Holman Jenkins reports that a group of economists led by Milton Friedman and Harry Markowitz are getting behind the idea of putting an end to the expensing of options. It is a great column. Jenkins goes on to discuss options backdating and makes the following points, which will sound unfamiliar to TOTM readers:
- “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:
- Backdated options have incentive effects too.
- Regulatory quirks involving accounting rules may have provided firms the incentive to backdate.
- If we are to believe that some 2,000 companies engaged in some form of backdating, many did not appear to be hiding it.
- 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.”
- 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?