Should Size Matter When Regulating Firms? Implications from Backdating of Executive Options

Abstract

This paper presents a data point relevant to significant issues of policy concerning areas of law where small firms have either been granted exemption from regulations or not investigated for violations of laws that, on their face, apply to them. Whether small firms should be exempted is an empirical question the answer to which depends on the likelihood of such firms violating regulations. Researchers, however, face a problem when obtaining data on violations because violations are typically observed only when they are investigated. The selection of firms for investigation is under the discretion of enforcement officials who may select larger firms for investigation, passing over smaller firms, to either promote societal welfare or to further various career aspirations. The stock options backdating scandal provides a unique opportunity to examine the likelihood that a firm is engaging in illicit activity by observing stock price behavior regardless of whether the firm is ever investigated. Our data set thus enables us to compare the size of the firms likely to have engaged in illegal backdating of executive stock options with those firms that have been investigated or prosecuted for these frauds. Our results show that smaller firms are overly represented in the sample of firms that have engaged in illegal activity, but spared the bulk of law enforcement efforts. Thus, these firms have essentially been given a free pass to engage in illicit behavior – raising significant issues for public policy.

Keywords: Exemptions for small firms, Options backdating

JEL Classification: G34, G38, K22, K42