Erik Lie
August 29, 2016
Ido Baum

It’s still secret what arrangement was reached between Jacob Alexander, former founder and CEO of the Israeli voicemail company Comverse, and the U.S. Securities & Exchange Commission. It’s known that when “Kobi” Alexander landed back in the United States last Wednesday after 10 years on the lam, he was detained – and instead of being released as he expected, he was kept behind bars because, the Brooklyn judge explained, he’s a flight risk.

Alexander stands accused of securities fraud. He became one of thousands of American market animals who were caught backdating stock options, which boiled down into ill-gotten gains – investors thought the executives were being rewarded for good performance. But backdating stock options is like drawing the bulls-eye on the board after you shot the arrow.

The great majority of executives caught in the backdating scandals were fined; some were never charged at all. (One who rose above it without any damage to his reputation was Steve Jobs, though two other Applites were fined and had to pay millions.)

Kobi Alexander may have suspected that Comverse would be handled differently because of the company’s size, and the extent of malfeasance associated with him. Be that as it may, rather than face the music, a decade ago he fled to Namibia, an African nation with which the United States has no extradition agreement.

A short success story

Alexander founded Comverse, originally known as Efrat Future Technologies, in 1982 together with Boaz Misholi and Yechiam Yemini, and later took it public on Wall Street. A pioneer in developing voicemail technology, the company grew rapidly and at its peak was the first-ever Israeli company to win a place on the S&P 500 index. Given the status of the company and Alexander’s alleged offenses, he was always likely to be treated more harshly. But he was reportedly surprised when the court ruled that he remain behind bars until the end of proceedings against him, on the grounds that he is a flight risk. He has the right to challenge the decision, but his chances of prevailing in the appeal are small.

During Comverse’s heyday, another promising Israeli businessman arrived in New York. A partner in founding the Israeli high-tech company Cyota, he was hired to manage a division in the American high-tech company RSM, where he worked until 2006. His name is Naftali Bennett. Today he is minister of education and is in charge of the Council for Higher Education, a body that has a great deal of influence over research incentives.
Unfortunately, the Council for Higher Education is partly responsible for scientific research in Israel having no incentive to expose dysfunction in the Israeli capital market.

This matters: The backdating scandal was exposed thanks to researchers in American academia, which is a critical player in the American capital market. In contrast to the conventional wisdom in the press, it was not the Wall Street Journal investigators who were responsible, but rather a young finance professor called Erik Lie at the Henry B. Tippie College of Business in the University of Iowa.

Miracles on Wall Street, okay, but how many?

Lie wanted to scientifically test the claim that executive pay by stock options does improve corporate performance. He collected data on 2,000 stock option allocations from 1992 to 2002 and discovered – that the figures were too good to be true.

Checking stock performance before and after the stock option allocations, he saw something consistent. Before option allocation, stocks underperformed the market. After the allocation, suddenly there was a dramatic upswing. What’s more, this weirdness only grew worse with time: the allocations in 1999-2002 stood out the most.

Naifs might think that the stock options motivated the managers to lift their companies to new heights. Erik Lie is not a naïf and didn’t think miracles are quite that systematic, certainly not affecting hundreds of companies.

In a 2005 paper “On the Timing of CEO Stock Option Awards”, published in Management Science, Lie wrote this: “Unless executives possess an extraordinary ability to forecast the future marketwide movements that drive these predicted returns, the results suggest that at least some of the awards are timed retroactively.” Ouch.

That paper led to investigations by the media and the securities officials, and boosted the unknown Iowan professor to the Time Magazine listing of the 100 most influential people in 2007.

Cross Mean inmates, toothless watchdog

The amazing thing about the backdating brouhaha isn’t just its incredible extent – it’s that thousands of companies simply dated the stock options to a convenient date in history just as the watchdog was starting to breathe down their necks. The backdating reached its peak after the enactment of the Sarbanes-Oxley Act, which was supposed to improve corporate governance in America. It did indeed strengthen internal enforcement at the companies, following the accounting shenanigans at Enron and the like. But the backdating came along and showed just how toothless the watchdogs and boards were against powerful executives.

The rot would never have come to light if not for the efforts of people like Erik Lie, who devoted time and resources to studying the underlying assumptions of the capital market, and how these assumptions are implemented.

Academic research of this sort hardly exists in Israel. The education ministers throughout the ages, who are in charge of the Council for Higher Education, including Naftali Bennett, have not encouraged implementation.

At Israeli universities, the researchers expend their best effort on writing papers for foreign journals, mostly American ones. The pinnacle of achievement to which researchers of economics, finance or law in Israel aspire is to be published in a leading American journal. That confers prestige and probably promotion too, to a far greater degree than publishing in an Israeli journal.

Israel takes pride in the regulation of its capital market; some like to say it’s over-regulated. When it comes to corporate governance, for example, Israel adopted a good chunk of Sarbanes-Oxley (through amendment of the Companies Law and the Securities Law). But it didn’t adopt the whole thing. An Israeli committee convened to think of ways to improve corporate governance had decided that adopting Sarbanes-Oxley as is, would be too onerous for the Israeli market.

Academic research plays a key role in exposing malfeasance in the markets. If Israel’s researchers are preoccupied writing papers for international journals, Israel’s market could well be riddled with little Kobi Alexanders. The education council isn’t doing enough to redress the balance and motivate Israeli researchers to study their own backyard.
 

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