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Friday, September 01, 2006

Backdating: Yes, Virginia, Execs Do Want Inflated Pay

The stock options backdating scandal continues to unravel, showing yet more examples of corporate greed and misrepresentation.  However, the folks at the Truth don't seem to have much of a problem with it.

From Geoffrey Manne:

But it isn’t stealing. Ultimately, the total value of the grants is fully disclosed. Unless you think that, but for the non-disclosure of the real grant date, shareholders would never endure compensation at this level, this doesn’t sound like theft. And I think the required assumption is extremely unlikely. This isn’t the time to reopen the compensation debate, but does anyone really believe (whether one adopts a market model or a managerial power model) that absent backdating, executive compensation would be lower?

Josh Wright makes a similar point:

[T]here 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.

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.

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.

But the sentiment in (2) is something I actually see a lot when it comes to issues of executive compensation.   It's a form of "compensation nihilism": hey, there are no limits on executive compensation, so what does it matter how much executives pay themselves?  Frankly, I think this logic is counterproductive: if you say it often enough, somebody is finally going to say: "O.K., fine, here are your limits!"  But beyond that, I think it ignores the interaction of disclosure and norms when it comes to corporate pay.

For accounting reasons, it became standard practice to issue stock options at the market price of the day of issuance.  Sure, the option price could have been anything, but accounting rules punished lower prices, and executives didn't want higher prices.  (As a side note, wouldn't higher option prices provide even more of an incentive?)  Since options all had the same feature, it became possible to compare option grants and come up with some sense of what other executives were getting.

Certainly, stock option valuations vary widely from company to company, depending on initial share price and the stock's volatility.  But within a company, the quantity of the option grants offered some grounds for comparison between employees.  And the size of option grants is roughly comparable even between firms.  If the option grant happened to be at a low point for the stock -- well, that executive got lucky.  But changing the date to pick a low point is clearly gaming the system.  It's outside the norms of what stock options represented.

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 the norm in the 1990s -- staggeringly so.  Backdating violated the norms of that process and may also have violated accounting and disclosure requirements.

So yes, I do think that if options had not been backdated, executive compensation would have been lower.  Pay norms would have kept the option grants roughly the same in quantity.  After all, not everyone was backdating -- in fact, at least 75% of firms were not doing it.  With the same number of options set at the actual date of issue, pay would have been lower, and shareholders would have made more money.  That's ultimately what this is all about.

Posted by Matt Bodie on September 1, 2006 at 11:59 AM in Corporate | Permalink

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» Bodie on backdating from Ideoblog
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 2, 2006 10:23:53 PM

» Bodie on backdating from Ideoblog
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 4:28:30 PM

» Bodie on backdating from Ideoblog
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 4:31:18 PM

» Blawg Review #73 from Workplace Prof Blog
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» Backdated Options: Follow the Bouncing Ball from ProfessorBainbridge.com
Bodie begins. Ribstein replies. Bodie bangs back. Manne and Wright intervene. Back to Bodie. It's all very interesting, but at the end of the day the discussion didn't change my view that the problem is simply one of disclosure. [Read More]

Tracked on Sep 5, 2006 2:33:35 PM

Comments

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"The stock options backdating scandal continues to unravel, showing yet more examples of corporate greed and misrepresentation."

Phrases like "corporate greed" is a dead giveaway: the speaker has no clue about finance. What does "corporate greed" exactly mean in the context of option backdating? A corporation is greedy? One set of a corporation's employees (directors) allegedly overpaid another set of employees (managers), and the corporation is "greedy"? So, if my husband overpays our car mechanic, our household is "greedy"? What a meaningless gibberish. This is so tiresome.

There is a legitimate question of whether hidden pay signals inefficiency of compensation markets, but the “greed” language has no place in a serious conversation.

Posted by: Kate Litvak | Sep 1, 2006 5:48:54 PM

"But changing the date to pick a low point is clearly gaming the system."

I don't see the inherent evil or gaming involved. I can give an executive 5 dollars, or I can give him a backdated option to purchase a security worth $10 dollars today for 5 dollars (the price, say, a year ago). For tax and/or business reasons, the option route may very well be preferred.

Now, nondisclosure is a different issue-- backdating without disclosure is not totally unlike handing a CEO a garbage bag full of 100 dollar bills without disclosing. But I can't think of anything inherently wrong with backdating an option, or why setting the strike price at the current price is somehow more "ethical."

"wouldn't higher option prices provide even more of an incentive?"

Sure, if the CEO worked for you in the first place. How would you like to be paid in deeply out of the money options? A company isn't going to have much chance hiring the next Jack Welch by giving him the "incentive" (!) to get paid only if the stock price quadruples.

"Backdating violated the norms of that process"

Gosh, the *norms* were violated? Let's send them to jail! How dare a compensation committee be innovative!

I just don't see what is inherently evil about well-paid CEOs. Why isn't this a matter between the shareholders and the management? If one is that bothered by a CEO's high pay-- and no laws are being broken-- then just sell your shares. On the other hand, if some people are happy to pay $$$ for top talent, why interfere?

Posted by: andy | Sep 1, 2006 7:03:01 PM

and i apologize for the flippant tone of that post. complaints made about executive pay, a company's obligation to "buy american," and a company's obligation to provide full-scale health benefits to unskilled temporary workers without discussing competitive pressures tends to push my buttons.

Posted by: andy | Sep 1, 2006 7:08:22 PM

A few points:

(1) When I said "corporate greed," I meant greed in the context of a corporation, not greed by a corporation. Just like when you say "corporate crime," you're referring to crime in the context of the corporation, not a corporation committing a crime. As the post makes clear, I'm concerned about managerial greed at the expense of shareholders.

(2) I don't really understand the mechanic example. If your husband found hidden or inflated charges in the mechanic's bill after he had paid it, he might think the mechanic was greedy and engaging in misrepresentation. No?

(3) There's nothing wrong with disclosed, in-the-money options. There is an inherent problem with backdated options. Backdating -- intentionally putting the wrong date on the options -- is a lie.

If you don't think any of these folks were trying to hide something, check out the Comverse complaint here: http://www.sec.gov/litigation/complaints/2006/comp19796.pdf
You might read, for example, paragraphs 75-79 discussing the "I.M. Fantom" accounts.

Posted by: Matt Bodie | Sep 2, 2006 12:03:55 AM

Again, what does “greed in the context of a corporation” mean? How is it different from any other kind of greed – or from an ordinary desire to earn more, which is essential for the economy? Execs want inflated pay, but so do I, and so does my gardener. Why aren’t you concerned with my greed at my school’s expense? Why aren’t people calling for state intervention to stop me from overpaying my gardener? How about me overpaying my lawyer? Or me overpaying for a pair of shoes?

With the car mechanic, you’ve missed the point. If I have an agent (my husband) who willingly chooses to overpay my employee (mechanic), at my expense and without telling me, that’s between me and my agent. It’s not between me and my mechanic. And it’s surely not between you and my mechanic. It’s not about mechanic’s greed. It’s about my agent’s poor judgment and about the weakness of my oversight. If there is a problem at all, the solution is to increase my power of oversee my agents’ decisions, not to put my mechanic to jail or confiscate the alleged overpayment. Oddly enough, the same people who most loudly yak about “corporate greed” also oppose the increase in shareholder power.

Posted by: Kate Litvak | Sep 2, 2006 1:09:44 AM

"And it’s surely not between you and my mechanic. It’s not about mechanic’s greed."

But...But...But...they're making a lot of money! That's not fair!

Posted by: andy | Sep 2, 2006 2:17:40 AM

We seem to be getting drawn into a debate about overall CEO compensation levels. Has anyone put forward any legitimate reason for manipulating reported income by failing to compute on the basis of true option dates, as distinct from an argument that the manipulation doesn't matter?

Posted by: Eric Morgenstern | Sep 4, 2006 1:17:42 PM

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