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.