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Wednesday, August 16, 2006

The Continuum from Ethical to Criminal: The Option Backdating Controversy

There's been a flurry of commentary this morning provoked by a Wall Street Journal op-ed piece that is something of an apologetic for the option backdating controversy of recent weeks.  Larry Ribstein weighs in, if I have his argument right, not to say that the backdating, if it occurred, was right, but remedying it should not be a matter for the criminal law (versus SEC civil enforcement, assuming there is a cause of action for backdating).  Dale Oesterle over at Business Prof Blog (part of the Law Professor Blog Network) makes the deontic argument about respecting rules qua rules.

I have not read the op-ed piece (I'm relying on Larry summary) because finding a copy of today's WSJ quickly demonstrated another aspect of what here in New Orleans is referred to as "the post-Katrina world."  But the gist of it is this.  Let's assume that I am granted 100 stock options in a public company today at a $10 strike price, reflecting yesterday's closing price of $10 per share.  If the stock price rises to $20 in two years, I "exercise" by buying the stock at my option price, and either hold it, or more commonly, immediately sell it, and get proceeds of the difference between the market price ($20) and the strike price ($10) times 100 shares:  in this case, $1,000.  For tax purposes, that $1,000 is ordinary income to the recipient, but for a number of years there has been an underlying controversy how this income to the recipient should be reflected in the financial reporting of the company.  Historically, under generally accepted accounting principles (GAAP), option compensation as just described never shows up as an expense of the corporation.  Its cost is reflected, if at all, in the effect of dilution on all the existing shareholders when the new shares are issued, upon exercise, at less than the market value.   The exception to this was if you issued an option having a strike price BELOW the market price as of the day it was issued (or the closing price the night before).  In that case, the option cost had to be expensed on the company's income statement.  This reduced the current earnings of the company, something managers and Wall Street stock analysts do not like to see.  (I should note that while I am not an economist, I am sympathetic to an economist's reaction that in a transparent world of perfect information, none of this accounting treatment should make any difference to value.)

Despite my sometimes insufferable Kantianism, I am also sympathetic to the idea of letting  economic markets determine economic outcomes, like how much executives or baseball players or Jessica Simpson or Paris Hilton get paid.  But I worry when, during the course of normative argument,  the implicit utilitarianism that is the philosophical basis of most economics is not made explicit.  Again, I do not think Larry Ribstein is saying that backdating options is okay; I think he is making the point that it is not a matter for the criminal law.  But, below the fold are some moderately inchoate thoughts on this.

The WSJ article appears to construct the following apologetic:  (1) Companies wanted to recruit good new people by giving signing bonuses that were money or some form of recognized compensation equivalent.  (2)  Giving money would be reflected as a hit to earnings, but there existed a system by which you could give real value without it being so reflected:  stock options. (3)  The accounting rules would let you give a "strike price at market" option but that wouldn't give the company the benefit of having provided real value to the employee, particularly when you wanted to give the value now as a signing bonus.  (4)   If you gave a "strike price below the market" option that would accomplish the purpose of giving real value to the employee, but you would take an earnings hit, which is exactly what you didn't want in steps 1 and 2.  (5)  The accounting rule was silly, but it was clear.  (6) If the stock had been trading at $5 six months earlier, and you just made the agreement, as they say, "nunc pro tunc" (now for then), by putting a six month old date on the agreement, you accomplished both objectives.  (7)  Backdating was not clearly impermissible (though I wonder how often it spanned a tax or fiscal year).  (8) Using a questionable but not clearly impermissible technique to avoid a clear and undesirable  implication of the alternative is not such a big deal.

I think a lot of what passes for moral outrage or deontic analysis on this issue is really normative political argument about wealth distribution, and consistent with good old American populism, going after rich people is pretty easy.  I have no issue with the straight-up argument "I was freely offered what seems to be an outrageous amount of money for what I did, but it was all disclosed and above-board, I earned it, and I'm going to enjoy the benefits of it."  (What I think of the person will probably depend on the definition of "enjoy the benefits of it" - did he/she endow a fund for diabetes research or buy a 150 foot yacht? or, even better, both.)

But this technique (speaking as a former GC and as an academic ethicist) bothers the hell out of me.  The former GC can come up with all sorts of consequentialist reasons for not doing this.  (One of my epigrams has been:  "whenever I thought I was doing something extremely clever, it generally came around to kick me in the a__.") [NB:  when I speak as a former GC, it is spiced with mild profanity.]

The academic ethicist wonders again about the conflation of practical reason as between determining correct ends, and using what is also called "practical reason" to get the result I want (See Richard A. Posner, Economic Analysis of Law, 6th ed., at 3-28).  Larry Solum recently highlighted a paper on this subject by Pamela Hieronymi at UCLA.  Just yesterday, we had a discussion about whether one might just pay the parking tickets over the course of a year rather than pay the greater cost of a parking permit.  It seems to be there IS something more than rational calculation, and even if, to Larry Ribstein's point, it is not a matter of criminal law,  the absence of that something is reflected in legal and business minds that would let the practice go forward.   

Posted by Jeff Lipshaw on August 16, 2006 at 01:34 PM in Corporate, Current Affairs, Lipshaw | Permalink


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Very interesting reflections on this. I recall one of the first stories in this series was on the CEO of United Health, who apparently got over one billion dollars in compensation over a decade at the company (much in backdated options).

To explain why I'm uncomfortable with that, I'd add in a few more ethical/economic distinctions:

1) Entrepreneur vs. manager: certainly we want to give people with great ideas the incentive to risk a lot, and win big if they succeed. BUt this CEO was a manager. He appeared to have almost no downside. What's the justification for massive upsides with no risk of downside?

2) Ratchet effect: In the article, a member of the board (as I recall, a dean of a nursing school) said something like "we had to pay him a lot, everybody else was paying their CEO's alot." This recalls Robert FRank's classic article, The Frame of Reference as a Public Good. By any objective standard, any salary above $10 million per year is fantastic. But once one starts comparing oneself to other CEO's, it might look downright inadequate. And if everybody else can host parties on a 100-foot yacht, you look vaguely ridiculous hosting a gathering on your mini-yacht (which the WSJ helpfully let us know (in last week's Personal Journal) can cost as little as $2 million!)

3) Criminality: But I have to say, regardless of what ultimately is adjudicated here, I hate to see these money/fraud cases leading to jail time. I think it would be far more effective, and helpful to the public, to take (a lot of) the defendant's money (and future income stream--can the recent bankruptcy bill help us here?) and direct it to charities serving basic human needs. (And for those of you who think this is classist--i'd apply the same standard to many poorer defendants in fraud cases.)

Posted by: Frank | Aug 16, 2006 1:52:13 PM

The point of Holman Jenkins article today (like his previous ones) is not that backdating is ok, but that it had a business purpose (it's not just "CEO greed") and it was encouraged by unrealistic accounting rules that assumed that options were an expense only if in the money. Nobody is claiming that it is ok to misstate profits, and that is exactly what backdating does: backdating makes an in-the-money option look like an at-the-money option. The point is that this is not appropriately dealt with as a criminal matter. If you can make a Kantian or other argument that figures out a way to lock up Comverse people but not Steve Jobs, I'd really like to see it.

Posted by: Larry E. Ribstein | Aug 16, 2006 2:33:57 PM

Larry, I think we violently agree about criminality. My point is that even if it has a business purpose in recruiting good people who ultimately benefit the shareholders (not the greedy CEO), there's still a question to be pondered about how the lawyers and executives manage to rationalize this marginal practice into the mainstream. (CEOs don't just feed on money; they feed on success and share price is usually the proxy for success.) Like my parking example, how close do you come to crossing the line when the line doesn't make legal or economic sense, but it's still the line? By the way, I wouldn't make parking scofflaws criminals either.

Posted by: Jeff Lipshaw | Aug 16, 2006 3:07:49 PM

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?

Posted by: geoffrey manne | Aug 16, 2006 7:10:40 PM

That double posting was not impatience; in fact I was surprised at how quickly my comment came up. It seems to be a (non-user) glitch of some sort.

Posted by: geoffrey manne | Aug 16, 2006 7:21:13 PM

I fixed the double posting. What power.

The issue for me isn't lying. It's wondering about how we go about deciding what is the right thing to do. I wonder about the judgment in which the actors justify even a technical violation of the rules in this particular setting (as I understand it, the real problem is it may not be a technical violation of anything - it is a clever way of getting around something you clearly cannot do, which is grant a below the market option and fail to expense it).

But if it's not lying, it seems like the next best thing, at least in this context. What intrigues me is the intuition that there is something wrong about saying or writing words that do not mean what they say. In many ways, that's related to the "Of Fine Lines" thesis, which is that there is something of an apriori expectation that what we say is true, that ought to be the basis for the legal presumption that what we say is true. If, on December 31, the option grant says "XYZ hereby grants 1,000 options at a strike price as though this document were executed on June 30," there's no lie. But it's also likely ineffective to avoid expensing. On the other hand, if we write a document on December 31 that looks just like a June 30 document, it's at best a half-truth, or a latent falsehood (whether or not it's an important one).

And let me go back to the context, perhaps to Larry's point. Notwithstanding the gray areas, judgment calls, and fudge factors in GAAP, the idea is to have a set of technical rules that create consistency in financial reporting, so that roughly speaking, everybody's numbers are speaking the same language. "Bill and hold" for revenue recognition at the end of a fiscal year has no economic substance; it's all about the buckets into which we drop the data. The difference between moving the stuff outside the gates or leaving them inside, the technical rule of F.O.B. seller's plant, means something - that the $2.50 per share you reported as your earnings was made by trying to throw down the middle of the plate, reporting-wise, and not picking at the corners.

Posted by: Jeff Lipshaw | Aug 16, 2006 9:39:01 PM

ISS, the Institutional Investors Service, has put together a wonderful overview of the options backdating scandal. What I find very egregious is the way some of the companies have exploited investors - particularly technology companies - by fattening the wallets of executives at the expensive of individual investors.

High Tech Executives Create Volatility In Their Stock to Enable Options BackDating

Posted by: Mr Wave Theory | Sep 18, 2006 6:38:28 AM

Backdating is not just an accounting trickery. It does indeed hurt share holder value. Take the example where the $10 option was granted at $5, and then exercised two years later at $20. The gross proceeds is $2000. The amount due company is $500. The amount of gain is $1500. Well, the real amount due company would have been $1000, if the date was not fraudulently changed. The share holders have just been embezzled $500 by the management they hired to run the company.

In quite some cases, the backdated options are not used to recruit outside talent. They are instead used as a compensation to the senior management themselves. This is of course lying, this is also criminal.

Posted by: svll | Oct 19, 2006 1:59:29 AM

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