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.