The real options-backdating culprits
Almost every day there's another one, a top executive thrown out of his job for backdating options. These are some otherwise perfectly respectable people we're talking about: William McGuire at United Health, Shelby Bonnie at CNET, Andrew McKelvey at Monster. Even Apple's Steve Jobs has gotten tangled in the backdating web, although there are no signs that he'll lose his job over it.
When supposed wrongdoing is this widespread, one can't help but wonder: Are there really this many willful rule-breakers in corporate America, or did somebody change the rules on these guys in midstream?
I'm tempted to lean ever-so-slightly toward the second answer. What was done was clearly against the rules, but those rules were until recently treated with such disdain in the business world and even by many investors that it's perhaps understandable that so many executives saw no harm in breaking them.
First, a brief explanation of options backdating: Say your company's stock is trading for $15, and it gives you 100 options--expiring in 10 years--to buy that stock at $10 a share. So far, so good. As Holman Jenkins argued in The Wall Street Journal last week (not available online unless you have a financial relationship with Dow Jones & Co.), there's nothing intrinsically wrong with giving employees' in-the-money options. It's just like giving them restricted stock, or cash.
What's wrong is reporting in a company's financial statements that the $10 options were granted at some time in the past when the stock happened to be selling for $10 a share. Until this year, options priced at the money (that is, with the stock trading for $10, you get an option to buy a share for $10) were considered free for accounting purposes--while an option granted in the money (with the stock at $15, you get an option to buy it for $10) was counted as a compensation expense.
This accounting distinction was of course entirely loopy. When last I checked this afternoon, United Health stock was trading at $48 a share. Meanwhile, an option to buy a share of United Health for $50, expiring in Jan. 2009, was selling on the American Stock Exchange for $10. That is, even out-of-the-money options have value.
In 1993, after long deliberation, the members of the Financial Accounting Standards Board--the people who determine what constitutes a General Accepted Accounting Principle--acknowledged this truth with a proposed accounting standard requiring that all employee options be valued with one of the mathematical models widely used in the options-trading world (the Black-Scholes model or the related binomial model).
Then all hell broke loose. In what should go down as one of the most shameful episodes in modern business history, corporate America bullied FASB into backing down. Silicon Valley was loudest in its opposition, but all the big business groups joined in. Joe Lieberman was enlisted as the chief hatchet man on Capitol Hill (his more vocal allies included Bill Bradley, Barbara Boxer, and Phil Gramm), sponsoring a 1994 resolution--which passed 88-9--urging FASB not to change accounting for options, and making threatening noises about effectively shutting the board down if it didn't comply.
There were and still are valid objections to the method FASB proposed for valuing options. It takes a fleeting estimate--the valuation set by the Black-Scholes or binomial model on the day the option is granted--and sets it in earnings-statement stone.
But you can't make a serious accounting case for treating options as free, which is what most of FASB's opponents were after. So they couched their argument in economic terms: By motivating employees and aligning their interests with shareholders, options were promoting economic growth. Expensing options would thus hurt the economy, which made it a bad thing. The same argument can be made about expensing cash paychecks, of course, but that didn't seem to bother anybody at the time.
This victory of politics over accounting logic had consequences. As Warren Buffett, a lonely voice in support of FASB back in 1994, told me in 2002: "Once CEOs demonstrated their political power to, in effect, roll the FASB and the SEC, they may have felt empowered to do a lot of other things too." Buffett was referring to the accounting shenanigans at Enron and Worldcom, but the connection to the options backdating scandal is much more direct.
After the Enron and Worldcom meltdowns, the political climate shifted. More and more companies began expensing options voluntarily, and in 2004 FASB finally pushed through its rule. Starting this year, all options granted to employees have to be expensed.
But the backdating offenses coming to light now (thanks to the work of University of Iowa business school professor Erik Lie) almost all predate 2002. They were committed back in a day when virtually every significant business organization in the country was arguing that options shouldn't be expensed, a view endorsed by the Big Six accounting firms (yes, there were six back then), Congress, and even a lot of big money managers. In such an environment, it wasn't all that out of line for the people at United Health and CNET and Monster and Apple and Comverse and Broadcom and Brocade to think tweaking the grant date of an option was a mere technicality.
I am not saying don't blame them, blame society. I'm saying blame them and society--society in this case consisting of the American Electronics Association, the Business Roundtable, the big accounting firms, Joe Lieberman, you name it. The guilt is shared pretty widely here.
Posted by Justin Fox 1:54 PM 13 Comments | Add a Comment
Very accurate and correct interpretion of the situation.
C. Richard Baker
Professor of Accounting
Coming from a long stay in Corporate America as I have and seen these executives in action I know most great "ideas" such as back dating are generated by company hired consultants. I keep waiting to hear of the name(s) of HR or compensation consulting firms who pitched this to Corporate America. I have doubts that outright rule violation was dreamed up by so many excutives on their own.
Wouldn't it be nice to know the outcome of something and have the chance to place a bet and be richly rewarded??...please, CEO's are by definition mostly very smart people (especially those of public companies) they knew EXACTLY what they were doing by backdating options so either they or their employees would stand a better chance of an unjust gain. The corporate accounting issue is nothing more than a misguided excuse in defense of their unethical actions. None could agrue that a senior office or their board made them do it - America is full of such events over its rich capilistic history and more will come...
A leader earning millions per year HAS the resources to get competent advice on accounting gray areas. If the advice is to push the grayness to the limit and then the issue is brought to light you could be in trouble
Sprint lost two executives who were advised by their outside audit companies to participate in complex tax shelters that the IRS over-turned.
If the issue is to hide compensation then these people gambled and lost.
I'm still not sure that the 1994 resistance to expensing options was some insidious battle between nefarious politicians and business leaders on the one hand and accounting logic and truth on the other.Knowledgeable and fair minded people can disagree on the issue -- we don't recognize revenues when a Company sell stock because it effects the Company's capital account and the number of shares outstanding rather than the Company's internal resources.Also,ascribing values to probabilistic future events has never been accepted under historical accounting standards-- after all there are many probabilistic occurrences which effect a Company's potential earnings.Disclosure is the key. As long as there is a way to track share dilution and project future earnings per share, then one can in fact assess the impact of the future exercise of stock options without confusing the P&L with the expensing of share options and the expensing of actual costs which drain the Company's cash resources.
Every company that used option back-dating should be fined, and its CEO/CFO should be prosecuted as they signed off on the financial statements to ensure the accuracy of the statements.
What concerns me the most about this topic du jour is the fact that our executives and corporate america felt no wrong doing irregardless of the rules, laws or other inherent ethical principles existing in our society today. 99.9% of us who are not lucky enough to win the CEO lottery would love to acquire investments at a very low price and sell them for a tremendous gain. This type of manuever should have been considered inherently wrong by somebody in the corporate governance structure on fiduciary principles to shareholders alone. I work at a company where our last executive walked out of there with a $10+ million severance package for not delivering a lick of value. And this wasn't even in his contract, the board voted to give it to him after the fact! Can somebody out there remind me again what the downside of being a CEO is? 'Cause I don't see it.
This is just another example of really smart people using all their talent for one thing-their own enrichment. What if we could get some of these people to try and solve the health care crisis, the energy crisis, the environmental crisis? We waste our talents pursuing empty, shallow goals and that help few and hurt many. If we ever needed an little injection of socialism, now is the time. Businesses aren't giving back to communities, they aren't training Americans to do more, they are lifting profits form communities and concentrating them in places where the a couple dozen live large and a few thousand struggle to get by, worrying if they'll have their jobs next year. Its a shame that it has come to the point where the our government has to step in and regulate/oversee corporate america to save its citizens from the pollution and poisoning of our environment and the erosion of the middle class. If the people who run these companies had been able to control their own greed, and give back more, how much more could we accomplish without having to waste so much time and millions of tax payers dollars chasing option backdaters, serial polluters, superfunds, and blatant criminality. Maybe if we didn't have so much of that same element in the White House, we could have staved off this problem instead of it now being a full blown epidemic throughout corporate america.
Sacrificial lambs.....that is what this is about. However, unlike some, if you're left a multi-millionaire, I'm not too worried about them. It's the rest who have to pay without that financial cushion. Is it ok to rob the shareholder of value (an unreported expense)? Obviously, some thought so for a long time.
Something that is being overlooked by the pundits of the "CEO's weren't inherently trying to be dishonest" scenario is that the goal of a CEO is to increase shareholder value and to account properly so that shareholders have an accurate picture of the financials. Do you really think that failing to expense options provides an accurate financial picture and increases shareholder value?
I have a problem with all the hindsight on options backdating, corporate accounting scandals, "friends and family" IPOs, tax shelters, etc. Anyone who has a half decent set of ethics knows when they are cheating the company, its shareholders, or the government. How could you not know that backdating options to guarantee a payout is wrong? How could you not know that giving F+F IPO stock to customers or brokerage buddies was wrong? On the one hand, we treat executives like they are gods - all knowing titans who turn around companies and earn millions, and yet we believe that they did not know right from wrong on simple ethics issues. Absurd
My thought is that the shareholders of any company that has participated in options back-dating should be allowed to back-date the sale of their shares at the highest price during the past year. What's fair for execs IS fair for shareholders too. Additionally, these same execs and their boards should be responsible for the difference between the current and a back-dated share price. No need for long and involved trials. Just give them a taste of their own medicine. It won't take much of this to ensure that options back-dating, like stage coach robbery, disappears into the dustbin of history.
Your article on stock options misses a few points that are essential to understanding the abuses.
The executive wants to be granted the options with the lowest exercise price possible and sell the stock they receive from the exercise at the highest price. He will scheme to do so unless prohibited by law.
There are Securities laws and rules that are meant to deter insiders from using their inside information to line their pockets by buying low and selling high.
The SEC accomodated the executives' options scams by passing rules in 1996 which allow the executives to escape the enforcement of Section 16b of the Exchange Act of 1934, which made it very difficult to back date and spring load.
The SEC could have eliminated all the options scams by merely requiring the options to be designed a particular way.
The idea of valuing the options at grant day and expensing the value over the vesting is silly and does nothing more than give a lot of work to accountants and valuers, while confusing the public. The is a simple way to expense options, but the SEC is not interested.
There is another scam that apparently has escaped the investigator's eye. This is the procedure of deliberately making premature exercises and selling the stock, with the understanding that the company will soon lavish another load of options on the executive to "align his interests with the company" which he lost because of the early exercise and sale of stock.
The problem lies in the fact that options are really understood only by a small group of options traders.
There are thousands of advisors who dominate the employee options arena, who do not have a clue to how options work. They therefore resort to cheating.
Its as simple as that.
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