I had lunch with a new colleague today, and we discussed both stock options and the SEC’s new Exec. Comp. rule.Â My colleague asked many good questions, not the least of which dealt with securities fraud.Â Given that I live alone, my conversation with my colleague was the first time I had tested out my “backdating is securities fraud” theory.Â My sense is that my stock optionÂ backdating qua securities fraud might not sit well with some of you, so I thought I would put it out there:
My view is that backdating optionsÂ is clearly fraudulent b/c “[f]raud is . . . lying to someone to get them to give you their stuff.” Susan Koniak, Corporate Fraud: See Lawyers, 26 Harv. J.L. & Pub. Pol’y 195, 197 (2003).Â More specifically, why do companies backdate?Â To avoid the expensing, right?Â Well, why?Â Because it would convey a weaker picture to the market than the company would like to convey.Â Why is the company opposed to that?. . . .Â Hmmmm. . . . .Â The answer is “because it would turn some investors off and they would sell and/or not buy your stock or support your company.”
So what is a company doing when they are backdating options?Â They are (all together now) “lying to someone to get them to holdÂ the company’sÂ stock or buy more.”
Onto the SEC’s Exec. Comp. rule:Â I have vague recollections of Gordon Smith and. . . maybe Larry Ribstein (?) not being huge fans of the rule when it was proposed.Â My lunch companion brought up a point that I think either Gordon or Larry earlier raised:Â Doesn’t additional disclosure increase the risk that the investor will either not read the massive disclosure at all or will inappropriately weight some of the minutia of the disclosure?Â My response was two-fold:Â (1) At least if the Exec. Comp. disclosure is made, the investor has a fighting chance at receiving and processing the information (whereas, if the disclosure were never made, the investor would be doomed to beÂ short on information)Â and (2) large institutional shareholders have increased in number and size over the past two decades, and these folks read the disclosure.
I should have added that a history of granting in-the-money options could affect a company’s ability to obtain shareholder approval for equity compensation plans in the future. Generally, institutions and advisory services look at whether companies have engaged in shareholder-friendly practices–such as refraining from repricing (before rule changes made that much more costly), using performance-based designs such as premium-priced and contingent-vesting options, and the like–when deciding whether to make additional shares available.
Some investors believe that granting in-the-money options sends a signal that management expects the stock price to be stagnant over the next few years. So putting aside the question of whether the income statement is distorted by backdating, telling investors that all options are at-the-money when they’re actually in-the-money is misleading, though the materiality of the misstatement is another question.
I’m just referring to diluted earnings per share. Options represent a (discounted) obligation on the part of the company to issue shares in the future. When the options are in the money the discount is minimal (but not, I assume, exactly zero, because there is always some chance that today’s in the money options won’t be in the money tomorrow). Earnings stay the same, more shares are issued (or expected to be issued) — voila: lower earnings per share. And outstanding stock with lower earnings per share is likely to trade at a lower price. One effect of backdating, then, because the options are in the money upon issuance (although they need not be — I bet some backdating just makes the strike price closer, but not-yet-arrived) is to make the stock price immediately decrease. It’s thus not costless to firms, nor is it hidden — if anything, it’s even more tangible than issuing out-of-the-money options for which the discount has to be estimated by the market.
Gentlemen, thanks for the comments. Geoffrey, could you please unpack this:
“More importantly, I donâ€™t think itâ€™s right that issuing backdated options avoids an effect on stock price â€” the options are, by definition, in the money when they are issued and that should have clear consequences to the firmâ€™s earnings per share. Expensed or not, the effect is not hidden; thereâ€™s no lying here.”
Just to riff on Geoff’s theme a little bit, it seems that the “backdating as fraud” story misses something. The policy discussion surrounding back-dating, I think, if we separate out backdating per se from a failure to properly disclose. With respect to the former, I agree with Geoff that there are a lot of reasons that an efficient executive compensation contract might take the form of backdated options (and we really are just talking about the form of compensation, aren’t we? There seems to be no dispute that each of the firms backdating could have offered the same value with different form without a problem).
With respect to the disclosure issue, obviously, it is a problem if backdated options are not properly disclosed. A separate issue with respect to disclosure is selecting the optimal level — which of course, mandates some discussion of the costs and benefits involved. As Geoff’s paper (which is well worth the read, by the way) points out, the discussion has been lacking on the cost side of the equation.
On backdating: I’m not sure that your logic holds. First of all, I can think of some reasons other than avoiding expensing that firms might backdate — I’ve suggested some here and elsewhere. More importantly, I don’t think it’s right that issuing backdated options avoids an effect on stock price — the options are, by definition, in the money when they are issued and that should have clear consequences to the firm’s earnings per share. Expensed or not, the effect is not hidden; there’s no lying here.
On executive comp disclosure: I will gladly add my name to the apparently-short list of those not thrilled with the SEC’s rule. Obviously(!), the first thing to check out is my draft article on the topic. In response to your response to your colleague, I would say that it’s not at all clear that “the investor” is well-served by “receiving and processing the information.” Fundamental research is time-consuming and, for almost everyone, a huge waste. Cheaper access to information makes it more likely that investors will waste time processing that information. There are other costs, as well (see the article). And, importantly, they probably get the benefit anyway — it is not the case that, absent direct disclosure to investor A, investor A is “doomed to be short on information.” Investor A gets access to a world of information not by reading disclosures but through the stock price. Now, it could be the case that executive compensation information will be more efficiently incorporated into stock price when disclosed under the new SEC rule than it would have been otherwise. Unfortunately, no one — least of all the SEC — has bothered to determine whether this is likely to be the case. There are, as I have stressed, both costs and benefits to disclosure. It is improper simply to assume that the benefits will outweigh the costs.