Did backdating cause any harm?

In my many posts on backdating I have been assuming that although backdating stock options was not the evil greed that has been portrayed in the press, it likely harmed investors by misreporting the cost of the options.

Now Geoff Manne, in a comment to one of my posts, has persuaded me that even this latter concession was not necessary. Although companies were technically misrepresenting the difference between the strike price and the stock price at the time of the grant by misrepresenting the date of the grant, the companies were likely correctly reporting the difference between the strike price and the stock price on the date of disclosure. In other words, at the same time the market learned about a company's stock option grant, it also learned about the real (even if not the accounting) cost of the options to the company.  Efficient markets would reflect that cost in stock price.

Now, this does not mean that the accounting was honest. And there might have been some harm to investors if markets were not instantly looking through the accounting numbers.  But surely this insight reduces the significance of the whole backdating pseudo-scandal, and lends further support to my argument that this conduct should not be criminalized. 

Nevertheless I expect that irresponsible journalists will keep flogging this story to within an inch of death, and numerous corporate executives will be facing jail time as a result.

Comments

[Bill Sjostrom]

It seems to me that the revelation of backdating harms investors primarily because it puts into question the integrity of the firm’s management and internal controls. The market absorbs this new question mark, and the price of the stock drops accordingly. Granted the media frenzy and prosecutorial zeal surrounding the issue certainly exacerbates the downward pressure. Maybe its time to go long stocks of companies embroiled in the scandal.

[Larry E. Ribstein]

True. But what determines the size of the "question mark"? Possible answer: Gretchen Morgenson and the WSJ.

[geoffrey manne]

And, even if true, management conduct that leads investors to question managerial integrity (and which is priced by the market) isn't yet a criminal offense, is it? If it were, I think we'd have zero managers. This is the slippery slope Larry has been warning us about, and, properly conceived, the criminalization of backdating is pretty far down precisely this slope. Again -- there may be a technical disclosure violation here if the practice contravenes a company's stated options scheme, but it just doesn't seem to merit the negative attention it's received (so, as Larry notes, the WSJ and Gretchen M. rear their ugly heads (no offense to Ms. M's presumably lovely visage intended)).

[Mukund Mohan]

Larry
Now that we have over 25% of the companies under the "cloud of backdating" reporting that they have no reason to worry or that their internal investigation said they found no wrong doing, many of the "irresponsible journalists" have egg on their face.

At the outset, I am not sure they are aware of the issues and the implications - which is where 90% of the people blogging about backdating or commenting about it are also.

Most of these reporters assumed that there was an issue of CEO's and executives padding their wallets (a la Tyco, etc.) versus administrative paperwork that was incomplete.

If you really think that WSJ and NY Times had a big impact on investors or the public in general why do you think the general public is still not up in arms - one possible reason - they are discerning enough to know that a few reports from these newspapers dont constitute the reality.

Mukund Mohan
http://blog.vangal.com

[Michael Guttentag]

Sorry to jump in late, but I think the discussion above avoids some of the difficult issues raised by the failure to properly disclose the timing of options grant at public companies, or perhaps I’m just restating Bill Sjostrom’s in a slightly more formal manner.

Disclosure requirements serve a variety of purposes. From the perspective of enhancing share price accuracy, the failure to disclose the timing of option grants is probably no big deal. But what about the role that disclosure requirements play in terms of reducing agency costs? Paul Mahoney in his 1995 Chicago Law Review article, Mandatory Disclosure as a Solution to Agency Problems, does a nice job of showing that at least from a historical perspective reducing agency costs is a significant part of why firm disclosures are required.

Mahoney’s argument, as I recall, is that disclosing information about transactions between the firm and its agents, which he calls agency information, reduces agency cost. I’m not sure if he specifies the mechanism by which requiring the disclosure of this information would have this effect, but I’m happy to speculate. Investors who are not aware of transactions between the firm and its agents would need to discount security prices to reflect the extent to which the firm’s agents would be expected to enter into transactions that benefit the agents more than the firm. By credibly committing to disclose any transactions between the firm and its agents, the agents are providing a means to assure investors that funds will not be inappropriately transferred out of the firm. Presumably with the disclosure of these transactions, investors would be put on notice and provided information that facilitates heightened scrutiny. Further, we would assume the firm’s owners have some way to take action if dissatisfied with the transactions disclosed, and so the agents would be discouraged from entering into these types of transactions. The value of the firm increases.

What does this have to do the backdating of option grant timing? It is probably true that the required disclosure of the timing and amount of options is a rule that was adopted to achieve these agency cost reducing benefits. If this is correct (Mahoney shows many of these rules were adopted by firms before they became mandatory), then the choice of the firm’s agents to circumvent these rules might be quite significant, whether or not share price accuracy is affected. If agents are allowed to choose to ignore rules that are adopted to reduce agency costs, this benefit from requiring disclosure may be lost.

Of course questions remain. Do disclosure requirements of this type really reduce agency costs? Even if manger’s circumvented rules that were intended to reduce agency costs, perhaps this was a rational decision from the perspective of shareholders in this case.