it’s . . . hard not to see the self-interested ethics of the plaintiff’s bar spilling across the entire legal profession. In their official roles, prosecutors invent Kafkaesque new ways to ensnare the unpopular wealthy in legal trouble, then jump to private law firms and make seven-figure livings protecting the wealthy from the monster they themselves unleashed. Shakespeare had a solution, but, alas, this would also be illegal. Thus it must fall to bloggers, the media and judges like Judge Wright to protect Americans from overzealous prosecutors.

Amen.  In our condemnation let us not forget about those plaintiffs’ lawyers.  They’ve been responsible for less human suffering here, and some general arguments can be made for the disciplinary effect of civil litigation.  But no assessment of civil litigation’s role is complete without considering the agency costs of plaintiffs’ lawyers. 

Consider the recent endgame in the Apple backdating litigation. The lawyers did come up with $16.5 million settlement.  But, as if to demonstrate that fiduciary problems are everywhere, the settlement diverted $2.5 million to “corporate governance” programs of three law schools. Two of the schools were affiliated with lead plaintiffs’ lawyers.  Beyond that, one wonders what effect the money would have on the schools’ teaching and research about litigation’s role in corporate governance.

Ted Frank’s Center for Class Action Fairness has embarrassed the parties into at least giving Apple shareholders an opportunity to get that money, and is now asking for a guarantee that the shareholders will get the entire settlement. Here’s the story.

I look pretty young but I’m just backdated, yeah (Geoff Manne)

Option Backdating: The Next Big Corporate Scandal? (Bill Sjostrom)

Backdated options and incentives (Bill Sjostrom)

Jenkins channels Manne (Geoff Manne)

Explaining Backdating (and Jenkins Channels Manne Again) (Josh Wright)

No, Matt, executive compensation is not all about norms (Geoff Manne & Josh Wright)

Thoughts on Walker on Backdating (Josh Wright)

Along with Larry Ribstein (of course) we were early critics of the law, economics and reporting of the backdating “scandal.”  One of our posts, “No, Matt, executive compensation is not all about norms,” was made into a short law review essay.  Geoff’s “I look pretty young but I’m just backdated, yeah” post was one of the first substantial criticisms of the claims in the Wall Street Journal article that broke the story.

Although we basically gave up the backdating reporting as the story dragged on, we have been interested to watch the spectacle unfold.  And it has been quite a spectacle.

With the latest”mockery of justice” in the prosecution of these cases upon us, we thought it might be a good time to revive some of our old posts for readers who might have forgotten that there was once a substantive debate over the topic, rather than a series of prosecutorial embarrassments.

Frankly, as Larry notes, the embarrassments stem in part from the fact–as we have discussed in the posts linked above–that these cases never should have been brought in the first place.  Maybe a reminder is in order.

This is a useful paper as far as it goes. The problem is that it has missed a significant chunk of the “literature” on this rapidly developing topic that has developed in our rapidly developing medium — i.e., the blogs. For example, consider my posts here and here and throughout my executive compensation archive, Josh Wright and Geoff Manne’s comprehensive post, and many many others by Bainbridge, Bodie, Fleischer, etc. This is not merely some kind of procedural problem. By missing this commentary, the article fails to pay any attention to some very important issues, particularly including whether the market looked through any accounting shenanigans. The latter issue alone would seem to be rather critical if you’re trying to explain backdating and its consequences, as Walker is.

Larry’s reaction to the paper has evoked reactions from Vic and Walker in the comments section. Holding aside the issue of whether Manne & Wright should be cited (as readers of this blog know, Geoff and I have elsewhere set forth our own thoughts on backdating, individually and cooperatively), I took Larry’s central criticism to be that the argument raised by some of these bloggers that “stealth compensation” is simply not a good description of backdating if it did not fool the market should be addressed in a paper purporting to explain backdating. It is a fair point and I tend to agree. To be sure, it is an excellent marketing strategy to describe the options this way. Indeed, I could describe backdated options as “alternative in-the-money compensation.” But I digress. Further, Larry offers a second post responding to Walker’s comment, and argues that any substantive explanation of backdating must address whether the market was fooled:

I continue to be puzzled how one can argue that options were “stealth compensation” without discussing whether enough information was available that the compensation was reflected in stock price. If the market knows what the executive is being paid, then I’m not sure how one can argue that it could not make the judgments that Walker is concerned about.

I agree with both Ribstein and Walker that this sort of exchange is precisely what the blogosphere needs more of. In that spirit, let me chime in with a few of my own thoughts here in response to Walker’s article.

First, the empirical contribution of this article should celebrated. In particular, in addition to documenting the fact that a good deal of backdating occurs with rank-and-file employees rather than executives, Walker conducts a descriptive analysis of backdating within the semiconductor industry and highlights differences in executive compensation for firms involved in the backdating scandal (p. 34-35). I think this sort of descriptive analysis is definitely value added and tells us more about the phenomenon which we are attempting to ultimately explain.

Second, I am left somewhat unsatisfied with Part III of the paper (which starts at p.21), which is titled “Explaining Backdating.” To be sure, Walker notes that “the aim of this part is to lay out a range of possible rationales,” and test them against the early empirical evidence. For my tastes, this paper does too much of the former and too little of the latter. Walker discusses a range of rationales including compensation concealment, share dilution limitations, cognitive biases, boosting ISO grants, and the influence of common advisors (which Walker lumps together, somewhat inexplicably, with “herd mentality”). With respect to herd mentality, the “evidence” is that a number of firms adopted the same practice in the Silicon Valley and Larry Sonsini was linked to many firms. I’m not sure what this has to do with “herd mentality,” but I can think of a number of reasons why many firms adopt the same practice which have nothing to do with psychology.

As for the other explanations, again, I find the paper a bit light on the discussion of evidence, which is odd, because I do believe that the central (and most important) contribution of Walker’s paper is his empirical work. Walker seems to be impressed with the naivete / cognitive bias explanation throughout this section, but as I have noted elsewhere, I do not find this explanation persuasive in light of the time series evidence (have compensation committee’s become more naive? Or for that matter, employees or executives?). In any event, to the extent that many of these explanations touch upon the economic explanation for the increase in executive compensation more generally, simple explanations like this one (that apparently explain much of the data) should be addressed, as should evidence of the stock price effects.

The strength of this paper, by my lights, is Walker’s empirical analysis. His contribution to our understanding of what is going on within a particular industry with a lot of backdating is an important one. In fact, I would be inclined to organize the entire paper around this analysis — which is really his unique contribution. I know, nobody asked me. Just a thought.

H. Timing of Option Grants

Some companies appear to have engaged in techniques to select their award dates in coordination with the disclosure of information to the public. For example, a company may have granted stock options while it knew of material non-public information that was likely to result in an increase to the stock price [i.e., spring-loading]. Alternatively, a company may have delayed the grant of options until after material information that was expected to result in a decrease to the stock price was issued [i.e., bullet-dodging]. To the extent such practices were used, questions have been raised as to whether an adjustment would be necessary to the market price of the stock at the measurement date for the purpose of measuring compensation cost. Pursuant to paragraph 10(a) of Opinion 25, the staff believes that compensation cost must be computed on the measurement date by reference to the unadjusted market price of a share of stock of the same class that trades freely in an established market.

In other words, neither spring-loading nor bullet-dodging creates an accounting issue. Of course, the question of whether these practices constitute insider trading (my view is that they do not) or give rise to tax issues remains open.

The corporate stock option backdating scandal has dominated business page headlines during the summer of 2006. The SEC is currently investigating more than seventy-five companies with respect to the timing and pricing of stock options granted during the boom years of the late 1990s and early 2000s, and the number of firms caught up in the scandal seems to increase every day. This essay contributes to our understanding of the backdating phenomenon by analyzing the economics of backdating and the characteristics of the firms under investigation. Its main points are the following: First, given the high volatilities of the stocks of the technology companies that dominate the list of firms under investigation and the fact that options granted to executives and employees typically may not be exercised for several years, press reports that focus on the size of the strike price “discounts� achieved by backdating significantly overstate the value of backdating. In some cases, reducing the strike price by a dollar per share by backdating increased the Black-Scholes value of the option by less than twenty cents per share. Second, completely unnoticed in the discussion so far is the fact that in many cases backdating dramatically reduced the apparent value of options. Because the size of executive stock option grants often is determined first by establishing the value to be delivered and then by calculating the number of shares to be covered by the option, reducing the apparent value of option shares may have substantially increased the size and true economic value of backdated executive option grants. Third, comparison of semiconductor firms under investigation for backdating with peer companies that are not suggests an association between backdating and the use of options in compensating non-executive employees. This essay considers several explanations for backdating non-executive options, including share limitations, minimizing apparent rank and file compensation, and cognitive biases. Finally, this essay argues that the backdating phenomenon is really not an accounting scandal. Backdating has accounting consequences, but it is unlikely to have been accounting driven.

In a post titled, “Backdating: Yes, Virginia, Execs Do Want Inflated Pay,� over at PrawfsBlawg, Matt Bodie weighs in on the backdating “scandal.� As many of you know, the topic has been much-discussed of late here at TOTM and over at Larry Ribstein’s Ideoblog (who, it turns out, beat us to this punch), and you’re probably wondering when we’re ever going to stop. Well, we (Geoff and Josh) think Matt’s post is so misguided that it merits its own paragraph-by-paragraph rebuttal in this, TOTM’s first-ever co-authored blog post!

Matt begins by quoting both me and Josh (you mean, me and Geoff) on why backdating isn’t the worrisome bother the Wall Street Journal, Gretchen Morgenstern, and Matt Bodie make it out to be. Then he takes us to task:

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.

First, it is not our claim that “the value of the grants is published at some point down the road.� Our claim is that the value of the grants is known – as well as (or even better than) it can be for any options – the moment the grants are made (or, assuming minimal insider trading, the moment the grants are disclosed), just as it would be for non-backdated options. Not only is the value known, but it is incorporated into share price (the effects of expected dilution when the options are exercised).

This is key. Most critics of backdating seem to act as if the options were in fact granted on the backdated date and not disclosed until later. In reality, disclosure is made in due course; only the strike price is set with reference to an earlier day’s stock price. There is not, in fact, delayed disclosure.

Matt goes on:

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.

As Lipshaw notes in that very post, the economic effect of options is independent of their accounting treatment. The fetishization of accounting is something Geoff has taken on elsewhere. But it bears repeating: Accounting is a convenient and imperfect means of quantifying behavior. It does not purport to — nor does it — represent true economic values. It’s a short cut; it’s a little like looking for your keys under the street light even though you lost them elsewhere. It certainly makes some calculations and some inter-firm comparisons easier. But accounting cannot do the impossible. There remain countless ways that, even under the same standards (hell, even under the same rules), accounting measures vary from firm to firm. If one firm expenses backdated options and another doesn’t, aside from the possible technical rule violation, the effect on inter-firm comparison, share price, market valuation, etc. is unlikely to be significantly impaired.

The point is that, even if the accounting treatment of backdated options is different than the treatment of options that are not backdated but nevertheless are granted “in the money” on the date of grant (the issue addressed in the Lipshaw post), you’d have to believe in a woefully imperfect an inefficient market to believe that the actual economic effect would pass unnoticed.  And, as Larry points out, even if it did, it takes a heroic and wholly-unsupported assumption to assert that the consequence of the oversight would be to line executives’ pockets.

As we have said here and elsewhere: THERE IS NO LIE. Here, in fact, is Geoff’s comment to the Lipshaw post referenced by Matt:

I’m not sure why anyone thinks options backdating is a lie (technical violation of a rule, maybe, but lie, no). There’s just no harm in the practice. It’s not like the options cruise along for a period of time out of the money (and priced by the market accordingly) and then are miraculously turned into at the money or in the money options the moment they are exercised. Rather, the day the options are issued, they are issued with a strike price AS IF they had been issued on an earlier date when the market price was lower. But there’s no lie here – it’s just a convenient way of providing more compensation (which I think is part of Jenkins’ point. Once again, he seems to be reading Truth on the Market (see my comments to this post). The same could be done, I assume, by arbitrarily picking a strike price lower than the market price on the day of issuance. Either way, as I note in the comment liked above, the moment the at the money options are issued they pull down share price. They are not free, nor is their effect somehow hidden from investors. So why should there be any moral outrage or any serious consequences here at all?

There is more (much more) below the fold.  Matt continues (this is one of our favorite bits):

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.

No limits??? NO LIMITS?!?!?!?! What do you think the market is, chopped liver? We do hold that there are no moral limits, no legal limits, no regulatory limits, no cosmological and no innate limits. But it is a gross mischaracterization of our position (and, we might add, a gross misdescription of the nature of markets in general) to say that we believe there are no limits on executive compensation. To take an obvious example, let’s consider the competition to hire an executive. There is vigorous competition between firms at the time of contracting to hire executives, and this competition results in various contract terms and compensation packages (including options grants). Whether Matt believes so or not, firms this competitive dynamic between firms generates limits on compensation packages.  This also bears repeating: Limits need not take the form of governmental fiat to be limiting!

He goes on:

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.

See above. Accounting rules don’t “punishâ€? lower prices. That’s ridiculous. If they did, we’d sure like to know about it. Because there would be lots of money to be made arbitraging this supposed “accounting effect.”

Matt continues:

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.

OK. Try this thought experiment. Let’s say you are a large shareholder in the Options-R-Us Corporation with a lot of extra time on your hands. You follow closely the Corporation’s disclosures. Hell, you even read the proxy materials. Yesterday you noticed that the Corporation granted its CEO 1000 shares of stock with a strike price equal to the market price of the stock on December 1, 2005. “That’s odd,� you think to yourself. “I can’t imagine how I missed this grant in prior quarterly statements, since I read them all religiously. Let’s see what the options are worth.� So you log on to Google Finance MSN Money and find out what the strike price is (if it isn’t listed explicitly in the statement). You quickly calculate the value today. Voila. You even compare this value to grants received by other executives on other dates – whether backdated or not. Where is the complication? Where is the hidden information? Where is the problem (other than in valuing those pesky, non-backdated, out-of-the-money options)?

But this is really our favorite part (and apparently it was Larry’s too):

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.

“Executive compensation is all about norms.� How can this possibly be true? It flies in the face of all common sense and basic economics since, say, 1776. Again, this view simply ignores the role of competition in determining executive pay packages and ignores the possibility that the prevalence of option backdating in compensation packages might well be evidence that these terms are an efficient component of executive compensation.

Further, we just don’t see how invoking “normsâ€? here helps to explain anything. Really this is just odd — the idea that prices are set by norms (although not at all unprecedented for Matt).  The market price for widgets is determined by economic forces (i.e. supply and demand).   The generation of the market price is not “all about norms.â€?  Nor would “normsâ€? analysis illuminate anything about what is really going on. The market price is the market price not because “normsâ€? say so. There is a process by which that price is determined. It is better to understand the process than simply label it a “norm,” lest we concede that the term has no serious meaning at all.

We should hope that this point is obvious. Antitrust law, for example, does not prohibit cartels because they violate the norm of charging the market price. Rather, they prohibit cartels because the economic consequences of price-fixing decrease consumer welfare. Executive compensation is also determined by competitive forces. There are real economic questions to be asked here, as Josh pointed out in his recent post, about the economic forces generating the backdating. The assumption that “normsâ€? can and should force firms to keep the number of options constant even when the value of each option increases might get the result that Bodie wants — less executive compensation but-for backdating — but it relies on an fundamentally misguided view of competition and an untenable view of firms.

And it is worth a break from our regularly scheduled tirade to dwell on this “untenable view of firms,” a view that is best evidenced by the opening line of Matt’s post (a point which Kate Litvak makes in the comments to his post): “the stock options backdating scandal continues to unravel, showing yet more examples of corporate greed and misrepresentation.”  Ah, yes, the ever-popular “corporate greed” explanation:  Simultaneously both wholly uninformative and immensely satisfying to the uninformed.  It is also worth pointing out that it is puzzling to try to figure out what Matt believes is causing backdating. On the one hand, he clearly believes it is a function of corporate greed and fraud. On the other hand, he believes that these greedy firms don’t understand the value of options — and by doing so, these greedy profit-maximizing firms leave dollars on the table. Perhaps the explanation of backdating is a combination of corporate greed, misrepresentation, and naivete. But we doubt it.  Nevertheless any day now we fully expect a behavioral economic model of backdating hypothesizing that behavioral biases in the firm prevent them from understanding that options have value!

We have, since the beginning, maintained that the practice of backdating may well have violated accounting and disclosure requirements, at least in a narrow technical sense. The idea that it violates norms—or norms that matter, anyway—is a lot harder to swallow. What, exactly, are these “pay norms?� 

As Josh noted the other day:

The focus on the backdating as fraud theory, in part, appears to be a product of the same sort of preoccupation. Preoccupation with a problem is not always bad. But merely repeating the mantra of fraud is not a substitute for rigorous analysis of backdated options, or the larger question of trends in executive compensation more generally (and especially, across countries). . . . At the end of the day, and sadly, public perception about backdating may be more important than actually understanding the practice.

Matt concludes:

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.

Actually, no it’s not. We can’t imagine what would make Matt (or anybody else) comfortable with the assumption that “pay norms would have kept the option grants roughly in the same quantity.â€? That just doesn’t make any economic sense. It assumes, as we’ve pointed out, that firms do not understand that options have value and that firms do not compete for executive hiring and retention by offering compensation packages of increasing value.  In other words, it assumes that executive compensation is simply a zero-sum game. This follows, of course, from Matt’s belief that markets don’t matter here, that compensation is just a skewed division of the corporate pie by the executives. But that assumption is ridiculous. The idea that “pay would have been lowerâ€? means necessarily that “shareholders would have made more moneyâ€? is precisely the “naivetyâ€? explanation to which Josh referred in his post. As he notes there:

As far as economic explanations go for the trends in executive compensation generally, and the increasing prevalence of backdating specifically, I find naivety from the economic actors concerning option value to be a particular unsatisfying explanation for a trend this robust. Have compensation committees become increasingly naive about option values since the 1990s? It is difficult for me to believe that hundreds of companies do not understand that options are not “free.� I do not find this explanation persuasive.

I suspect that one reason that economists and others are tempted to adopt naivety or fraud-based explanations of particular terms in executive compensation contracts is because we are puzzled by the growth of executive compensation in the US relative to other countries (especially Europe). Without an efficiency explanation for these practices and trends generally, it is tempting to appeal to intuitive notions of “stealing� or assert that compensation committees “just don’t get it.�

“Norms,� “optimism bias,� and the “endowment effect� are in a heated competition to become the new “monopoly explanation,� for otherwise misunderstood business practices. We are not claiming that these concepts are entirely irrelevant in all contexts.  Sometimes, they may be quite illuminating.  But we hope it is not too late in the discussion of backdating to suggest that less mysterious economic forces have long been at work in firm hiring decisions, much like was the case with other one-time “pernicious� business practices that are now thought of as largely innocuous (e.g., resale price maintenance, exclusive dealing, vertical integration, tying contracts, exclusive territories, among many others)  At a minimum, we believe that deeper investigation of the economic forces at work with backdating is a more promising path than that offerred by the alternative, and unsatisfying, theories derived from that strange combination of corporate malfeasance and corporate ignorance.

• “In no generic sense can one say executives “inflated” their pay or “stole” from shareholders. Backdated packages were not more “lucrative” — it’s fallacious to assume that the alternative package consisted of an identical number of options at a less advantageous price.”

• “Backdating did not provide “guaranteed” or “risk free” profits. It did not “undermine the incentive purpose” of options.”

• “It seems likely that companies, after all, did correctly report the number of options and their price to shareholders. Let it be remembered, too, that millions of these options were cancelled or expired unexercised.”

Geoff made exactly these points in this space months ago (and also more recently, here). Personally, I am thrilled to see a column that focuses on the real questions surrounding backdating: (1) Why do firms backdate? (2) What are the consequences of backdating? and (3) What is the theory of harm, if any, upon which we are going to base civil and criminal prosecutions? It is remarkable, but not incredibly surprising, how little attention has been paid to these questions in favor of the Gretchen Morgenstern-style rants that Professor Ribstein enjoys dismantling weekly.

Geoff’s earlier post frames the backdating issue in terms of the important economic (and legal) questions involved. For example, Geoff makes the following basic (and sadly overlooked) points:

1. Backdated options have incentive effects too.
2. Regulatory quirks involving accounting rules may have provided firms the incentive to backdate.
3. If we are to believe that some 2,000 companies engaged in some form of backdating, many did not appear to be hiding it.
4. There may be no harm whatsoever resulting from backdating. To borrow from Geoff: “It’s not like the options cruise along for a period of time out of the money (and priced by the market accordingly) and then are miraculously turned into at the money or in the money options the moment they are exercised. Rather, the day the options are issued, they are issued with a strike price AS IF they had been issued on an earlier date when the market price was lower. But there’s no lie here – it’s just a convenient way of providing more compensation.”
5. And finally, there 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.

Assuming for the moment that backdating is as rampant as the Lie study, media reports, and sudden wellspring of law firm and litigation consultant “backdating” teams suggests, it might be prudent to ask: “why?” and something along the lines of “so what?” The only answers to the “so what” question have been assertions about shareholder exploitation and comparisons to Enron. As to “why backdating,” there seems to be little interest in figuring out what economic and institutional conditions led to the widespread adoption of option backdating and whether the practice is an efficient element of a compensation contract or something more sinister. Rather, we get mostly claims that backdating is a function of widespread fraud or compensation committee naiveity. As I explain below the fold, I don’t think either of these theories get us very far in terms of explaining backdating.
It is difficult to see how far the “fraud” theory of backdating gets you in terms of explanatory power. Does rampant and simultaneous fraud explain the time series data, i.e. is there a reason to believe that backdating became a comparatively attractive form of fraud in the 1990s relative to other methods of accomplishing the same task? I haven’t seen any evidence to support this claim, though it may exist. Now, I don’t mean to suggest that it is not a problem if companies are not complying with SEC disclosure regulations. If so, non-disclosure is clearly a legal problem, holding aside the debate over the costs and benefits of such regulations for a moment. What I am saying is that I’m not convinced that the fraud explanation can explain what we see in the data (which firms involved, the timing, etc.).

Another commonly referenced explanation of backdating is naivety, i.e. compensation committees just don’t “get” that options are valuable and so give them out like candy. As far as economic explanations go for the trends in executive compensation generally, and the increasing prevalence of backdating specifically, I find naivety from the economic actors concerning option value to be a particular unsatisfying explanation for a trend this robust. Have compensation committees become increasingly naive about option values since the 1990s? It is difficult for me to believe that hundreds of companies do not understand that options are not “free.” I do not find this explanation persuasive.

I suspect that one reason that economists and others are tempted to adopt naivety or fraud-based explanations of particular terms in executive compensation contracts is because we are puzzled by the growth of executive compensation in the US relative to other countries (especially Europe). Without an efficiency explanation for these practices and trends generally, it is tempting to appeal to intuitive notions of “stealing” or assert that compensation committees “just don’t get it.” This, in my mind, is a tendency not unlike the one described by Ronald Coase in the antitrust context regarding economists’ preoccupation with the monopoly problem:

“If an economist finds something—a business practice of one sort or other—that he does not understand,he looks for a monopoly explanation. And as in this field we are very ignorant, the number of ununderstandable practices tends to be very large, and the reliance on a monopoly explanation, frequent.”

The focus on the backdating as fraud theory, in part, appears to be a product of the same sort of preoccupation. Preoccupation with a problem is not always bad. But merely repeating the mantra of fraud a substitute for rigorous analysis of backdated options, or the larger question of trends in executive compensation more generally (and especially, across countries). Interestingly, a recent paper by Xavier Gabaix and Augustin Landier paper addresses the question: “Why Has CEO Pay Increased So Much?” Their answer: competition in the market for executives. Tyler Cowen discusses this paper in this NY Times column. Cowen summarizes the state of play on these important economic questions as follows:

In any case, the debate over chief executives’ salaries has moved a step forward. Yes, there are numerous examples of corporate malfeasance. But it is not obvious that the American system of executive pay — taken as a whole — is excessive or broken. The critics contend that chief executives cheat public shareholders. But private equity typically pays its top executives very well, even though public shareholders are not a factor. Furthermore, the rate of productivity growth in the United States has been the envy of the world. Chief executives must be doing something right. The growth in executive compensation reflects how much more is at stake in American companies. Is not the real question which policies and institutions have led to this explosion of value?

At the end of the day, and sadly, public perception about backdating may be more important than actually understanding the practice. But one would think that there would be universal agreement that getting our hands dirty and thinking hard about how backdating imposes costs on shareholders (if it does), what those costs are, the consequences of the expensing rules, and most importantly, why so many firms apparently adopted the practice as an element of their compensation packages, would be a good thing. Perhaps there might even be agreement that we should think do this, and maybe even have tentative answers, before we start imposing criminal liability?