WaPo provided its two cents on option backdating in an editorial appearing yesterday (see here). Its solution is to rein in the use of stock options, perhaps through regulation, and instead go with restricted stock. The reason: “options are opaque” and therefore “invite abuse.” Well that’s certainly a convincing argument for stripping corporations of a widely used compensation tool, and I’m sure if we went with regulation, the government would get it just right as historically has been the case in the executive comp area (yeah, right).

Consistent with the finding of the article described here, this article describes a Bloomberg study finding that backdating “has so far cost investors at least $7.9 billion in market value.” The analysis looks to have controlled for industry specific factors by comparing returns to applicable sector indexes. What’s not clear, and this is a point made by Steven Donegal in a comment to the post linked above, is how long the effects of backdating persist. The article notes that for some companies “the damage proved fleeting.”  The article also points out that the impact on share price of a backdating revelation may be decreasing. “The average one-day loss for the first 30 companies to disclose investigations, from March 14 to May 25, was 2.9 percent, or 2.8 percentage points worse than their peers. The last 30 disclosures as of Aug. 31 prompted an average decline of 1 percent, trailing peers by 1.2 percentage points.”

Three Michigan B school profs have a new paper up on SSRN entitled “The Economic Impact of Backdating Executive Stock Options.� The paper adds some important data to the backdating debate. Specifically, the paper looked at 45 firms implicated in the backdating scandal and found that over a 21-day period surrounding the revelation of backdating, the average cumulative abnormal return of the stock of these firms was approximately negative 8%. It also found that the average market capitalization loss per firm during the period was $510 million. In light of these findings, I think it is now untenable to argue that backdating has caused little or no harm to investors. Yes, the monetary effects of backdating were timely disclosed and promptly incorporated into share price. However, as I noted in a comment to this post and as alluded to in the paper, the drop in price likely reflects reduced investor confidence in the firms’ management and internal controls exacerbated by the media frenzy and anticipated diversion of firm resources to deal with internal and external investigations, damage control, etc.

Professor Ribstein responds to David Walker’s backdating article, which Bill highlighted here at TOTM a few weeks ago. Larry’s take?

This is a useful paper as far as it goes. The problem is that it has missed a significant chunk of the “literature” on this rapidly developing topic that has developed in our rapidly developing medium — i.e., the blogs. For example, consider my posts here and here and throughout my executive compensation archive, Josh Wright and Geoff Manne’s comprehensive post, and many many others by Bainbridge, Bodie, Fleischer, etc. This is not merely some kind of procedural problem. By missing this commentary, the article fails to pay any attention to some very important issues, particularly including whether the market looked through any accounting shenanigans. The latter issue alone would seem to be rather critical if you’re trying to explain backdating and its consequences, as Walker is.

Larry’s reaction to the paper has evoked reactions from Vic and Walker in the comments section. Holding aside the issue of whether Manne & Wright should be cited (as readers of this blog know, Geoff and I have elsewhere set forth our own thoughts on backdating, individually and cooperatively), I took Larry’s central criticism to be that the argument raised by some of these bloggers that “stealth compensation” is simply not a good description of backdating if it did not fool the market should be addressed in a paper purporting to explain backdating. It is a fair point and I tend to agree. To be sure, it is an excellent marketing strategy to describe the options this way. Indeed, I could describe backdated options as “alternative in-the-money compensation.” But I digress. Further, Larry offers a second post responding to Walker’s comment, and argues that any substantive explanation of backdating must address whether the market was fooled:

I continue to be puzzled how one can argue that options were “stealth compensation” without discussing whether enough information was available that the compensation was reflected in stock price. If the market knows what the executive is being paid, then I’m not sure how one can argue that it could not make the judgments that Walker is concerned about.

I agree with both Ribstein and Walker that this sort of exchange is precisely what the blogosphere needs more of. In that spirit, let me chime in with a few of my own thoughts here in response to Walker’s article.

First, the empirical contribution of this article should celebrated. In particular, in addition to documenting the fact that a good deal of backdating occurs with rank-and-file employees rather than executives, Walker conducts a descriptive analysis of backdating within the semiconductor industry and highlights differences in executive compensation for firms involved in the backdating scandal (p. 34-35). I think this sort of descriptive analysis is definitely value added and tells us more about the phenomenon which we are attempting to ultimately explain.

Second, I am left somewhat unsatisfied with Part III of the paper (which starts at p.21), which is titled “Explaining Backdating.” To be sure, Walker notes that “the aim of this part is to lay out a range of possible rationales,” and test them against the early empirical evidence. For my tastes, this paper does too much of the former and too little of the latter. Walker discusses a range of rationales including compensation concealment, share dilution limitations, cognitive biases, boosting ISO grants, and the influence of common advisors (which Walker lumps together, somewhat inexplicably, with “herd mentality”). With respect to herd mentality, the “evidence” is that a number of firms adopted the same practice in the Silicon Valley and Larry Sonsini was linked to many firms. I’m not sure what this has to do with “herd mentality,” but I can think of a number of reasons why many firms adopt the same practice which have nothing to do with psychology.

As for the other explanations, again, I find the paper a bit light on the discussion of evidence, which is odd, because I do believe that the central (and most important) contribution of Walker’s paper is his empirical work. Walker seems to be impressed with the naivete / cognitive bias explanation throughout this section, but as I have noted elsewhere, I do not find this explanation persuasive in light of the time series evidence (have compensation committee’s become more naive? Or for that matter, employees or executives?). In any event, to the extent that many of these explanations touch upon the economic explanation for the increase in executive compensation more generally, simple explanations like this one (that apparently explain much of the data) should be addressed, as should evidence of the stock price effects.

The strength of this paper, by my lights, is Walker’s empirical analysis. His contribution to our understanding of what is going on within a particular industry with a lot of backdating is an important one. In fact, I would be inclined to organize the entire paper around this analysis — which is really his unique contribution. I know, nobody asked me. Just a thought.

The SEC Office of the Chief Accountant issued a letter today “summarizing the staff’s views regarding the accounting for stock options in the historical financial statements of public companies.” See here. The letter addresses a number of accounting issues concerning option backdating. It also has this to say about spring-loading and bullet-dodging:

H. Timing of Option Grants

Some companies appear to have engaged in techniques to select their award dates in coordination with the disclosure of information to the public. For example, a company may have granted stock options while it knew of material non-public information that was likely to result in an increase to the stock price [i.e., spring-loading]. Alternatively, a company may have delayed the grant of options until after material information that was expected to result in a decrease to the stock price was issued [i.e., bullet-dodging]. To the extent such practices were used, questions have been raised as to whether an adjustment would be necessary to the market price of the stock at the measurement date for the purpose of measuring compensation cost. Pursuant to paragraph 10(a) of Opinion 25, the staff believes that compensation cost must be computed on the measurement date by reference to the unadjusted market price of a share of stock of the same class that trades freely in an established market.

In other words, neither spring-loading nor bullet-dodging creates an accounting issue. Of course, the question of whether these practices constitute insider trading (my view is that they do not) or give rise to tax issues remains open.

Speaking of option backdating, David Walker from Boston University School of Law has just posted a new working paper on SRRN entitled “Some Observations on the Stock Option Backdating Scandal of 2006.” Here’s the abstract:

The corporate stock option backdating scandal has dominated business page headlines during the summer of 2006. The SEC is currently investigating more than seventy-five companies with respect to the timing and pricing of stock options granted during the boom years of the late 1990s and early 2000s, and the number of firms caught up in the scandal seems to increase every day. This essay contributes to our understanding of the backdating phenomenon by analyzing the economics of backdating and the characteristics of the firms under investigation. Its main points are the following: First, given the high volatilities of the stocks of the technology companies that dominate the list of firms under investigation and the fact that options granted to executives and employees typically may not be exercised for several years, press reports that focus on the size of the strike price “discounts� achieved by backdating significantly overstate the value of backdating. In some cases, reducing the strike price by a dollar per share by backdating increased the Black-Scholes value of the option by less than twenty cents per share. Second, completely unnoticed in the discussion so far is the fact that in many cases backdating dramatically reduced the apparent value of options. Because the size of executive stock option grants often is determined first by establishing the value to be delivered and then by calculating the number of shares to be covered by the option, reducing the apparent value of option shares may have substantially increased the size and true economic value of backdated executive option grants. Third, comparison of semiconductor firms under investigation for backdating with peer companies that are not suggests an association between backdating and the use of options in compensating non-executive employees. This essay considers several explanations for backdating non-executive options, including share limitations, minimizing apparent rank and file compensation, and cognitive biases. Finally, this essay argues that the backdating phenomenon is really not an accounting scandal. Backdating has accounting consequences, but it is unlikely to have been accounting driven.

[UPDATE:  In order to avoid linking glitches we removed the quotes from around the phrase, “all about norms” in the original title.  This post thus has a different url than the original but is otherwise the same.]

In a post titled, “Backdating: Yes, Virginia, Execs Do Want Inflated Pay,� over at PrawfsBlawg, Matt Bodie weighs in on the backdating “scandal.� As many of you know, the topic has been much-discussed of late here at TOTM and over at Larry Ribstein’s Ideoblog (who, it turns out, beat us to this punch), and you’re probably wondering when we’re ever going to stop. Well, we (Geoff and Josh) think Matt’s post is so misguided that it merits its own paragraph-by-paragraph rebuttal in this, TOTM’s first-ever co-authored blog post!

Matt begins by quoting both me and Josh (you mean, me and Geoff) on why backdating isn’t the worrisome bother the Wall Street Journal, Gretchen Morgenstern, and Matt Bodie make it out to be. Then he takes us to task:

I think Geoff and Josh are putting together two notions here: (1) the value of the grants is published at some point down the road, and (2) even if the accounting was a little unusual, it doesn’t really matter because executives could and would have paid themselves the same amount in any event. Although I’m doubtful about (1), it’s really (2) that I’d like to take issue with here. Yes, I do believe that in the absence of backdating, executive compensation would have been lower.

First, it is not our claim that “the value of the grants is published at some point down the road.� Our claim is that the value of the grants is known – as well as (or even better than) it can be for any options – the moment the grants are made (or, assuming minimal insider trading, the moment the grants are disclosed), just as it would be for non-backdated options. Not only is the value known, but it is incorporated into share price (the effects of expected dilution when the options are exercised).

This is key. Most critics of backdating seem to act as if the options were in fact granted on the backdated date and not disclosed until later. In reality, disclosure is made in due course; only the strike price is set with reference to an earlier day’s stock price. There is not, in fact, delayed disclosure.

Matt goes on:

As for (1), companies may have reported the value of the options down the road, and they may have reported the strike price. But as Jeff Lipshaw discussed here, accounting rules required different reporting for options issued at a price lower than the current market price for the stock. So backdated options were clearly a lie: they said they were issued on a date when they were not actually issued. In addition, it may have been a violation of the company’s stock option plan to issue options at a price other than the market price of the date in question. Backdated options would thus also violate the requirements of such plans.

As Lipshaw notes in that very post, the economic effect of options is independent of their accounting treatment. The fetishization of accounting is something Geoff has taken on elsewhere. But it bears repeating: Accounting is a convenient and imperfect means of quantifying behavior. It does not purport to — nor does it — represent true economic values. It’s a short cut; it’s a little like looking for your keys under the street light even though you lost them elsewhere. It certainly makes some calculations and some inter-firm comparisons easier. But accounting cannot do the impossible. There remain countless ways that, even under the same standards (hell, even under the same rules), accounting measures vary from firm to firm. If one firm expenses backdated options and another doesn’t, aside from the possible technical rule violation, the effect on inter-firm comparison, share price, market valuation, etc. is unlikely to be significantly impaired.

The point is that, even if the accounting treatment of backdated options is different than the treatment of options that are not backdated but nevertheless are granted “in the money” on the date of grant (the issue addressed in the Lipshaw post), you’d have to believe in a woefully imperfect an inefficient market to believe that the actual economic effect would pass unnoticed.  And, as Larry points out, even if it did, it takes a heroic and wholly-unsupported assumption to assert that the consequence of the oversight would be to line executives’ pockets.

As we have said here and elsewhere: THERE IS NO LIE. Here, in fact, is Geoff’s comment to the Lipshaw post referenced by Matt:

I’m not sure why anyone thinks options backdating is a lie (technical violation of a rule, maybe, but lie, no). There’s just no harm in the practice. It’s not like the options cruise along for a period of time out of the money (and priced by the market accordingly) and then are miraculously turned into at the money or in the money options the moment they are exercised. Rather, the day the options are issued, they are issued with a strike price AS IF they had been issued on an earlier date when the market price was lower. But there’s no lie here – it’s just a convenient way of providing more compensation (which I think is part of Jenkins’ point. Once again, he seems to be reading Truth on the Market (see my comments to this post). The same could be done, I assume, by arbitrarily picking a strike price lower than the market price on the day of issuance. Either way, as I note in the comment liked above, the moment the at the money options are issued they pull down share price. They are not free, nor is their effect somehow hidden from investors. So why should there be any moral outrage or any serious consequences here at all?

There is more (much more) below the fold.  (more…)

Holman Jenkins reports that a group of economists led by Milton Friedman and Harry Markowitz are getting behind the idea of putting an end to the expensing of options. It is a great column. Jenkins goes on to discuss options backdating and makes the following points, which will sound unfamiliar to TOTM readers:

• “In no generic sense can one say executives “inflated” their pay or “stole” from shareholders. Backdated packages were not more “lucrative” — it’s fallacious to assume that the alternative package consisted of an identical number of options at a less advantageous price.”

• “Backdating did not provide “guaranteed” or “risk free” profits. It did not “undermine the incentive purpose” of options.”

• “It seems likely that companies, after all, did correctly report the number of options and their price to shareholders. Let it be remembered, too, that millions of these options were cancelled or expired unexercised.”

Geoff made exactly these points in this space months ago (and also more recently, here). Personally, I am thrilled to see a column that focuses on the real questions surrounding backdating: (1) Why do firms backdate? (2) What are the consequences of backdating? and (3) What is the theory of harm, if any, upon which we are going to base civil and criminal prosecutions? It is remarkable, but not incredibly surprising, how little attention has been paid to these questions in favor of the Gretchen Morgenstern-style rants that Professor Ribstein enjoys dismantling weekly.

Geoff’s earlier post frames the backdating issue in terms of the important economic (and legal) questions involved. For example, Geoff makes the following basic (and sadly overlooked) points:

1. Backdated options have incentive effects too.
2. Regulatory quirks involving accounting rules may have provided firms the incentive to backdate.
3. If we are to believe that some 2,000 companies engaged in some form of backdating, many did not appear to be hiding it.
4. There may be no harm whatsoever resulting from backdating. To borrow from Geoff: “It’s not like the options cruise along for a period of time out of the money (and priced by the market accordingly) and then are miraculously turned into at the money or in the money options the moment they are exercised. Rather, the day the options are issued, they are issued with a strike price AS IF they had been issued on an earlier date when the market price was lower. But there’s no lie here – it’s just a convenient way of providing more compensation.”
5. And finally, there are a number of instruments available to compensate executives with or without backdating. I’m not sure if anyone really believes that in the absence of backdating the actual level of compensation would decrease, despite the fact that this assumption seems necessary to the theory of harm most frequently discussed.

Assuming for the moment that backdating is as rampant as the Lie study, media reports, and sudden wellspring of law firm and litigation consultant “backdating” teams suggests, it might be prudent to ask: “why?” and something along the lines of “so what?” The only answers to the “so what” question have been assertions about shareholder exploitation and comparisons to Enron. As to “why backdating,” there seems to be little interest in figuring out what economic and institutional conditions led to the widespread adoption of option backdating and whether the practice is an efficient element of a compensation contract or something more sinister. Rather, we get mostly claims that backdating is a function of widespread fraud or compensation committee naiveity. As I explain below the fold, I don’t think either of these theories get us very far in terms of explaining backdating. (more…)

I had lunch with a new colleague today, and we discussed both stock options and the SEC’s new Exec. Comp. rule.  My colleague asked many good questions, not the least of which dealt with securities fraud.  Given that I live alone, my conversation with my colleague was the first time I had tested out my “backdating is securities fraud” theory.  My sense is that my stock option backdating qua securities fraud might not sit well with some of you, so I thought I would put it out there:

My view is that backdating options is clearly fraudulent b/c “[f]raud is . . . lying to someone to get them to give you their stuff.” Susan Koniak, Corporate Fraud: See Lawyers, 26 Harv. J.L. & Pub. Pol’y 195, 197 (2003).  More specifically, why do companies backdate?  To avoid the expensing, right?  Well, why?  Because it would convey a weaker picture to the market than the company would like to convey.  Why is the company opposed to that?. . . .  Hmmmm. . . . .  The answer is “because it would turn some investors off and they would sell and/or not buy your stock or support your company.”

So what is a company doing when they are backdating options?  They are (all together now) “lying to someone to get them to hold the company’s stock or buy more.”

Onto the SEC’s Exec. Comp. rule:  I have vague recollections of Gordon Smith and. . . maybe Larry Ribstein (?) not being huge fans of the rule when it was proposed.  My lunch companion brought up a point that I think either Gordon or Larry earlier raised:  Doesn’t additional disclosure increase the risk that the investor will either not read the massive disclosure at all or will inappropriately weight some of the minutia of the disclosure?  My response was two-fold:  (1) At least if the Exec. Comp. disclosure is made, the investor has a fighting chance at receiving and processing the information (whereas, if the disclosure were never made, the investor would be doomed to be short on information) and (2) large institutional shareholders have increased in number and size over the past two decades, and these folks read the disclosure.

PCAOB recently issued an audit practice alert entitled Matters Related to Timing and Accounting for Option Grants. The alert mostly addresses option backdating and potential resulting improper accounting. Spring-loading is only mentioned in a footnote on page 2:

In addition, academic research has suggested the possibility that some issuers may have purposely granted options immediately before the release of information that the issuer believed would be favorable to its share price. While these practices may not result in the granting of discounted options, they may create legal or reputational risks and raise concerns about the issuer’s control environment.

This is a rather equivocal statement, especially compared to what the alert says about backdating. It seems to say that if the lawyers sign-off on spring-loading and the company has appropriate controls in place, there is no accounting issue. As I said before, to get the securities lawyers comfortable, I wouldn’t be surprised by companies adding disclosure along the lines of “we may from time to time purposely grant options immediately before the release of information that we believe will be favorable to our share price.”  The tax lawyers, however, could be a different story.

Today’s W$J has an article describing some of the option granting practices at Brocade (see here). Among them was the creation of a one member compensation committee consisting of Brocade’s CEO, Greg Reyes. The article gives the following as the reasoning:

The process of granting stock options was cumbersome because the compensation committee met only every three months. Mr. Reyes said he wanted to speed it up so he could recruit better in those hectic days in Silicon Valley. The board gave him authority to approve options by himself, including their exercise prices.

He said the idea was supported by Larry W. Sonsini, one of the most prominent attorneys in Silicon Valley, who was then a Brocade director. A spokeswoman for his law firm, Wilson, Sonsini,Goodrich & Rosati in Palo Alto, said that one-person stock-option committees are legal under the laws of Delaware. That’s where Brocade is incorporated. “One-person stock-option committees were adopted during a time of intense competition for hiring and retaining employees and the ability to act quickly was critical,” said the spokeswoman for the law firm.

Wilson, Sonsini is of course correct. DGCL Sec. 141(c)(1) provides: “The board of directors may, by resolution passed by a majority of the whole board, designate 1 or more committees, each committee to consist of 1 or more of the directors of the corporation.” (emphasis added). The MBCA has a similar provision. While it may not represent best corporate practice to have single member committees, given the statutory language it is certainly within the board’s business judgment as to whether it is appropriate in a particular case.

With respect to compensation committees, however, NYSE and Nasdaq listing standards adopted in 2003 make it clear that the CEO cannot be on the committee–it has to be composed entirely of independent directors. Note that the standards do not specify whether a compensation committee can consist of a single independent director, but they use the plural “directors” in a way that implies the answer is no.

Although listing standards may make the question moot for most public companies, if you were a director, would you sign-off on a single member compensation committee? My inclination is “no.” Even during “a time of intense competition for hiring and retaining employees,” it seems to me that at least three directors could make themselves readily available to approve option grants through written consent. Executive compensation is just too riddled with temptation for abuse to leave to one person.

Story here. The SEC will hold a Webcast press conference at 5pm E.D.T. (click here).

Institutional Shareholder Services (ISS) has posted an eight-page white
paper entitled An Investor Guide to the Stock Option Timing Scandal. The paper provides a good overview of the recent option backdating and spring-loading revelations.

There has been a number of posts in the blawgosphere debating the legality of backdating and spring-loading. While these practices are not necessarily illegal, as the paper points out:

The option-timing scandal . . . calls into question the oversight provided by boards and compensation committee members at these companies. . . . [I]nvestors may fear that other accounting problems exist but have yet to come to light. The disclosure of backdating sends a ’signal that management is willing to fudge numbers for their own benefit and they might be willing to play other accounting tricks.’

ISS recommends the following as best practices for option grants:

• Adopt “blackout” periods to preclude stock grants when company executives have material, non-public information in hand.
• Adopt fixed grant date schedules that provide for grants on a periodic basis (monthly, quarterly, or annually), along with rules for the establishment of option exercise prices on such grant dates.
• Refrain from making grants on these fixed dates when executives have market-moving news.
• Disclose the rationale for grants on a certain date, explaining why the compensation committee chose that date over other possible dates.
• File Form 4 reports on option grants promptly with the SEC.

While these practices would certainly go a long way towards eliminating backdating and spring-loading, as Geoff pointed out essentially on day one of the scandal (see here), option timing can be an efficient form of compensation. SEC Commissioner Atkins recently expressed a similar view regarding spring-loading in a speech before the International Corporate Governance Network (see here). This view, however, has not been particularly well received (see, e.g., here), perhaps in part for the reasons Tom discusses here.

It will be interesting to see how many companies adopt the measures recommended by ISS. For companies embroiled in the scandal, the lost flexibility in designing a compensation package would likely be outweighed by the potential restoration of investor confidence. For companies outside the fray, perhaps the scandal will simply result in a couple of lines of added disclosure along the lines of “The compensation committee may, in the exercise of its business judgment, from time to time approve grants of options shortly before the public disclosure of favorable company developments.”

Today’s WSJ has a great article by Holman Jenkins on reporting on the backdating “scandal.”  Larry is, of course, on the case.  I would also — modestly — point out that much of what Jenkins says in his article today, I said in this space about four months ago, when the news was first breaking.  The key elements:

1. The notion that backdating gives executives an incentive-defeating ”paper profit right from the start” is asinine.
2. “Backdating” may make perfect sense as a means of compensation, especially given certain regulatory quirks.
3. If the practice amounts to corporate shenanigans, they sure didn’t bother to hide it very well.
4. Non disclosure of the practice, if disclosure was required, may, of course, be illegal.
5. To quote Larry, ”second-guessing executive compensation is a tricky business, even when the problems seem clear.”

On the somewhat-related matter of spring-loaded options (the raising of which was not at all inappropriate, Elizabeth), I find myself in complete agreement with Larry.  Strange, I know.  But it ain’t misappropriation if the board knows what’s going on.  Once again, perhaps some disclosure is required, but it’s hard to see how non-disclosure of the compensation scheme could transform informed executive compensation into a section 10(b) violation.

In both cases, I’m pretty sure there’s no “there” there, but I’m equally sure we’ll be reading (and litigating) about them for quite some time to come.