So, why would a package include backdated options that grant such a “paper gain?” I think you raise at least one good answer: we are “fine tuning” the incentives. Remember, as Jenkins points out, these deals generally take place at the time of employment when there is a competitive market to hire these folks. The packages combine risk reduction and incentives. If one is not concerned about giving “current” options and a bag of cash as a compensation package, I’m not sure why the backdating of the option evokes any more concern as an element of the package.

As you pointed out in your prior post, and Larry and Prof B. have discussed, non-disclosure might give raise to other concerns. But these concerns are not about backdating per se, they the same concerns that would apply to non-disclosure of any element of the compensation package.

It is surely the case that the executive who receives options that are already well in the money on the date of grant has somewhat less risk than the regular old shareholder of his investment being worth zero in three years — and this is surely worth something — but Jenkins is right that both the option holder and the stock holder have the same incentive to increase the stock’s value — the shareholder to maximize his stock investment; the executive to get his full compensation.

Plus, if the cost to the executive of working hard enough to increase the value of his compensation via stock value increase is less than the expected increase, he’ll do it anyway — regardless of whether he’s already gotten some cash from the company. Opportunity cost and all that.

Moreover, my claim, at least, is not that options that are in the money on the date of grant aren’t worth something. My claim is that the fact that they are backdated (presumably as a form of compensation akin to salary or lump sum payment) does not remove incentive, nor is it illegitimate “paper profit.” It’s compensation. It’s risk reduction. Whatever. But only if all you look at is the option grant without considering the whole package is this even plausibly a concern.

Suppose a company through an informed and disinterested board has awarded options backdated to a low-price day or springloaded to beat good news about to be released to the market. Further assume that the company adequately disclosed and accounted for…

Just an observation:
Paper profits are viewed as profits because I think most of us bet on stock prices going up, right?

So while a CEO cannot cash in on his “paper profits” right this moment, his gains are no less real than are the gains in our retirement accounts that we cannot touch until we retire, right?

But Jenkins says “[The CEO with the paper profit options] is reduced, perforce, to the status of a long-term stockholder. And any stockholder, regardless of the price at which he acquired his stock, wants a higher price. The incentive purpose remains intact.” Jenkins IGNORES the fact that the long term stockholder might have bought at $50, and the stock is *still* at $50, whereas, from the moment the executive has his backdated options in his sweaty little palms, he is in a good position with NO downside risk because he has not yet exercised the options. Work hard, not work hard for the next several years until the options vest. Whatever.

The stockholder got his stock yesterday, for $50, and the stock is trading at $50. The stockholder needs for the corporation to gain some speed such that he can cash out and fund his retirement in three years. And the stockholder stands to lose his cash if his stock drops below $50 per share (since he *paid* $50 per share for his stock). The CEO got his options yesterday, backdated to January, when the stock was at $32. Given that the stock is trading at $50 today, the CEO really does not have much motivation to set the world on fire between now and three years from now when his options vest and he retires, right? Can you really say, Jenkins, that the CEO is motivated the same way the hapless $50 per share stockholder is? I mean, the CEO will show up and do his job, but all he needs is for things to remain the same for the next three years, and he’ll make $18 per share. Not too shabby for three years worth of holding the line. Whoo-hoo! Way to incentivize the CEO to. . . uhm. . . not worry too much about doing a whole heck of a lot over the next three years, Mr. Jenkins!

And don’t forget that if the CEO doesn’t hold the line, no harm done. If the stock is at $49 in three years when the CEO retires, he just won’t exercise his options. No harm, no foul. How is that the same as the poor slob who is holding $49 per share stock that he bought at $50?