Sunday, September 03, 2006
Backdating: A Response to Prof. Ribstein
In my earlier post on stock option backdating, I argue that executives used backdating to lie about the issue date of their options, thereby falsely inflating the value of the options. As a result, executives got options that were more valuable than they should have been. In response, Larry Ribstein argues that I am confused about the issue: backdating is only a disclosure issue, not a pay issue. In making his case, however, Ribstein ignores the very nature of the option. The option is not a set value; it's incentive compensation based entirely on chronology. Executives lied about the date of issue in order to get more pay. This is not a case of, "Whoops! I failed to disclose!" It's a case of false disclosure in order to get something you're not entitled to in the first place.
Ribstein claims that the amount of pay was fully disclosed because, as Geoff Manne has pointed out, everyone knew the option strike price when the option itself was disclosed. But that misses the point: the disclosure erroneously claimed that the option had been issued earlier than it actually had. It's like saying that it's okay for a mechanic (in Kate Litvak's example) to overbill his hours because those (overbilled) hours are disclosed in the final bill. Those hours are a lie, and the backdated options are also a lie.
Why is this lie so important? Because stock options are an incentive-based compensation that depends on chronology. Options say: "Starting at this point in time, you will get a bonus for any increase in the value of the stock." Yes, theoretically, an option can have any strike price. But the price is almost always the market price of the stock on the issue date. Part of this historically was for accounting purposes; options below the market price had to be expensed. But part of it is also the sense that you should get credit for any increase starting from that point. If the stock price is $30, why should you make money on the options if the price stays above $20? The option gives you an incentive to increase the share price from that time forward. Thus, when someone refers to the number of options they receive, it is an unstated understanding that the strike price is the market price on the date of issue.
As a result, backdating is a great way to get more compensation than the company would otherwise give you. After all, on the surface everything looks fine -- you received X options at date Y with a strike price of $Z. But the only reason you got the strike price of $Z is because you got them on date Y. If you happened to get them at a low strike price -- hey, lucky you! But luck had nothing to do with it when backdating is involved.
For a sense of how this worked in action, check out the Comverse complaint. Executives there allegedly created options falsely dated back to historically low prices. According to the complaint, they fooled their compensation committee into approving options for fictitious employees, creating a slush fund of ultra-valuable options. As a result, these executives were able to get more money for themselves than the compensation committee, the shareholders, and the market realized. Ribstein himself blogged about the Comverse scandal here.
Ribstein doesn't seem to have a problem with this, because he seems to believe that executives not only know exactly what their market worth is, but will be able to get it come hell or high water. Here's his key graph:
Assuming the market was fooled, then the misreporting may have facilitated paying the executives more than they otherwise would have gotten by reducing the earnings hit from the compensation. But this is far from clear. It seems more likely that the executives simply would have gone to different firms that would have paid them their market wage without accounting manipulations.
I think this reflects a strange understanding of the market for executive compensation. First, labor, unlike capital, is not infinitely mobile. The notion that these folks would have left to go somewhere else had their options not been backdated strikes me as fanciful. More importantly, as Bebchuk and Fried (among many others) have argued, the market for executive talent is far from a perfect market. These are not arms-length negotiations. That is why executive compensation is based so much on consultants' reports about what everyone else is getting -- it's the only way of making a case for some sort of market level of compensation. By backdating options, executives were able to get more than their market worth. The market believed the options had been granted on a certain date, and that belief was false.
So yes, backdating is about overpaid executives -- overpaid by market standards. "Greedy" is subjective, and appears to be a red flag for some folks. My American Heritage dictionary defines greed as "[a]n excessive desire to acquire or possess, as wealth or power, beyond what one needs or deserves." These executives sought to get paid more than their companies, and the market, said that they deserved. Perhaps greed is not always good.
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Matt Bodie says: Executive compensation is all about norms. Compensation committees pay experts to determine how much the average CEO in the industry is making, and then increase the amount to compensate their exceptional CEO. Stock options became part of [Read More]
Tracked on Sep 3, 2006 5:14:17 PM
The first time around when I was a guest blogger, I committed the journalist's cardinal sin of burying the lead.
I will take as my base case the backdated options I described in my first post - economically, it's just compensation. Accounting aside, if you can get it because you are worth it, more power to you. I have no populist angst about the distribution of wealth. Some of my best friends are rich people (though not the idle rich!). I will also assume the options were "disclosed" in the proxy (although my test in case like this was often - okay, if you described what you were doing in plain English in bold print on the first page of the employee newsletter, would you be happy with it?) As a good free marketer who believes for whatever imperfections exist, the market for CEO pay, senior vice president and general counsel pay, and law professor pay beats the hell out of any alternative, I confess I also don't quite get the greed arguments. It's all relative - why do you really NEED a vacation home, much less a 3,000 square foot vacation home, much less a 10,000 square foot vacation home?
My problem is something akin to Matt's, but arises from the standpoint of a person who (a) got lots of stock options and compensation (it's all a matter of public record), and (b) had the job of overseeing knotty issues of ethics within the company. It all stems from the "it's not a lie; well, maybe just a technical whatever." I don't know how you stand up in front of your employees and tell them to obey the regulatory rules (all of them, not just the ones that make economic sense), recognizing that it's tough enough to deal with what HLA Hart referred to as the fuzzy edges of the rules (so, just how aggressive are we in adjusting reserves for SMOG - slow moving and obsolete goods?) when you don't start from a well-centered position on the easy calls. You hire a VP of Engineering away from Brand X, pay her with a fully disclosed backdated option to avoid the accounting treatment (meaning you put a false date) on the option grant; then when one of the low level engineers decides the ASTM standard for wall thickness on PVC tubing is stupid from an engineering standpoint (what's another couple microns?), and his department can make more money if we save just a tad of raw material on each foot of tubing, you fire him for violating those ethical guidelines every good company publishes. As I have written, it's so easy to rationalize one's way to a bad conclusion, this very common double standard makes me uncomfortable. If you think the executive is worth $X, pay the executive $X, stand up for your decision to pay the executive $X, be proud of what you are doing for the company, and don't write on a sheet of paper that you are paying $Y.
I used to struggle with tough calls like this all the time. If a purchasing agent at a plant accepted a $1,500 Las Vegas junket from a supplier, it wouldn't be a close call - the agent would be gone. If our CEO receives a Christmas basket from the CEO of a major supplier, and it includes four or five bottles of wine selling for $120 a piece at the local gourment wine shoppe, what's the difference? You can make the argument that one is an out and out gratuity barred by the company ethics policy and one is a "nominal seasonal gift" which is permitted, but you have to argue now that we make that determination in relation to one's salary.
It goes back to rules and standards. Rule-breaking, even of the technical or nominal variety, at the executive level has to be taken very, very seriously. From my standpoint, arguing the law and economics of the compensation or the disclosure is beside the point. If we are willing to let rules at the executive level be broken for utilitarian ends, I'm not sure how we expect employees to process the far grayer standards we throw at them all the time.
Posted by: Jeff Lipshaw | Sep 3, 2006 5:45:57 PM
One other thing. I'm still thinking about and working on Vice Chancellor Strine's very interesting take in Abry on the right to disclaim reliance on non-contractual statement - hence, granting a limited right to lie (under his holding, the anti-reliance clause does not prevent a fraud claim for intentionally false reps made in the contract itself).
Along the way, the opinion wrestles with the strong moral compunction against lying, and grounds it, at least in part, in efficiency arguments (citing Posner's Economic Analysis of Law to the effect that lying should be illegal because it is inefficient). I confess, this is half-baked because I'm still working my way through it. But if we are not sure about the transaction costs involved in telling a lie (I think everybody would agree there is at least some possibility of an imperfect market in information), wouldn't the default rule with the highest likelihood of reducing transaction costs be one that presumes an affirmative statement is a truthful one? I invite the Coaseian economists to tell me how I'm wrong (teach me, teach me), but I think the equivalent in the backdating circumstance to negotiating around the default rule is disclosure, which means the disclosure has to be perfect to avoid the transaction costs, and thus insure the efficiency that the theorem predicts.
Posted by: Jeff Lipshaw | Sep 3, 2006 7:19:54 PM
Matt: I disagree with your statement that “stock options are an incentive-based compensation that depends on chronology.” As I’ve pointed out before (see here): “The incentive provided by stock options comes not from the strike price [or the date of grant] but from the fact that the option increases in value essentially dollar for dollar as the company’s stock price rises. If setting a strike price below market price [through backdating] is in and of itself problematic in terms of incentives, people should have been in an uproar when Microsoft and other companies changed from stock options to restricted stock. The grant of restricted stock is essentially the same as granting an option with an exercise price of zero. I do not recall any uproar, nor should there have been one.”
Jeff Lipshaw’s point on the seriousness of rule-breaking at the executive level is well taken, but keep in mind that at one time outside auditors were signing-off on backdating. Hence, some executives may have correctly believed that they were in technical compliance with the rules.
Posted by: Bill Sjostrom | Sep 3, 2006 7:46:45 PM
I have no problem with restricted stock because it's not claiming to be anything other than restricted stock. In fact, I think restricted stock is preferable as a compensation mechanism, because it provides for downside as well as upside risk.
Of course stock options could have been set at any stock price. My point is that they weren't -- they were always set at the market price of the day of issue. The point of backdating is to try to fool someone: the board, the compensation committee, the shareholders, potential shareholders, competitors in the market for executive talent, and/or simply the accounting rules. I think it's much more egregious when the board and compensation committee were among the parties being fooled.
Posted by: Matt Bodie | Sep 4, 2006 12:11:42 AM
"If the stock price is $30, why should you make money on the options if the price stays above $20? The option gives you an incentive to increase the share price from that time forward."
Oh, I don't know, perhaps because you could have received 10 dollars cash compensation instead of the in-the-money option?
"I think restricted stock is preferable as a compensation mechanism, because it provides for downside as well as upside risk."
Don't backdated options pose a downside risk as well? If the market price of the stock sinks, the value of the option sinks as well, even if it remains in the money.
What if a board wishes to grant an in the money option to an executive, knowing that in the coming months it will release adverse information to the market about the firm that will depress the stock price? Seems reasonable to provide a "cushion" in these circumstances-- I may want such a cushion if I were lured from a successful business to a sinking ship.
I fully agree that, if e.g. valid SEC regulations require full disclosure of executive pay, and that a company discloses that the exec received an option whose exercise price was set at the market price on the date of issue, but in fact the exec received a backdated option, then that would be illegal according to the plain terms of the statute. similarly, if the tax code grants favorable treatment to options issued at the market price, but not backdated ones, then taking advantage of such favorable treatment for a backdated option is plainly illegal. from a cursory review of the comverse complaint, i do agree that if the allegations are found to be true, then the executives should be punished. i do not care what is "efficient" or what is "utilitarian," but instead i care about what is legal or not legal. if SEC regulations prevent one from making efficient contracts, the "efficiency" defense is frivolous (though the SEC may be well advised to amend or repeal such regs).
however, i cannot possibly see how backdated options in any way suggest "greed" or how a backdated/in the money option is somehow a "bad" form of exec comp, and that a third party who has nothing to do with the relationship has a right to say "You have to pay him using this! You guys can't freely agree to issue a backdated option!"
Again, if there is legal fraud, that is one thing, but if we're suggesting moral fraud (i.e. "greed"), then the arguments against granting backdated options are simply untenable.
Posted by: andy | Sep 4, 2006 9:43:17 AM
Actually, it can be argued that in-the-money option grants create better incentives than at-the-money options, in that the recipient will lose money dollar for dollar in the event of stock price declines (as pointed out above) and will thus consider the downside risk of proposed actions. In the case of an at-the-money option, the recipient is likely to focus on the upside and pay less attention to the downside because all downside outcomes result in an equal payoff.
To the extent that good reasons for issuing in-the-money options exist, that seems to make the decision to disguise the fact that ITM options are being granted all the more suspect.
Note that a fuller discussion of this issue might address the fact that stock itself can be seen as a call on corporate assets, with attendant incentives for equity holders and their representatives to ignore downside risk to bondholders' detriment.
Posted by: Eric Morgenstern | Sep 4, 2006 2:35:21 PM
I would suggest a the reason for backdating is to avoid openly giving cash bonuses which might outrage shareholders, or look bad in the press. For example, at the beginning of a one year period stock in a corporation is trading at $17 a share. During the year the stock price drops to $10 a share, but by the end of the period is up to $15. If an executive is granted a cash bonus of $500,000 shareholders might be enraged that the executive is receiving a bonus for a period where the share price declined (BTW, I am not saying that the bonus is or isn't justified--merely that its grant could raise the ire of shareholders). On the other hand, if the executive receives a backdated option for 100,000 shares at the yearly $10 low, it focuses the shareholders' attention on the period between the backdated date and the present, and gives the appearence of being directly tied to the rebound in the company's stock price.
Would such sleight of hand really fool any significant group of real world investors? I have no idea. I do know, however, that prior to the current flap on backdating, the practice seemed to fly pretty much under the radar. On the other hand, the granting of cash bonuses to executives whose companies' stock prices remained static, or even declined, did cause complaints by shareholders which periodically showed up on the business pages.
Posted by: Harry Gerla | Sep 4, 2006 7:59:42 PM