Remember that era long ago when the term “options” wasn’t yet a dirty word? Yeah, neither do we. These days, you can hardly pick up a business section without seeing a provocative headline using some combination of the words “options” and “scandal.” A brief sampling:
From the Financial Times on June 17: “Options Scandal Hits Home Depot”
From Newsday on June 14: “Investigating the backdating game; Widespread exposure of stock-options revision points to a national scandal.”
From the Washington Post on June 11: “The Next Options Scandal; How to pay executives under the table.”
In recent weeks, this supposed national corporate stock options scandal has started to remind us of nothing less than the Duke lacrosse scandal — perhaps because in both cases the swarm of accusatory press coverage swirling around the developing story seems to have rapidly outpaced any actual proof of criminal wrongdoing.
The current hubbub can be traced to an academic paper that a Norwegian economist in Iowa published last year in a seemingly obscure journal called Management Science.
In the study, “On the Timing of CEO Stock Option Awards,” Erik Lie, a finance professor at the University of Iowa, examined how and when various companies awarded stock option grants to their executives between 1992 and 2002.
“Stock options are generally granted with a fixed exercise price equal to the stock price on the award date,” Lie wrote in the paper’s introduction. “If executives can influence the timing of a grant, they might therefore time it to occur (i) after an anticipated future stock price decrease, (ii) after a recent price decrease…or (iii) before an anticipated stock price increase. In any of these cases, self-serving behavior by executives should manifest itself in stock price decreases before stock option grants and/or stock price increases afterward.”
The results?
“Using a large sample of stock option awards to CEOs from 1992 through 2002, I find that the abnormal stock returns are negative before the award dates and positive afterward,” wrote Lie. “This prompts me to propose a novel alternative hypothesis that the awards are timed ex post facto. That is, the grant date might be set to be an earlier date with a particularly low price.”
From there, the would-be scandal gained momentum this past March, when the Wall Street Journal picked up on Lie’s research and published a story entitled, “The Perfect Payday,” which would prove to be the first of an ever-expanding series of articles about options backdating.
“The Journal‘s analysis of grant dates and stock movements suggests the problem may be broader,” reported the Journal. “It identified several companies with wildly improbable option-grant patterns. While this doesn’t prove chicanery, it shows something very odd: Year after year, some companies’ top executives received options on unusually propitious dates.”
Over the past several months, short of actually proving chicanery, the Journal has suggested the possibility of chicanery at a long list of companies. For readers who like their schadenfreude catalogued, the Journal has even published a handy Options Scorecard, listing some 50 or so companies and noting which ones are currently being investigated by the SEC, the justice department, and so on.
But having your books looked over by the SEC no more makes you guilty of corporate malfeasance than having your block patrolled by a beat cop makes you guilty of kicking the tar out of your neighbor. With more than two-thirds of all SEC investigations resulting in clean bills of health, we humbly submit that the nation’s greatest business paper should impose some minimum quota on its a priori insinuations of guilt.
Indeed, the vast majority of companies on the Journal‘s most-wanted list haven’t been found guilty of anything — a fact that the editors of the Journal‘s series themselves admit (albeit in a roundabout manner).
“Granting an option at a price below the current market value, while not illegal in itself, could result in false disclosure,” reported the Journal.
This is kind of like saying: buying alcohol at the store, while not illegal in itself, could result in drunk driving. What would happen if a powerful paper in a close-knit community published the names of everyone in town who had recently bought alcohol as part of a larger story about a widening drunk driving scandal? Chances are, other people in the community would soon start wagging their tongues and pointing their fingers at the people on the list — which is exactly what has happened to the companies fingered by the Journal.
Ever since its initial report was published in March, various other news organizations around the country have piled on with perfunctory Enron-references, overblown talk of a widening scandal, and self-serving quotes from members of Congress who are just shocked and simply outraged at the smug, reckless, behavior of overly entitled college athletes.
Er, rather, the smug, reckless behavior of overly entitled corporate CEOs.
Today, to its credit, the Journal published the best piece about options backdating that we’ve read so far. In a column entitled, “The ‘Backdating’ Witch Hunt,” Holman W. Jenkins, Jr. takes a giant whack at the ongoing coverage of the “scandal.” He writes:
Let’s try to remember — as some of the subsequent scandal coverage hasn’t — that options typically vest over time, and the value of the CEO’s pay package is determined by two factors, not one: The net price of the options multiplied by the number of options.
These simple facts make a mockery of two standard assumptions of the media coverage: that backdating automatically means CEOs were “padding” their pay; and that backdating is the equivalent of being allowed to bet on a horse race after it has been run.
How so?
“Think about it this way: Options packages don’t spring out of the ground, but must be designed and agreed upon,” adds Jenkins. “A company and its executive both have an interest in simplifying the negotiation as well as an interest in understanding clearly what the package is likely to be worth.”
“Why would backdating be appealing in this light?” he continues. “Because it lets one parameter be locked in so negotiation can focus efficiently on the other, the size of the grant. It eliminates a perverse incentive to game the stock price during the negotiation. It leaves a valued executive no reason to grump about the issue date or feel there was any invidious message in its selection, yet the company retains full control over the size of the package.”
We hope that in the coming weeks, the Journal‘s reporters will take note of Jenkins column before rushing to “out” companies for accounting techniques that were widely popular in the late ’90s and which, in recent years, appear to have fallen by the wayside.
“Since Enron, a great deal has been said about corporate governance, most of it useless,” concludes Jenkins. “The one lesson that should be reinforced is that overseeing CEO incentives is among the most important board responsibilities, and boards should keep control of it and do it clearheadedly. Yet there is nothing categorically corrupt or improper about backdating to justify a conclusion that the boards here weren’t doing just that.”
We couldn’t agree more.
Felix Gillette writes about the media for The New York Observer.