Criminalizing backdating: continued

I’ve previously written about the problems with criminalizing the seemingly pervasive backdating practices. A couple of new stories yesterday and today about Comverse and Pixar further highlight these problems.

It seems clear that there have een disclosure violations (which, as I’ve repeatedly said, is the only problem here). The question is where to draw the line between criminal and civil liability for these violations. Are we going to throw a significant fraction of corporate America in jail? As I think the discussion below the fold further indicates, backdating could become the Rubicon of criminalizing agency costs.

In Comverse, an alleged elaborate backdating scheme has led to criminal and civil charges against the founder and two other executives, according to yet another story in the Backdating (aka Wall Street) Journal. The executives allegedly sent forms for approval to the board with selected dates but nowhere for the board to indicate the approval date, so the forms looked like the directors approved the option grants on the grant dates, whereas the approval took place sometime later – in other words, the options were backdated. The company also allegedly maintained a “slush fund” of options approved by the board for phony employees which could then be awarded at will. The former ceo and founder Kobi Alexander got about a quarter of the grants, but many were apparently used to recruit talent.

So, like other backdating and related schemes, the effect of the scheme was apparently to hide the true cost of employee recruitment by reporting in-the-money options as at-the-money through manipulating grant dates – a disclosure violation.

The interesting question in these cases, for me, is not whether any disclosure violation should be subject to civil liability or regulatory action, but whether it should send the executives involved to jail. As I said in my previous post on this issue linked above, it’s not enough to justify criminalization to label the conduct with epithets like “fraud” or “theft.” These epithets simply do not substitute for analysis in solving the line-drawing problems here.

The line-drawing problem becomes particularly clear in light of the news just yesterday that the vaunted Pixar apparently had its own backdating problem, and that one of the grants was to its guiding creative spirit, John Lasseter. So, again, how far are we going to go? Should we say that it’s ok to jail the heretofore little known Kobi Alexander, but draw the line at the famous John Lasseter, or Steve Jobs, Pixar’s co-founder and board chair?

Or is the key that Jobs himself didn’t receive options but Alexander did? But, then, how distinguish Brocade, discussed in my first post on criminalizing backdating, where the indicted ceo apparently also did not gain?

Or is the distinction that the board may have authorized the options in Pixar, but the indicted Comverse agents apparently tricked their board? But the board apparently approved the Brocade options.

Also, the evidence of who did, and knew, what may get a little tricky. A member of the Comverse board’s compensation committee was Alexander’s sister. And note that a lot of this evidence of a coverup is based on affidavits by Comverse board members, who appointed the internal review committee.

More importantly, based on the WSJ story, the whole approval process in Comverse smells a little fishy. How could the board members not have known that the options they approved (at least outside the slush fund) were not backdated, given that the relevant dates on the forms were weeks earlier. The story says that the board members thought these dates were when they were initially contacted to say the paperwork was on the way. When were these calls – weeks before? If so, shouldn't the board have suspected that something was up?

In the Pixar case, the WSJ story implies but doesn’t say that the board was in on the scheme. It notes that one compensation committee member was Jill Barad, former Mattel ceo, who also served on Microsoft’s compensation committee while Microsoft was backdating. Another director was famed lawyer Larry Sonsini, who was also on the Brocade board and had long advised Apple and Jobs. (Sonsini is the subject of all sorts of sly innuendos, falling just short of actual accusations, in this NYT article.)

But what difference should it make whether the insiders fooled the board, and therefore the shareholders, or the board was in on the scheme? Is it, again, just that we don’t want to send the likes of Barad and Sonsini to jail, but it’s ok to catch the small fry?  And can we be sure who was in on what?

Or should the key distinction as to criminalization be whether the insiders lied to the auditors, as may have happened in Comverse? If so, why is it worse to lie to the auditors than to your board?

This whole business of fixing responsibility within large organizations, or even not so large, is part of the problem of criminalizing agency costs. As I’ve said in my short paper The Perils of Criminalizing Agency Costs:

Disciplining agents also requires pinning responsibility for corporate failure on particular people in the organization. If someone should be criminally responsible for obscuring Enron's financial condition, who should it be – the midlevel executives who designed the misleading structures, the executive officers who signed off on them, the independent directors who failed to object, the lawyers, accountants, banks and other executives who enabled them, anybody who knew about them and didn’t speak up, the whistleblower who told only those within the organization, or all of the above?

Finally, we might ask: where was SOX during all this? The answer, of course, is that for all the costs SOX imposes on firms, it can’t stop fraud. And if it can’t do that, what, exactly, was the point? But don't get me started on that. . .

Comments

[ebird]

Do you think, with you knowledge, is the fenomena of "back dating" stock option programs has been standard i EU al well as US?

[panasianbiz]

Larry, I found this post absolutely fascinating! I don't think I've ever found a better discussion of backdating, and your specific examples were outstanding! This was a terrific and informative read!