How the media produced the backdating scandal

Dealbreaker has a very interesting set of posts that, although not entirely aimed at this objective, give insight into how the media helped produce the backdating scandal.

Let's start with the most recent post by John Carney. Carney explains two basic points about backdating. First, the simple point that it's not as bad as it looks. As I've said before, "the misreported option value is significantly less than the difference in exercise price from the backdating." To use Carney's example:

Consider that a $10-in-the-money backdated option has an exercise price of $90. Without backdating, let's say, it would have been set at $100. Under the Black-Scholes option-pricing model, assuming a risk-free rate of a 5 percent return, the backdated option has a theoretical value only $1.80 higher than the non-backdated option. The backdated option with a 119-month term would be worth $68.88, while the regular option with a 120-month term would be worth $67.08.

Second, even the correctly disclosed figure is misleading because it only gives the value at the date of disclosure, not reflecting any later fluctuations.

The options are priced when they are dated, and future increases or decreases in the stock price don't change that number. So the officially disclosed numbers have only a theoretical, best-guess, most-likely, pretty-much-ish relationship to what executives may actually make from their options.

Indeed, says Carney, "the urge to backdate is in part created by the "one-off" nature of this disclosure."

Carney concludes:

[M]any companies found it irresistible to fudge a number that didn't reflect actual values anyway. This doesn't mean that fudging the numbers is okay but it does give us good reason to be skeptical about some of the hysteria over backdating. And, at the very least, to wonder whether this is really a matter for prosecutors and criminal trials.

To see whether it should be a criminal matter, Carney says, we would have to know whether the misrepresented values were material, and

something about the mindset of the people dating the grants. Were they trying to secretly smuggle more money to the executives without telling shareholders or were they backdating the options for more innocent reasons? Are there innocent reasons for backdating? Well, the fact that backdating seems to have been so widespread provides one innocent reason. If it was the standard industry practice, it's easy to imagine that a compensation committee would assume it was acceptable. What's more, a company's financial position is not actually changed by the fact that it made the grant on November 14th rather than August 14th.

But there is a problem with backdating:

A combination of accounting rules, corporate governance fads and perceived public outcry against executive compensation, may have created an atmosphere where a companies felt pressured to reduce the apparent size of compensation package below the actual level of compensation they believed were required to hire and retain top level executives. But if companies were under the impression that disclosing actual levels of compensation would upset shareholders, well then it seems they at least believed that they were making a materially false disclosure to the markets. And that, of course, makes backdating a serious legal issue.

And if the company is operating under a legally or self-imposed compensation cap, which many are advocating, then the materiality may be more apparent.

But here's the real point: the fact that companies are operating under these constraints is largely attributable to the media frenzy over compensation. Goldman, for example, doesn't have backdating problems because, as Dealbreaker reports, "it has no shame. Blankfein and Co. just put it all right out there: our guys make more than everyone you know." Goldman apparently doesn't have to worry about media criticism of backdating.  Firms that sell to ordinary consumers need to worry about the image they'll get in the papers if they pay their people what the journalists view as "too much."

So, in conclusion, firms need to pay their people a lot to hire and keep them. But the media imposes a shame cost on disclosing these amounts. The backdating executives figure it doesn't really matter because even the correct option numbers are bogus and the real numbers, which measure the firms' actual performance, are disclosed. But the media is actually focusing on the bogus numbers, so the disclosure problem may be material because the media makes it so. And, finally, as I've discussed in many posts, the media, anxious for readers and Pulitzers, inflates this into a scandal of major proportions that requires the gathering of scalps. The prosecutors, sensitive to public opinion and ready to reap benefits from high-profile cases, are ready to oblige.

Got it?