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Backdating: A little less than meets the eye
I'm not defending it, but ...

In a recent conversation about options backdating that I had with Stanford law professor Joseph Grundfest, who heads its Rock Center on Corporate Governance, he kept having to use that phrase as he explained an interesting point I hadn't really appreciated until then. Now I'll need to make liberal use of that phrase too.

Though recipients of backdated options received unfair gains, and shareholders were deceived--and I'm not defending either injustice--in each case the extent of the harm may be a little less than some of us are assuming.

Suppose a company gave you, in 1999, one option to buy one share of stock whose closing price that day was \$20. Suppose further that the company backdated the grant by a week, so that it could give you an exercise price of only \$19. You haven't received \$1 of profit yet, however, because your option won't vest for at least a year, and you don't know what the price will be then. In Silicon Valley, options typically vested over a four or five year period, with a one-year "cliff" before the first of them started vesting. Because of the bursting of the tech bubble, a great many, if not most, were out-of-the-money and worthless by the time they vested.

One way to measure what you've received would be to calculate the difference between a Black-Scholes valuation of the \$20 option and a Black-Scholes valuation of the \$19 option. When we were talking, Grundfest then went to one of the many Black-Scholes calculators on the web, filled in some hypothetical parameters--the calculation will vary a little depending on factors like volatility and expiration date--and found that the fair market value of his hypothetical backdated option (with a \$19 exercise price) would have been \$13.31, while the fair market value of the non-backdated \$20 option would have been \$13.06. So, in a sense, you were given about a quarter, not a dollar. Of course, a lot of quarters can mount up to real money, so I'm not defending this practice.

When it comes to trying to figure out the degree to which shareholders were deceived, the computations are difficult, in part because, at the time, the biggest piece of the accounting deception was lawful: companies could pretend that at-the-money options bore no cost at all, requiring no expensing at all. In addition the accounting methodologies for expensing in-the-money options in 1999 and at-the-money options today are different, making comparisons difficult.

Indeed, just doing the proper calculation for in-the-money options in 1999--a process called variable accounting--was hellishly difficult. The company theoretically would have had to recalculate the amount to expense each quarter, based on the fluctuations of the stock price vis-a-vis the strike price. The process was so complex that most companies avoided having to do it, and many accountants still aren't sure about how to handle certain details of the process.

For a company now to do a retroactive restatement applying that methodology over a period of years for multiple grants of thousands of options will typically require that it miss its quarterly filing deadline. Missing the filing requirement will probably cause the company to receive a delisting warning from its stock exchange and put it in technical default on its bank loans. So there is a snowball effect that, in some cases, may be disproportionate to the crime.

But I'm not defending it.
Posted by Roger Parloff 6:44 AM 9 Comments  | Add a Comment

Roger, even more relevant is the extent to which a business valuation should be impacted by dirty execs. For example, should a market cap be punished by 25%, when the execs have taken unjust compensation worth a few million? My take is no, but for now the equity markets have treated quite severely any companies involved with these shady dealings.
Posted By Big John Stud, NY, NY : 8:58 AM

It seems like you are making this a little too complicated. All you seem to be saying is that options are only valuable if the stock goes up. In some cases the stock went down, so the option was worthless even at the lower price. Thus no harm was done.
Posted By Ross Williams, Grand Rapids Minnesota : 10:57 AM

I think that the damage may be less the funny money accounting, but a tangible issue that companies that did not participate may have lost good employees becuase they were competing on an uneven field. If you are given a job offer with options are for a price that makes the offer appear greater by 50k, 100k or more it becomes hard to refuse. This resulted in companies loosing their talent and possibly their ability to compete.
Posted By Adam Smith, Boston, Ma : 2:05 PM

I think Roger is absolutely right that there's less to this than meets the eye. It's a public opinion-generated frenzy, stoked by a feeling that, legal or not, the elites are getting a better deal than the rest of us.
Posted By Little Jimmy Dickens, NY, NY : 11:26 AM

Other aspects: First, if a company had 1 billion shares outstanding and with multiple option beneficiaries issued options on 10 million shares, the voting power of present owners is diluted. Second, one way for the company to be able to issue options,is to acquire shares by purchase in the open market Then the company has reduced its cash position by its purchase price. Presumably it has received less that the current fair market value when the options are exercised. Very likely, a cash loss. And voter dilution. Third,the other way to have stock available for options is to issue shares that are authorized and not previously issued. Again, the company has presumable received less than current market value and voter dilution also occurs. Fourth, each of those situations, causes loss to the stockholders and inaccurat financial records - which are violations of the fiduciary duties of the officers and directors of the company and may expose them to proceedings for violations of the Sarbane-Oxley Act.
Posted By F. Patti, Brookhaven, PA : 8:02 PM

Are you all kidding?

CFOs and CEOs flat out lie, and you evaluate the problem solely in terms of the financial cost of their lie?
What about the cost in integrity? In the example they set to their employees? In the moral rot they cause to their organization and to public confidence?
I am astonished that the comments on this to date say things like "no harm was done," or "companies losing their talent," or saying it amounts to "a public opinion-generated frenzy." People, once you countenance lying by senior officials for the sake of financial self-aggrandizement, you're way way down the garden path.
This kind of moral myopia is exactly why business gets a bad name.
Posted By Charles H. Green : 3:28 AM

Last comment, I forgot to include my address.
Posted By Charles H. Green Morristown NJ : 3:29 AM

As "Adam Smith" (god rest his smutty soul, points out, you may be looking at this in an overly simplistic way. What seems to be missed is: "Why is it done in most cases?". I think the answer is to retain talented people with other offers on the table. That is unfair competition.
Posted By beancounter, boston MA : 4:06 PM

Please do not try to minimalize the impact of the act of backdating. It is still theft (stealing value from the stockholders) and cannot be tolerated. If you think this is an acceptable practice, please tell me how much theft you, as a stockholder, would accept before you raised an objection.
Posted By Jerry, Apple Valley, Mn : 9:29 PM