by opportunistic stock gifting by insiders.[6] Executives often donate to take advantage of the tax subsidies and if there were stricter rules and harsher insider trading liability, perhaps insiders would not donate stock as frequently. Many studies conclude that donations increase substantially as the availability of tax deductions increase.[7] The government, however, also has an interest in ensuring that gift tax exemptions are appropriately applied for those donations that will serve the public good. Further, the government has an interest in upholding the integrity of the securities markets.
We thus propose four regulatory reforms to address these issues. First, we propose that the late-reporting exemption given to the gifts should be eliminated. Under current law, gifts can be reported up to 45 days late after the end of the fiscal year. Our research finds that executives are exploiting this exemption to backdate their gifts. We propose that the reporting requirements for gifts be harmonized with other insider transactions to require reporting within two business days of the gift. Second, we propose increased penalties for late reporting of gift transactions. These penalties must be stated as a percentage of the amount of the gift and must be increasing with the number of days gifts are reported late. Third, if any gift transactions are reported late, we propose that the executives be required to explain the circumstances that led to the late reporting and certify that the gift was not backdated.
To address timing issues, we suggest an ex-post settlement device. Following the lead of the Private Securities Litigation Reform Act of 1995, we suggest that a look-back provision be implemented for tax-deductions for insider gifts of stock.[8] If the stock price drops over the 90 days following the date of gift-giving, then the average share price during the 90-day period following the gift should be used for the purpose of the corresponding tax deduction, instead of the price at the date of the gift. This provision will help disincentivize both inside information motivated donations as well as spring-loading and bullet-dodging.
ENDNOTES
[1] For academic studies on backdating, see Erik Lie, On the Timing of CEO Stock Option Awards, 51 Mgmt. Sci. 802-12 (2005); M. P. Narayanan & H. Nejat Seyhun, Do Managers Influence Their Pay? Evidence from Stock Price Reversals Around Executive Option Grants (Ross Sch. of Bus., Working Paper No. 927, Jan. 2005), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=649804 (finding that executive options are backdated); M. P. Narayanan & H. Nejat Seyhun, Effect of Sarbanes-Oxley Act on the Influencing of Executive Compensation ( Nov. 2005), available at http://ssrn.com/abstract=852964 (again finding that options are backdated and that SOX mandatory grant date reporting decreases, but does not eliminate opportunism); Randall A. Heron & Erik Lie, Does Backdating Explain the Stock Price Pattern Around Executive Stock Option Grants?, 83 J. Fin. Econ. 271 (2007); and M.P. Narayanan & Nejat Seyhun, The Dating Game: Do Managers Designate Option Grant Dates to Increase Their Compensation? 21 Rev. Fin. Stud. 975-1007 (2008).
[2] Pub. L. No. 107-204, 116 Stat. 745 (codified in sections of 11, 15, 18, 28 and 29 U.S.C.).
[3] Suppose that a stock purchased at $100 was gifted when the stock price reached $200 and subsequently, the stock price declined back to $50 after the gifting. In this case, the individual can take a deduction for $200 instead of holding a share worth $50.
[4] See David Yermack, Deductio ad absurdum: CEOs Donating their own Stock to their own Family Foundations, 94 J. Fin. Econ. 107 (2009) at 107.
[5] Id.
[6] Yermack, supra note 5, at 122.
[7] See id.
[8] Pub. L. No. 104-67, 109 Stat. 737 (1995) (codified in various sections of 15 U.S.C.). The Private Securities Litigation Reform Act (PSLRA) was enacted in response to concerns that large damage awards potentially available in securities fraud class action lawsuits was encouraging the proliferation of frivolous suits. See, e.g., Novak v. Kasaks, 216 F.3d 300, 306 (2d Cir. 2000) (“Legislators were apparently motivated in large part by a perceived need to deter strike suits wherein opportunistic private plaintiffs file securities fraud claims of dubious merit in order to exact large settlement recoveries”). The PSLRA addresses this in part by a 90-day “look back provision,” which reduces a plaintiff’s recovery to the difference between the purchase price and mean price of the security at issue during the ninety day period after corrective disclosure. 15 U.S.C. § 78u-4(e).
The preceding post comes to us from S. Burcu Avci, visiting scholar at the University of Michigan, Cindy A. Schipani, Merwin H. Waterman Collegiate Professor of Business Administration and Professor of Business Law, and H. Nejat Seyhun, Jerome B. & Eilene M. York Professor of Business Administration and Professor of Finance, University of Michigan. The post is based on their paper, which is entitled “Manipulative Games of Gifts by Corporate Executives”, is forthcoming in the University of Pennsylvania Journal of Business Law, and is available here.