Wednesday, July 27, 2011
Backdating and a culture of endemic corruption
Larry Ribstein continues his campaign against the campaign against backdating by referring to said campaign as an "overblown" "so-called scandal" that essentially led to the Madoff fraud and the 2008 financial crisis. How, you ask? By sucking up enforcement and journalistic resources that would otherwise have ferreted out these more nefarious deeds. In support, he cites a recent paper by Stephen Choi, Adam Pritchard, and Anat Carmy Wiechman that claims the SEC spent more time on backdating that was justified by the subsequent results. It's an interesting theory. But I wanted to point out a few things quickly, just in response to Ribstein's post.
Backdating violates the law, by definition. It is a misrepresentation about the date on which the stock option was granted. Ribstein has done his best to play down, mitigate, justify, rationalize, brush off, scoff at, and ridicule this basic reality, but it's inescapable. Executives lied about when their options were granted in order to get more money than they were legally entitled to. It's a fact -- discovered by a business school professor -- and there's no getting around it. And it happened at many companies, likely hundreds.
Luckily, there proved to be a quick fix to this problem -- change the required time of reporting the option grant. So the problem no longer exists; it is essentially impossible to backdate anymore without being obviously in violation of the law. So in terms of punishing the crime, deterrence, of at least that particular crime, is no longer an issue. That may counsel for civil sanctions rather than criminal prosecutions. To that extent, I agree with Larry -- it seems whimsical and capricious to single out some of the backdaters for jail time when the problem was much more widespread. (Although the Comverse case seems particularly egregious.)
But if anything, I think the backdating scandal has been underappreciated, at least from a corporate governance perspective. Here you had hundreds of executives blatantly lying to their shareholders, federal agencies, and in some cases even the board about their compensation. That to me indicates a culture of corruption -- a culture of "I will get as much as I can, even if I have to lie about it." Sandwiched as it was between Enron and WorldCom before and the financial crisis after, it is yet another indication of the rapaciousness of some significant segment of the corporate and financial communities. It is further indication that executive compensation has deep flaws within its structure, and we need to keep thinking about ways to change the structure and the culture. Even though it has been "solved," with regard to the particular problem, it is a symptom of a much deeper condition. To that extent, the corporate law community should not dismiss backdating as simply an overblown footnote in the annals of finance. Perhaps the criminal prosecutions were overly zealous, in some instances. But that does not mean there wasn't corruption.
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Well said, Matt. A rose by any other name ...
Posted by: Len Rotman | Jul 27, 2011 4:05:18 PM
Ribstein isn't arguing that backdating was legal or non-corrupt, he is arguing that, given that the SEC has scarce prosecutorial resources they should have diverted them to more serious forms of corporate corruption. By prosecuting more serious forms of corruption, regulators can more effectively combat the "culture of corruption" that you seem concerned about. In support, he cites empiricial research. I don't see what your conclusion--"But that does not mean there wasn't corruption"-- adds. The illgality of backdating is a premise that Ribstein and Choi et al both accept. Accordingly, if you care about corporate corruption, shouldnt you be cheering his "campaign" for more efficient enforcement? Here's from the Choi abstract:
"We find that as the level of media scrutiny of option backdating increased, the SEC shifted its mix of investigations significantly toward backdating investigations and away from investigations involving other accounting issues. We test the hypothesis that SEC pursued more marginal investigations into backdating as the media frenzy surrounding the practice persisted at the expense of pursuing more egregious accounting issues that did not involve backdating. Our event study of stock market reactions to the initial disclosure of backdating investigations shows that those reactions declined over our sample period. We also find that later backdating investigations are less likely to target individuals and less likely to accompanied by a parallel criminal investigation. Looking at the consequences of the SEC’s backdating investigations, later investigations were more likely to be terminated or produce no monetary penalties. We find that the magnitude of the option backdating accounting errors diminished over time relative to other accounting errors that attracted SEC investigations."
Posted by: Matt | Jul 27, 2011 5:46:36 PM
You're exactly right, Matt. I think this quote from Lynn Turner says it all:
"Lynn Turner, a former chief accountant for the SEC, laughs darkly at the idea that the criminal justice system is broken when it comes to Wall Street. "I think you've got a wrong assumption — that we even have a law-enforcement agency when it comes to Wall Street[.]""
Posted by: Frank | Jul 27, 2011 6:12:08 PM
Matt, I think you are being somewhat generous in reading between the lines in Ribstein's post. I'll confess I'm responding more to Larry's tone and his past posts, in part, that this brief highlight of the Choi et al. article. But I don't think he's ever copped to it being illegal. And even the Choi et al. paper subtly undermines the illegality of backdating. Here's the description of backdating from p. 2:
"Option backdating is the practice of retroactively assigning award dates for stock options granted to employees to put the options 'in the money' at the actual time of the award. The practice of backdating reflects a number of features that would seem likely to attract SEC scrutiny. On its face, backdating seems to undermine the incentive rationale for awarding stock options, giving employees a built‐in profit from their option awards without any relationship to performance. Moreover, assigning award dates with the benefit of hindsight suggests that management may have been less than candid with directors. These issues raise concerns about corporate governance, a traditional bête noire of the SEC. More subtly,
backdating raises tax and accounting problems for the issuing company; the former is the concern of the IRS, but the latter falls squarely within the bailiwick of the SEC."
Do you see any mention of illegality? I see "seems to undermine the incentive rationale," "suggests that management may have been less than candid," and "[m]ore subtly . . . raises tax and accounting problems." Saying the practice raises "subtle . . . problems" is not saying its illegal. It's that kind of downplaying, rationalizing, and minimizing from the backdating apologists that drives me crazy.
Posted by: Matt Bodie | Jul 28, 2011 10:32:54 AM
But, Matt, it's not cold-cocked that the backdating is illegal. I've taken the position it was WRONG (that is, I disagree with Larry), but even a misrepresentation made with scienter (intention) under securities law has to be material to be illegal in connection with the purchase or sale of a security. There are a lot of misrepresentations that go on in the world that aren't only not illegal, they're not even wrong. I can backdate a check if nobody's hurt by it (but it is a "misrepresentation"), I can backdate an agreement, I can ask for an order to be effective nunc pro tunc (now for then), but it's not "by definition" illegal.
Just to supply some information around this. The reason for backdating (and the reason it's wrong, whether or not it's illegal) is that the grant of an option at less than the current market price caused the option, under GAAP, to be expensed, and therefore it became a charge to earnings. That was one of the big pre-financial crisis, pre-Madoff bete noires of some governance critics - that options to executives came at a cost to shareholders, and GAAP treatment without expensing failed to show that. So the end run around the GAAP treatment of a below market option was to backdate the option to one at which the price was lower. Personally, I would have come down like a ton of bricks on executives in my company who wanted to play that game, and I wouldn't have needed to get to illegality to do it. I would have applied the "New York Times" test. The GAAP rule may be stupid, but you can't make up a false document to get around it.
Three other points. First, I don't have data at hand on this, but I understood, by and large, senior management was not granting itself backdated options. It was using backdated options to recruit lower level people. Again, that doesn't make it right, but there's at least a rationale that is less agency cost and company or shareholder oriented. Second, it wasn't, pace Frank, a "Wall Street" phenomenon as much as a Silicon Valley phenomenon. Third, I'm still not sure it's not primarily a manifestation of availability heuristic. Even if there was backdating at a couple hundred tech firms in Silicon Valley, it's still a minute percentage of what I believe are in excess of 9,000 publicly traded companies in the U.S.
Calling backdating evidence of a culture of endemic corruption is like judging unions by Jimmy Hoffa or the Lee J. Cobb character in "On the Waterfront." I wouldn't call Gerald McEntee (AFSCME) corrupt even though I fundamentally disagree with him about corporate governance.
Posted by: Jeff Lipshaw | Jul 28, 2011 7:37:04 PM
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