TCS Daily


The Most Efficient Policeman

By Stephen Bainbridge - June 15, 2006 12:00 AM

The Securities and Exchange Commission (SEC) is cracking down on corporate backdating of options. As many as 40 corporations may be under SEC investigation. At least 20 have been sued by shareholders. Fifteen senior executives who received backdated options have resigned or been fired, including four CEOs and three general counsels.

Stock options long have been a component of executive compensation, but they took on special prominence after 1994 federal tax legislation barred corporations from deducting executive compensation in excess of $1 million per year. Because incentive- and performance-based pay, such as options and certain bonuses, were exempted from the $1 million cap, they quickly came to dominate executive pay packets.

Compensatory options are normally issued with a strike price equal to the company's stock market price on the date the options were issued. If the company's stock price subsequently rises, the executive can exercise the options and sell the shares at the higher market price. In theory, the resulting potential for profit aligns shareholder and manager interests and thus reduces agency costs by incenting executives to maximize the company's stock price. Both the executive and the corporation may also realize various tax benefits (go here for details).

Example: On June 1, 2005, Acme Corporation issued me options on 1,000 shares with a strike price equal to the then-prevailing market price of $10 per share. One year later, the stock price has risen to $15 per share. I exercise the option, paying Acme $10,000 (the $10 strike price times the 1000 shares I'm buying). I then sell the shares at the market price of $15 per share, for a total of $15,000, realizing a profit of $5,000.

When a corporation backdates an option, it issues the options with a strike price that prevailed on an earlier date. Because the strike price will always be set as of a date on which the company's stock price was lower than the current market price, the option is in the money immediately upon issuance.

Example: On June 1, 2006, Acme Corporation issued me options on 1,000 shares. The option, however, was dated May 1, 2006, and carried a strike price equal to the May 1 market price of $10 per share. On June 1, the stock price had risen to $15 per share. I exercise the option immediately, paying Acme $10,000 (the $10 strike price times the 1000 shares I'm buying). I then sell the shares at the market price of $15 per share, for a total of $15,000, realizing a profit of $5,000.

(Note that in all these examples I'm ignoring the complications resulting from the vesting period typically required for compensatory stock options.)

The legal consequences for both corporations and executives of backdating options will be severe. Both the company and the executive likely will have to amend their tax returns for relevant years, paying more taxes and penalties. Companies may have to restate earnings for the affected years. Executives will face criminal and civil fraud charges. Shareholders will sue for securities fraud.

Yet, is backdating an option intrinsically wrong? According to the San Francisco Chronicle:

"A key reason companies grant stock options is to motivate executives to help elevate the stock price. When the stock goes up, their options are worth more. Backdating options appears to undermine that incentive.

"'From a shareholder perspective, it's fine to pay people (with stock options), but in an ideal world you're paying them for performance they deliver,' said Kevin Cameron, president of Glass, Lewis & Co., which advises institutional shareholders. 'These seem to be cases where the executives were getting a substantial leg up through the backdating of the options.'"

In fact, however, backdated options could be a very powerful incentive tool. Suppose I know that if I make a lot of money for the company, the board will give me backdated, in the money options, which I'll immediately exercise and pocket the profit. In effect, what the board has done is to give me a bonus. Ex ante, the prospect of receiving such a bonus should incent me to work harder and thus maximize share prices.

It's the lack of disclosure that's the real problem with backdated options. Under tax regulations and stock exchange listing standards, shareholders generally must approve stock option plans. When soliciting shareholder approval of such plans, corporations tell the shareholders that the options issued pursuant to it will be issued with a strike price equal to the market price on the day issued. Backdating options breaks that promise and thus constitutes securities fraud.

In addition, public corporations must disclose the issuance of options as part of their on-going periodic disclosure obligation. By falsely claiming that the option was issued on an earlier date than it actually was, the company again commits securities fraud.

If you want to eliminate backdating of options, disclosure is the solution. Economists Randall Heron and Erik Lie report that the SEC's adoption in 2002 of a rule requiring that options be disclosed within two days of being granted has reduced the frequency of backdating, but not eliminated the practice:

"Extant studies document that stock returns are abnormally negative before executive option grants and abnormally positive afterward. We find that this return pattern is much weaker since August 29, 2002, when the SEC requirement that option grants must be reported within two business days took effect. Furthermore, in those cases in which grants are reported within one day of the grant date, the pattern has completely vanished, but it continues to exist for grants reported with longer lags, and its magnitude tends to increase with the reporting delay. We interpret these findings as evidence that most of the abnormal return pattern around option grants is attributable to backdating of option grant dates."

Their results -- especially the findings with respect to the effect of reporting lags -- suggest that the SEC could solve the backdating problem simply by going back and amending the rules governing disclosure of executive stock transactions on Form 4 to require same day electronic disclosure of option grants.

In addition, investors considering using Rule 14a-8 proposals to address executive compensation might want to consider one adopting a bylaw requiring that the corporation grant all executive options on the same day every year, which would eliminate virtually all gaming of the timing of such grants.

On the other hand, because there's nothing inherently wrong with paying bonuses by even backdating an option contract, so long as proper corporate procedures were followed and the grant does not amount to a waste of corporate assets, we could also solve the problem by changing the relevant tax and securities law rules to allow backdating of options so long as an option plan allowing backdating was fully disclosed to and approved by the shareholders and there is prompt disclosure when backdated options are granted.

Either way, the answer to backdating options is to be found in Louis Brandeis' famous aphorism that "Sunlight is said to be the best of disinfectants; electric light the most efficient policeman."

Steve Bainbridge is a Professor of Law at UCLA. He writes two popular blogs: ProfessorBainbridge.com and ProfessorBainbridgeOnWine.com.

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4 Comments

Deeply flawed logic
An incentive ex ante is no "incentive" at all; at least you recognize that the lack of disclosure here is dishonest, but your argument that backdated options provides an incentive is ridiculous. A true incentive is something you have to WORK for, not something that is granted you after the fact.

These kinds of specious arguments are what provide continuing ammunition to those who would rein in executive compensation, and if this is the best defense one can muster for the excessive compensation of the executive class, they deserve all the vitriol they get.

However...
Had Congress not passed IRC Sec 162(m), this would not occur. I think that this is clearly an attempt to have compensation contain enough elements to meet some narrow definition of incentive comp, while in substance it is nothing more than a judgemental bonus, which is not exempt from 162(m). Congress should close the loop hole or abandon 162(m).

Tax and Security lawyers love rules like 162(m)- since they determine compliance and develop evasion/avoidance strategies-all for a big fat fee. This is exactly how the Bar has attained its hegemonic wealth and stature.

As for the "executive class", save your vitriol-they are scum, but no more and no less than those who have wealth the left likes, aka George Soros, Hollyweirdos and the rest of moveon.org's sugar daddies.

Expensing Options and Disclosure
Now with the new rules of expensing options and SOX disclosure, what was once innocuous becomes criminal.

Intent
The people prosecuted for backdating options were prosecuted for fraud, and what they did was, according to the article, fraud. Case closed.

Congress passed a law saying that compensation beyond $1M is treated differently. One can make a case that giving stock options with strike equal to current spot is different from monetary compensation because the options have no value unless the stock price increases. This argument fails for backdated options, which have a present intrinsic value when issued and therefore are equivalent to a certain amount of cash, i.e. monetary compensation. This clearly is contrary to the intent of the law.

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