[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…)

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.

Over at Professor Bainbridge’s place, Iman Anabtawi has some thoughts on the granting of “spring-loaded” options, an option granted at a market price that does not incorporate some favorable non-public information, and insider trading laws. The practice is analytically similar to granting a discount option (one with an exercise price below the market price) and is related to backdating (issued retroactively after the information is released). Check it out.

UPDATE: Ribstein responds.

Today’s W$J has an article about Zion Bancorp’s plan to register and sell to the public stock options that mimic the stock options it grants to its employees .  It seems like another good example of the unintended consequences of disclosure regulation that Geoff has blogged about before (see here, here and here).  Zion does not plan to issue the options to raise capital but instead, because employee stock options (”ESOs”) are now required to be expensed (see here and here), to establish a market value for ESO accounting purposes.  Apparently Zion is assuming that the market value will be lower than that generated by the option valuation method it currently uses for ESO accounting purposes.  It will then use this lower value when expensing its ESOs thereby reducing the hit to income from issuing ESOs.  Perversely, according to the W$J, “[t]he lower price would help to offset the company’s cost of issuing the options-linked securities.”  Huh?  Aren’t we just talking about different accounting treatment but no difference in economic substance?

See here for the story.

I blogged earlier about Vonage taking advantage of recently liberalized SEC rules that allow the use of written marketing materials during the IPO waiting period (see here). Specifically, they emailed a letter to their customers regarding a directed share program. They then followed up the letter with a voicemail blast (see here). All this is allowed under SEC regulations provided certain conditions are met. Well it seems that Vonage dropped the ball on some of the conditions. They failed to include a hyperlink to their latest preliminary prospectus in the email. They also did not include all required information in the voicemail blast.

See below the fold for the disclosure on these issues added to Vonage’s amended registration statement. (more…)

The Investment Company Institute (ICI), the mutual fund industry trade organization, recently published a survey entitled “Understanding Investor Preferences for Mutual Fund Information.� Click here for the survey and here for an ICI press release with highlights of the survey. Here’s some the findings:

• Mutual fund investors focus primarily on fees, historical performance, and risk when purchasing funds.
• Recent fund investors make little use of prospectuses or shareholder reports. Around two-thirds of investors did not consult fund prospectuses or shareholder reports in making their purchase decisions.
• Few investors reviewed information about a fund’s portfolio manager (25 percent), proxy voting policies (15 percent) or board of directors (15 percent).

These findings are not surprising to me as I would be in the majority on each one.

The survey also includes several findings that go to internet usage by mutual fund investors, mainly, that they have ready access, are comfortable using it, and use it frequently. It’s obvious that these findings are directed at the SEC. The mutual fund industry wants the SEC to adopt the “access equals delivery model� for mutual fund materials. Under the model, a fund can meet delivery requirements by posting materials on the web and notifying investors of their availability instead of mailing hardcopies. The SEC recently adopted the model for prospectus delivery and has proposed a rule applying it to proxy materials. Investment companies, however, are specifically excluded from coverage.

I’m in favor of extending the model to mutual funds. As I’ve said before, hardcopy distribution requirements are simply inefficient and wasteful in the internet age. Further, as the ICI survey points out, few investors even look at mutual fund prospectuses or shareholder reports. Switching to the model will result in cost savings for the funds.  These savings will presumably be passed on to investors, especially given investor focus on fund fees as demonstrated by the survey.

You might have noticed that the current Bausch & Lomb product recall is on my list of things to blog about. Let us start in on it:

As you likely know, Bausch & Lomb announced a worldwide recall yesterday of its MoistureLoc product. This recall comes about a month after B&L disclosed concerns about and discussions with the FDA regarding a rare eye infection (Fusarium keratitis) that had cropped up among some number of MoistureLoc users (and users of other products, made by other companies, it is worth noting). At that point, in April, B&L suspended sales in the US of its MoistureLoc product.

The CEO of B&L told us yesterday that investigations have shown that there had been no contamination or tampering with the MoistureLoc product, which leads B&L to deduce that “some aspect of the MoistureLoc formula may be increasing the relative risk of Fusarium infection in unusual circumstances.” To be safe, B&L is recalling the product, while B&L continues to investigate the link between the infection and MoistureLoc.

Three things are interesting to me:

1. The wires tell us that the FDA just released a report chastising B&L for not reporting in a timely fashion 35 cases of eye infections reported by its MoistureLoc users in Singapore and for not notifying the FDA immediately when B&L withdrew its product from the Singapore market in February (well before B&L pulled the product in the US). (I could not get my hands on the FDA report, hence my introduction “the wires tell us.�)

2. The MoistureLoc solution has apparently been used since late 2004. In December of 2005, a class-action suit was filed against B&L by a woman who claimed that she suffered an eye infection as a result of using B&L’s solution, and the infection ultimately required her to get a corneal transplant.

3. The RiteAid and Target directors have not yet responded to a fax (or e-mail) I sent to them last month, asking whether I should stop using their generic eye care products (in the event that their products were made by B&L and/or Alcon).

Allow me to expand on these three things: Points two and three above are interesting to me because they would make good facts for an exam question. Specifically, I view B&L’s disclosure failures and the fact that B&L was on notice of potential problems months ago as raising fun securities fraud and director liability (for good faith failures) issues.

On the issue of securities fraud, B&L appears to have been holding off on filing 10Qs and 10Ks for months. Initially, the reason given was unrelated to the MoistureLoc eye infection issues. My question is “at what point did B&L know enough about the eye infection potential that it became material disclosure that *had* to be made, such that the failure to make the disclosure while making *other* disclosure constituted securities fraud?�

Remember the balancing test from Basic v. Levinson – essentially balance the contingency against the impact it would likely have if it came to pass? It seems to me that (a) getting sued by a bunch of folks who have serious eye problems (including blindness- God forbid), (b) having to pull a relatively significant product, and (c) losing consumer confidence in other unrelated products are all things that I would peg as “material enough� (for lack of a better phrase) under Basic to merit disclosure sooner rather than later. I understand that making disclosure sooner rather than later raises the risk of alienating investors if it later turns out that the fungal infection issue is a non-starter. But we are talking about eyes here, people; not toenail fungus infections.

On the director liability front, I would love to know how much the B&L directors knew about the potential MoistureLoc concerns and when they knew it. I see this as a policy sort of exam question – “if you are called by your friend Sue, a director for Generic Eye Care Inc., and she tells you that the COO of Generic mentioned something while on the links with her about a class action suit related to eye infections but the COO said this sort of litigation was de rigeur in the medical products world, and Sue asks you if she needs to raise a red flag with her fellow directors, what do you tell her? Remember that the modern board is a ‘monitoring board,’ at best.�

With respect to point three above, I faxed (or e-mailed) letters to the Boards of Directors of both Target and Rite-Aid back in April when I heard about B&L’s product recall, asking whether either of their private label eye solutions (which I use) were actually B&L products about which I should be concerned. I also asked in the letter what I should do, in terms of using the products and/or getting my eyes examined.

In a *shocking* turn of events, I have not yet heard back from even a single director.

It looks like Vonage is taking advantage of recently liberalized SEC rules that allow the use of written marketing materials during the IPO waiting period. It recently filed this letter as a “free writing prospectus.� Here’s the body of the letter:

As you may know, Vonage has filed a registration statement with the Securities and Exchange Commission (SEC) related to its proposed initial public offering (IPO) of common stock. Because much of our success is attributable to our customers, we have asked the underwriters of the IPO to reserve shares of common stock for sale to certain Vonage customers at the IPO price in a Directed Share Program.

You may be eligible to participate in the directed share program if you meet certain eligibility requirements, including having been a Vonage customer from December 15, 2005 through February 1, 2006. You do not need to continue to be a Vonage customer in order to participate. Further information about the terms and conditions of the Directed Share Program, including the eligibility requirements and the process for participating in the program, are available in our registration statement and at the following website:

www.vonageipo.com

Presumably the letter will be emailed to current Vonage customers. According to Dealbook, up to 13.5% of the IPO shares will be reserved for the Directed Share Program.

Under old SEC rules, the only written materials that could be used to market an IPO during the waiting period were preliminary prospectuses and tombstoned ads. Now, an IPO company is free to email out any marketing materials during the waiting period so long as the email includes an active hyperlink to the preliminary prospectus.

Back in February, I criticized the SEC’s rules regarding how energy companies must disclose their oil reserves in securities filings. My main point was that the conservative way the SEC measures reserves is quite different from the measurement approach the oil companies themselves take when deciding how to invest billions of their own dollars. If the SEC is going to require disclosure of some reserve estimate, shouldn’t it be the estimate upon which managers are willing to bet the corporation’s money?

An op-ed in today’s W$J makes the same point and nicely explains what’s wrong with the SEC’s antiquated oil disclosure rules.

Under SEC rules, a public company is required to start expensing options commencing with its quarter one 10-Q for its fiscal year beginning after June 15, 2005. This means the time has arrived for public companies with calendar year-ends, and as a result, this month many companies have reported or will be reporting for the first time numbers that reflect option expensing. In a January post on the subject (here, and discussed by Geoff here), Rich Booth noted as follows:

In the end, it might not matter whether a company treats the grant of options as an expense. Studies show that a company’s choice of accounting convention makes no difference as to stock price. As it is, analysts can translate earnings into cash flow, while CFOs can explain away the aberrant effects of accounting rules by calculating pro forma earnings.

Based on this article in today’s W$J, however, this may not be true with respect to option expensing, at least in the short term. According to the article: (more…)

Option backdating was on page one of the W$J again yesterday (here). The story was spurred by comments made by UnitedHealth’s CEO, William W. McGuire, during UnitedHealth’s First Quarter 2006 Results Teleconference on Tuesday. UnitedHealth’s option grants to Dr. McGuire were among those cited as suspicious by a March 18 page one W$J (article here; earlier blog post here).

The Journal’s analysis raises questions about one of the most lucrative stock-option grants ever. On Oct. 13, 1999, William W. McGuire, CEO of giant insurer UnitedHealth Group Inc., got an enormous grant in three parts that — after adjustment for later stock splits — came to 14.6 million options. So far, he has exercised about 5% of them, for a profit of about $39 million. As of late February he had 13.87 million unexercised options left from the October 1999 tranche. His profit on those, if he exercised them today, would be about $717 million more.

The 1999 grant was dated the very day UnitedHealth stock hit its low for the year. Grants to Dr. McGuire in 1997 and 2000 were also dated on the day with those years’ single lowest closing price. A grant in 2001 came near the bottom of a sharp stock dip. In all, the odds of such a favorable pattern occurring by chance would be one in 200 million or greater. Odds such as those are “astronomical,” said David Yermack, an associate professor of finance at New York University, who reviewed the Journal’s methodology and has studied options-timing issues.

Dr. McGuire addressed the issue during Tuesday’s teleconference (click here for the transcript). Among other things, he recommended that that UnitedHealth: (more…)