Iowa Alumni Magazine | April 2007 | Features

Shock Options

By Amy Schoon
A UI finance professor targets unscrupulous executives.

Erik Lie >"Something was fishy," Lie says, "and we ended up getting to the bottom of it. We were catching the bad guys."

"The Power 30." The name alone speaks volumes about this impressive group of financial behemoths, industry giants, and titans of trade. Smart Money magazine's collection of the world's most influential people in investing includes famed investor Warren Buffett, the chairman of the Securities and Exchange Commission, the Secretary of the Treasury, and the CEOs of Apple Computers, Google, and YouTube.

And let's not forget UI associate professor Erik Lie.

Erik Who?

Most people would probably have asked that question before this mild-mannered finance professor made headlines around the world for uncovering what's been described as one of the largest corporate scandals in American history. His research—the result of years of dogged investigation in the face of almost universal disbelief by other academics—shot him from obscurity to glory.

So, where does Lie keep his Smart Money plaque, his memento of the financial world's high esteem and one of the most public vindications of his efforts? Tucked modestly behind the door of his office in the UI Tippie College of Business.

Such contradictions sum up this humble Norwegian professor with Viking heritage. Lie takes pride in his work and accomplishments, but he shies away from fame and deflects praise. He insists that he was just doing his job.

"Everyone who does research is striving to somehow make this world better," he says. "In this situation, something was fishy, and we ended up getting to the bottom of it. We were catching the bad guys."

Lie is the first to admit that the number-crunching and finance trends he and his colleagues find sexy tend to make the rest of the world's eyes glaze over. But through his recent discovery involving business executives, company stocks, and document doctoring, Lie caught the attention of the U.S. government and the international media.

Through his research, Lie uncovered patterns that indicated many companies were fiddling with their numbers by backdating executive stock options—indicating a false date for when they gave stocks to executives as part of their compensation packages. Illegally backdated in this way, stocks are potentially much more valuable to their holders (for an explanation of backdating, see the sidebar).

Even though the professor's last name is pronounced "Lee," it seems fitting that he was compelled to uncover a lie.

It took several years of study, changes to reporting regulations, and plenty of old-fashioned persistence, but Lie's hunch turned out to be right on. Early estimates put the amount of money that company executives earned illegally through backdating in the billions of dollars. Losses are adding up now, too, as executives fall under intense scrutiny, companies suffer tarnished images, and innocent employees lose their jobs in the aftermath of scandal.

Preparations for Lie's big discovery actually began when he was a child in Norway, he says, as his parents impressed upon him the importance of working hard and taking pride in what you do. He came to the United States in the late 1980s to attend the University of Oregon, where he earned a bachelor's degree and a master's in business administration. After a required stint in the Royal Norwegian Navy and Norwegian Coast Guard, he returned to the United States to the doctoral program at Purdue University. He earned his Ph.D. in finance in 1996 and joined the faculty at the College of William and Mary.

The corporate numbers game—earnings, compensation, performance and the like—fascinated Lie. He dove into the executive stock options issue back in 2002 at William and Mary, following up on an intriguing paper by New York University (NYU) professor David Yermack that had questioned the timing of stock option grants. The ten-year-old Yermack study concluded that executives might be timing the granting of stock options right before good news about their companies was announced, which would boost stock prices.

Lie didn't buy that explanation; he wanted to get to the bottom of the mystery. Using a database of the largest 1,500 companies—the S&P 1,500—he started analyzing numbers and developing a pattern. His illegal backdating theory was born.

Looking back on his own data and studying Lie's findings, Yermack says that backdating now makes perfect sense. "What I missed in hindsight was that killer explanation—backdating. It never occurred to me," he says. "When I first heard of Erik's proposal, I thought it was preposterous. I never thought there were that many companies out there cooking the books in this type of way."

There was one big problem with Lie's research paper, though. He couldn't prove that the patterns were actually caused by backdating. He had data that could trace some patterns as far back as the early 1990s. But, he admitted, it could be that people were simply excellent at predicting the market and planning well. Although, he had some evidence that backdating was occurring, nothing indicated the prevalence of the practice.

His paper was made available to the public in the summer of 2004. Lie also sent it to the Securities and Exchange Commission (SEC), because he knew the agency was looking into similar issues in an investigation unrelated to his own. But he still didn't have his "smoking gun."

Undeterred, he continued the hunt for evidence. After joining the UI faculty in 2004, he started on a follow-up research paper, working with Randy Heron, one of his doctoral classmates at Purdue who had joined the faculty at Indiana University. This time, they had access to a larger database, with stock option information for 15,000 companies.

They also had the benefit of the Sarbanes-Oxley Act, which has changed many reporting regulations for companies since it was enacted in the wake of the 2001 Enron accounting fraud scandal. One change required that anyone who bought shares, granted options, or exercised options had to officially file the information within two days. This regulatory change made it much easier for Lie to track backdating. If companies were truly reporting within two days, they couldn't backdate more than two days. For those who were following the rules, the patterns disappeared. For those who filed late, the pattern continued. The results were clear to Lie and Heron. Indeed, they have since estimated that about 2,000 companies have backdated at least one option grant.

"They were pretty clever about it, too," Lie says. "Firms weren't backdating every single grant, and they weren't always picking the lowest price."

As soon as the professors saw their results, they knew they had uncovered something big. Convincing others wasn't so simple.

"We got rejected by academic journals," Heron recalls. "They said, 'No way. No one's silly enough to do this [backdating].'"

Then, in fall 2005, the SEC publicly announced the investigation of multi-billion-dollar software company Mercury Interactive. That high-profile case became the ticket to legitimacy for the Lie-Heron paper.

Released to the public in 2005, the paper ran in the February 2007 issue of the Journal of Financial Economics. Lie and Heron also sent their findings to the Wall Street Journal (WSJ), encouraging the respected newspaper's reporters to do a little extra digging. They emphasized that the Mercury Interactive case was not an isolated incident.

The newspaper put a team of journalists on the backdating beat and, using Lie's research, ran stories and graphics throughout 2006, identifying hundreds of companies being investigated, including Apple Computer and United HealthCare. Apple's chief financial officer resigned last October. United HealthCare chairman resigned that same month, as did the company's general counsel and its director. And these are only two examples of how the backdated options scandal is playing out. According to WSJ, more than 50 executives of companies under scrutiny either had resigned, been terminated, stepped down, or retired as of January 2007.

The Wall Street Journal's ongoing series, "Perfect Payday," recently garnered one of investigative journalism's top awards—the 2006 Philip Meyer Award, presented jointly by the schools of journalism at the University of Missouri-Columbia and Arizona State University for investigative journalism that utilizes social science research methods.

So how big was Lie's discovery of deceit? According to Yermack, huge would be an understatement.

"It's the biggest thing to come along since insider trading scandals of the 1980s, and it's among the biggest corporate scandals of all time," he says. "We still don't know how big it will be. There are a lot of open investigations still pending."

Heron, Lie's co-author on the famous research paper, admits he's biased. But, he says he's "convinced that this is about as big as it gets as far as corporate scandals go."

The backdating scandal shook Wall Street and turned Lie's life upside down for a while, as journalists, financial analysts, and lawyers hounded him. Last fall, he testified before a U.S. Senate committee on the backdating matter. Apart from being featured in the Wall Street Journal and Smart Money, Lie and his research have been profiled and cited in numerous publications, including Business Week, The Economist, the Financial Times, Fortune, the U.K.'s Guardian, the New York Times, USA Today, U.S. News & World Report, and the Washington Post. He's also appeared on BBC World Service, Bloomberg TV, CNBC, C-SPAN, and National Public Radio.

Lie's colleagues say that all the publicity and attention haven't changed his inherent nature. He still rejects the spotlight and is reluctant to do interviews or seek out self-promotion. He continues to leave his office door open whenever he's in, trying to be as accessible as possible to his students and fellow faculty—and, perhaps, to keep that Smart Money "Power 30" plaque hidden from view.

He remains a gentle-natured, kind, friendly soul with a dry sense of humor and fierce devotion to family. And he still tries to see the good in people, even though the data he studied indicated that hundreds, maybe thousands, were cheating the system.

"In some cases, undoubtedly they knew they were doing wrong. They were trying to hide their tracks. In other cases, certain decision-makers may have gotten bad advice about whether it was OK to do it from a tax perspective," says Lie. "I think a lot of people got caught up in trying to justify their behavior, which happens to many of us. When we're driving 65 miles an hour down the highway and everyone else is driving 75 and not getting caught, we think, 'Well, maybe it's OK for me to go 75, too.'"

Todd Houge, UI assistant professor of finance, has an office next door to Lie and the two have become close friends. He says Lie is driven by his values, which are surprisingly similar to those usually credited to "typical Midwesterners."

"If you didn't hear his accent, you might describe him that way. He's honest, extremely ethical, hardworking, a family guy. He's humble, quiet, reserved, with no grandstanding," Houge says. "There's a bit of 'aw shucks' in him, that he can't believe he's getting all this attention."

Lie's wife, Heidi, whom he met at Purdue, grew up in Iowa. They moved back to the state to raise their two children and to work for the UI. (Heidi is a lecturer in finance at Iowa, too.) Still, as well as he's adapted to life in America's Heartland, Lie remains passionately proud of his heritage and wants to pass it on to his children. They visit Norway every summer and every other Christmas. He shares with them his lifelong love of the outdoors, particularly activities of his Scandinavian homeland, such as windsurfing, kayaking, and cross-country skiing.

In his quiet, determined way, Lie also passes on his values—to his children through his parenting and to the world through his work.

Head Lines Lie's backdating research shook Wall Street, permeated the business media, and changed laws.

During his research on backdating, he struggled to come to grips with the negative aspects of his findings. He watched companies and their people being investigated, and he took anonymous phone calls from those who had been directly affected.

"They called me and told me their personal stories. They didn't blame me, but at the same time I realized this research affected people adversely. That's hard to know," Lie says. "A lot of these cases have ruined people's lives. Rank-and-file are getting fired, losing their jobs because the company is getting into trouble. You don't think about this when you're doing your research, but afterwards you see the effects.

"I'd rather this not happen in the first place. I'd rather have people being good and honest. I believe most people are good. People see these executives as crooked, but maybe they're mostly good people who got tricked into doing something stupid."

No matter what, Lie says, he doesn't regret having done the research. The attention from the media and academia helped put the University of Iowa in the spotlight and continues to boost its reputation.

Many media stories raised the questions Why didn't one of the "big" universities, a Harvard or Stanford, uncover this mess? What was so special about Iowa?

"We show that we can do anything in Iowa that can be done anywhere else. It's good to help put Iowa on the map," Lie says. "There's such great research going on here. I'm proud to be part of this place." He hopes for one more reward from his backdating research: the possibility that it can lead to positive corporate change. After all, he brought these negative behaviors to light in the hope of preventing them from happening again. The SEC eventually may file civil suits against alleged offenders, although most investigations are likely to end with paperwork restatements and fines. Other authorities could file criminal charges if the situations warrant.

Meantime, lawmakers are crafting new disclosure laws to curb backdating and similar practices. Perhaps, Lie says, the media focus itself will be enough to significantly limit backdating in the future.

NYU's Yermack expects the effects of Lie's research to reach far beyond the stock option scandal itself. Researchers and skeptics who are trying to determine the validity of any sort of corporate data now will have to consider whether backdating could have been used to manipulate the data.

"Erik's proposed this new way of interpreting data that has introduced a healthy degree of skepticism into all financial information," he says. "It turned out he had great insight. He's a very clever guy."

Indeed, Yermack says Lie may have done far more than simply catch the bad guys. He may have forever changed the way businesses do business.