Jenkins channels Manne

Geoffrey Manne —  12 July 2006

Today’s WSJ has a great article by Holman Jenkins on reporting on the backdating “scandal.”  Larry is, of course, on the case.  I would also — modestly — point out that much of what Jenkins says in his article today, I said in this space about four months ago, when the news was first breaking.  The key elements:

  1. The notion that backdating gives executives an incentive-defeating “paper profit right from the start” is asinine.
  2. “Backdating” may make perfect sense as a means of compensation, especially given certain regulatory quirks.
  3. If the practice amounts to corporate shenanigans, they sure didn’t bother to hide it very well.
  4. Non disclosure of the practice, if disclosure was required, may, of course, be illegal.
  5. To quote Larry, “second-guessing executive compensation is a tricky business, even when the problems seem clear.”

On the somewhat-related matter of spring-loaded options (the raising of which was not at all inappropriate, Elizabeth), I find myself in complete agreement with Larry.  Strange, I know.  But it ain’t misappropriation if the board knows what’s going on.  Once again, perhaps some disclosure is required, but it’s hard to see how non-disclosure of the compensation scheme could transform informed executive compensation into a section 10(b) violation.

In both cases, I’m pretty sure there’s no “there” there, but I’m equally sure we’ll be reading (and litigating) about them for quite some time to come.

Geoffrey Manne


President & Founder, International Center for Law & Economics

5 responses to Jenkins channels Manne


    Geoff, I think your point is the an important one and has unfortunately been overlooked in most discussions of backdating that I have seen. Backdated options are an element of a compensation package. The important economic question is when would backdated options be an efficient element of a compensation package? But there has not been a great deal of attention paid to this question. To give an antitrust analogy, it is generally a well understood proposition that one should understand a business practice or role of a particular contract term (say, an exclusive dealing term) in in the competitive process as a whole before condemning it.

    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.


    The answer to your questions, Elizabeth, turns on the recognition that stock option grants are but one part of a negotiated and — let’s just assume for now without going into the whole managerial power thing — efficient compensation package. The claim, for example, that “the CEO really does not have much motivation to set the world on fire between now and . . . when his options vest” is true only if approximately $18 worth of options plus whatever else he’s getting totals full, competitive compensation. But it’s just as likely (more likely, in fact) that the first $18 is just an accounting-preferred means of giving the executive a chunk of salary ($18 times the number of shares, discounted to present value and accounting for risk). He could rest on those laruels and not try to increase the shares’ value. And he could also accept a $100,000 salary for a $1 million job. But both are unlikely.

    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.

    Elizabeth Nowicki 12 July 2006 at 1:39 pm

    Iwillnotspendhoursblogging; Iwillnotspendhoursblogging; Iwillkeepwritingmyarticles;

    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?

Trackbacks and Pingbacks:

  1. TRUTH ON THE MARKET » Explaining Backdating (and Jenkins Channels Manne Again) - August 30, 2006

    […] 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. […]

  2. Ideoblog - July 13, 2006

    Optics liability?…

    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…