Thursday, July 20, 2006

Even more on stock options backdating

Ryan argues that the problem isn't stock option backdating, but that the board is controlled by the managers running the company.

Well, of course it is a problem is that the board is controlled by the CEO. Still, the particular problem here isn't that the board is handing the CEO a lot of money, but that they are telling the shareholders that they aren't doing this--and that what they are really doing is offering the CEO an incentive to improve the company's performance.

Interestingly, the backdating problem is claimed to have diminished with passage of the Sarbanes-Oxley Act. (Despite this, the charges the Justice Department and the Securities and Exchange Commission brought against Brocade Communications today involved activity that stretched up until 2004, two years after passage of Sarbanes-Oxley.) SOX requires that stock option issuances be reported within 2 days, rather than the month that was required before. It's much easier to fudge the date of an options issuance when you've got a month to report it, than when you've got 2 days. It's also much easier to notice that options always get issued right before good news is reported if the window is only 2 days wide. (There is also a tax treatment issue involved here that also kinda put the kibosh on backdating, but when a certain economist friend of mine explained it to me, what I heard was "blah blah blah backdating blah blah blah treatment blah blah.")

Also, post-SOX listing standards for the New York Stock Exchange, NASDAQ and other U.S. exchanges now require board compensation committees (the committees on the board of directors charged with setting managerial compensation) to be made up entirely of independent directors. It's probably a little too early to tell if this will have any effect on executive compensation. One argument is that this is all driven by a Lake Woebegon Effect, where every CEO is above average (and demands to be compensated accordingly), and every compensation committee believes it must pay above-average compensation to attract above-average leadership. On the other hand, it's not just a bunch of socialist hippies who are complaining about executive compensation these days. It's also pesky "activist shareholders"--you know, those annoying people ("locusts", as the Germans call them) who actually own the company and show an interest in how their money is being used. They seem to think they would be happier if executive compensation were somehow linked to executive performance.


Mukund Mohan said...

At the end of the day there is a total compensation that most stock holders care about which comprises of:
1. Base pay
2. Bonus
3. Variable pay - options, restricted stock etc.

Since these 3 have tax implications for both the company and individual, they are usually masked by the companies. If you read the research on executive pay (
there is a indirect correlation between CEO pay and performance. Which means they are getting paid a lot more than they deserve.

At the end of the day if stock holders were made aware of the total pay AND taxes were accounted for properly there would not be a big hue and cry over backdating.

What do you think?


M.D. Fatwa said...


I don't think there is anything wrong, per se, with stock options. They are just another form of compensation, and theoretically at least, one that may be better at aligning the interests of shareholders and managers (though I think recent events show that there are probably better mechanisms). However, the backdating just doesn't make sense unless you are trying to obscure this compensation from shareholders or for tax purposes. Otherwise, why not just issue in-the-money options?

I have read some of the literature noting that there is little correlation between CEO pay and corporate performance. I'm not terribly surprised.