I look pretty young but I'm just backdated, yeah

Geoffrey Manne —  19 March 2006

P1-AE351_BACKDA_20060317175555.jpgThe WSJ this weekend has a long piece on the issue of stock option backdating, “The Perfect Payday.” Here’s the tagline:

Some CEOs reap millions by landing stock options when they are most valuable. Luck–or something else?

It’s an interesting article, much of which is devoted to debunking the assertion that backdating of options grants doesn’t happen.

On a summer day in 2002, shares of Affiliated Computer Services Inc. sank to their lowest level in a year. Oddly, that was good news for Chief Executive Jeffrey Rich.

His annual grant of stock options was dated that day, entitling him to buy stock at that price for years. Had they been dated a week later, when the stock was 27% higher, they’d have been far less rewarding. It was the same through much of Mr. Rich’s tenure: In a striking pattern, all six of his stock-option grants from 1995 to 2002 were dated just before a rise in the stock price, often at the bottom of a steep drop.

Just lucky? A Wall Street Journal analysis suggests the odds of this happening by chance are extraordinarily remote — around one in 300 billion. The odds of winning the multistate Powerball lottery with a $1 ticket are one in 146 million.

* * *

Mr. Rich called his repeated favorable option-grant dates at ACS “blind luck.” He said there was no backdating, a practice he termed “absolutely wrong.” A spokeswoman for ACS, Lesley Pool, disputed the Journal’s analysis of the likelihood of Mr. Rich’s grants all falling on such favorable dates. But Ms. Pool added that the timing wasn’t purely happenstance: “We did grant options when there was a natural dip in the stock price,” she said.

Backdating could be a real problem for some firms because, as the article explains,

Granting an option at a price below the current market value, while not illegal in itself, could result in false disclosure. That’s because companies grant their options under a shareholder-approved “option plan” on file with the SEC. The plans typically say options will carry the stock price of the day the company awards them or the day before. If it turns out they carry some other price, the company could be in violation of its options plan, and potentially vulnerable to an allegation of securities fraud.

According to the article, the “SEC is understood to be looking at about a dozen companies’ option grants with this in mind.”

There are really two questions somewhat conflated in the article: Does the statistical evidence demonstrate that the practice is actually occurring; and, if so, is it a problem worth correcting?

On the first question, I admit that the evidence looks strong. But I would also point out a few things the article neglects — reasons why correlation might not be so surprising:

  1. Options grant timing may not be exogenous to stock price changes. The announcement may suggest insider confidence to the markets, and perhaps options grants generally are correlated with upticks.
  2. Obviously, a trough is 2-sided. Whatever uncertainty there may be about post-grant price movement, there is certainly perfect knowledge about the pre-grant trend. It wouldn’t be at all surprising to find options grants coming after a price slide. And sometimes the slide must be followed by an uptick.
  3. And even often a slide followed by a large option grant must be followed by an uptick: To the extent that the CEO can affect share price, the grant of a large number of options coming on the heels of a big price dip would seem to provide substantial motivation.

In other words, even without backdating, a lot of the same effect might be observed.

But I think the second question is the more important one: Even if this is going on, why do we care? The article suggests that backdating is tantamount to executives stealing from shareholders, and that, because it gives recipients “a paper gain right from the start” it has no useful incentive effect. Both of these are inaccurate, I believe.

  1. First, as I noted, and as Prof. B. remarks, the practice may amount to securities fraud. Obviously that’s a problem. But it only begs the question.
  2. 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?
  3. Moreover, these aren’t one-offs. Directors and, implicitly, shareholders are continually signing off on this behavior. Most of the companies discussed in the article engaged in the practice repeatedly. It could be that managers are just running roughshod over boards and their compensation committees, but it also could be that the practice is an efficient component of compensation. The only evidence of the former in the article is a baseless assertion that “in some instances, backdating wouldn’t be possible without inattentive directors.”
  4. And I do think backdated options can provide real incentive. The idea that a “paper gain right from the start” makes any difference is ludicrous. First of all, these things aren’t (as far as I can tell) backdated from the exercise date; they’re backdated by a matter of days. It still matters a lot to the recipients that the stock increase in value. Presumably even backdated options provide real incentive.
  5. And it is important to note that there is no science here. “Incentive” is nice, but no one knows ex ante how much incentive is optimal, in part because the extent of an executive’s contribution to firm success is ambiguous. There is nothing magical about a non-backdated options grant. Backdating at least permits a little fine-tuning around the edges (or, more accurately, slightly less-gross incentivizing).
  6. Finally, just because options can be used as incentive pay, doesn’t mean they need to be. Perhaps their favorable accounting treatment makes them attractive substitutes for some fixed pay. While this might undercut some of the very strong arguments against required options expensing (on which see Rich Booth’s excellent post), it also could help to explain their use.

And in the end, the real question is: Just because there may be a problem, should we really try to fix it? As Larry reports from the Berkeley SOX conference:

I found this discussion interesting, because it showed how, invasive as reform proposals might seem to skeptics, the reformers are telling us you ain’t seen nothing yet: federal rules prescribing the independence of the whole board; prohibitions on board compensation; more shareholder democracy. All prescribed at the federal level because the states can’t be trusted.

There are still a lot of folks out there who want to throw federal regulatory (and criminal) solutions at every perceived governance problem. As Larry notes elsewhere in that same post, backdating isn’t “per se wrong — it depends on what’s disclosed.” But when the SEC is done “correcting” the problem, it may well be outlawed. Why does anyone believe that state of affairs will necessarily be an improvement over the status quo?

UPDATE: Paul Caron has a nice summary of the article and the research underlying it here.

Geoffrey Manne

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http://laweconcenter.org/

8 responses to I look pretty young but I'm just backdated, yeah

  1. 

    If companies are failing to comply with disclosure obligations, the SEC should clearly do something about it. The real question is whether backdating of options should be a disclosure obligation. Regardless, the fact that companies apparently are not properly disclosing the practice raises the specter of impropriety. Note that backdating could be used to manipulate fully diluted earnings per share, i.e., a company could essentially lower option exercise prices through backdating and thereby reduce the number of options it has to grant to confer a particular dollar amount of value.

    On another note, here’s a link to what I assume is at least a piece of the “academic research� referenced in the article.

Trackbacks and Pingbacks:

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  6. TRUTH ON THE MARKET » Option Backdating: The Next Big Corporate Scandal? - April 20, 2006

    […] Option backdating was on page one of the W$J again yesterday (here). The story was spurred by comments made by UnitedHealth’s CEO, William W. McGuire, during UnitedHealth’s First Quarter 2006 Results Teleconference on Tuesday. UnitedHealth’s option grants to Dr. McGuire were among those cited as suspicious by a March 18 page one W$J (article here; earlier blog post here). The Journal’s analysis raises questions about one of the most lucrative stock-option grants ever. On Oct. 13, 1999, William W. McGuire, CEO of giant insurer UnitedHealth Group Inc., got an enormous grant in three parts that — after adjustment for later stock splits — came to 14.6 million options. So far, he has exercised about 5% of them, for a profit of about $39 million. As of late February he had 13.87 million unexercised options left from the October 1999 tranche. His profit on those, if he exercised them today, would be about $717 million more. The 1999 grant was dated the very day UnitedHealth stock hit its low for the year. Grants to Dr. McGuire in 1997 and 2000 were also dated on the day with those years’ single lowest closing price. A grant in 2001 came near the bottom of a sharp stock dip. In all, the odds of such a favorable pattern occurring by chance would be one in 200 million or greater. Odds such as those are “astronomical,” said David Yermack, an associate professor of finance at New York University, who reviewed the Journal’s methodology and has studied options-timing issues. […]

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