The other (non-tabloid) side of backdating

Holman Jenkins is back on backdating. Today his point is that the whole backdating thing amounts to the classic line from Spinal Tap about the amps that "go to 11." As he's said before (see my recent discussion here), backdating can be linked to the accounting rule that required expensing of in-the-money but not at-the-money options.

Jenkins points out that firms could have paid the same amount of compensation by increasing the number of optioned shares (or, for that matter, lengthening the term or decreasing the vesting period) rather than decreasing the strike price, which is the problem with backdating. But prospect theory suggests that the executives the firms were trying to recruit would highly value the in-the-money feature -- sort of like Nigel and his amp.  And the accounting rule provided the temptation to accommodate this preference by backdating rather than taking the earnings hit.

Prospect theory is an interesting explanation of the incentives here. But it's also true that if firms had increased the number of optioned shares, this might have increased dilution, including of shares the top executives held. Also, changing other terms of the plan might have been more difficult, including requiring this for all employees, when the firms wanted to target a few they really wanted to recruit.

Jenkins' explanation is important because it provides yet another plausible business purpose for backdating that further weakens the idea that the conduct ought to be criminalized, a result I've argued against, e.g., here. As he says,

embroiled are not just a few bad apples (pun alert) but Apple, Pixar, Microsoft, Juniper Networks and, if Prof. Lie is to be believed, 29.2% of all listed companies. In such circumstances, "the CEO is a crook" is an explanation that quickly loses power.

Yet we get very little of the Jenkins perspective, particularly in his own newspaper, because "CEO is a crook" is the splashy and visceral explanation that sells papers. In other words, the WSJ, by endlessly flogging the story without providing the alternative explanation, has sunk to the tabloid level. And the result of this coverage, like the overheated coverage of Enron, is still more misguided criminal prosecutions.

Comments

[geoffrey manne]

(Also posted over at Prawfs in the comments to the trackback above):

I’m not sure why anyone thinks options backdating is a lie (technical violation of a rule, maybe, but lie, no). There's just no harm in the practice. 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 (which I think is part of Jenkins' point. Once again, he seems to be reading Truth on the Market (see my comments to this post: http://www.truthonthemarket.com/2006/08/04/stock-options-exec-comp-etc/). The same could be done, I assume, by arbitrarily picking a strike price lower than the market price on the day of issuance. Either way, as I note in the comment linked above, the moment the at the money options are issued they pull down share price. They are not free, nor is their effect somehow hidden from investors. So why should there be any moral outrage or any serious consequences here at all?

[Larry Ribstein]

Good point. I basically agree, though I think it would be technically more accurate to say that there is a lie (the options were not actually at the money when issued), but not one that harms the market.