Thursday, July 20, 2006

Robert Reich and backdating stock options

I almost never agree with former Labor Secretary and regular National Public Radio columnist Robert Reich on anything. He's a lawyer who pretends to be an economist. I don't pretend to be an economist. I don't even pretend to be a lawyer. But in this case, he's taking on a corporate shill who pretends to be a libertarian--namely, Securities and Exchange Commissioner Paul S. Atkins. (From my previous post on the Competitive Enterprise Institute, you know how that just sticks in my craw.)

The issue is one of those things that sounds intensely boring, unless you are involved and understand that it means lots and lots of free money, in which case it sounds intensely interesting. Basically, it goes like this. A stock option is a right to buy from someone (usually the company) a certain number of the company's shares at a certain price, at some determined or undetermined future date. In the 1990s, stock options were hailed as a way to solve the problem first widely recognized in 1932 by Adolf Berle and Gardiner Means that the modern corporation had become characterized by a separation of ownership and control--in other words, the people who ran the company and made its business decisions were not the people who owned the company (i.e., the company's shareholders). In most small companies--and, indeed, in many larger companies in much of the world today--the people who own the company also run it, and so there is no conflict between their goals. But where ownership and management are separated, conflicting goals can arise. Both groups want to get rich, but since managers are managing "Other People's Money" (the title of not just a 1991 Danny Devito movie, but also the title of a 1914 book by Louis Brandeis when he was just a famous law professor and not a famous Supreme Court Justice), the managers are in a position to get rich at the expense of the shareholders.

Stock options were supposed to solve this problem by aligning the interests of management and shareholders. Basically, the company's board of directors issues a set of options at a price at or slightly higher than the current market price of the company's securities. If the company prospers, the company's share price will increase and the executive will be able to exercise those option rights at issuance price (say $100 per share), turn around and sell them on the market at today's trading price (say $120 per share), and pocket the difference.

There are lots of real-life problems that have cropped up about stock options, most of which I won't go into here. However, one issue that has recently come to light is that some companies issued stock options at below-market rates (an option to buy stock at $80 per share when those shares are currently trading at $100 per share), but then "backdating" them so that it seems like the options were issued a month ago when the shares actually were trading at $80 per share.

In addition, these options were issued right before good news about the company was released to the public. And such options were almost never issued right before bad news went out. In other words, companies appeared to give their executives stock options at exercise prices "at the money" (at market prices) or even "out of the money" (above market prices). But in reality it was predictable with almost absolute certainty that the price of the company's stock would jump very shortly. For practical purposes, these stock options were "in the money" (below market prices) from the get-go. Granting "in the money" options is the equivalent of just giving money to option-holders. But lying about when the options were granted--or issuing them right before the company issues material information to the public--means the company is lying to its shareholders about how much the company is paying its executives. (When the options are exercised, the company has to go out and buy those shares on the market for $100 per share, and sell them to the executive for only $80 per share. That $20 difference is shareholder money.)

Commissioner Atkins, in a recent speech at the International Corporate Governance Network 11th Annual Conference, offers up an innovative justification for this practice:

In the best exercise of their business judgment, directors might very well conclude that options should be granted in advance of good news. What better way to maximize the value that the option recipient attaches to the option? Conversely, a board would avoid granting options right before bad news hits since recipients are likely to place a lower value on such options. A board that times its options grants wisely can achieve the same result that it would by granting more options at a time when the stock price is likely to stagnate or drop. A board that makes a consistent practice of timing options grants before the stock price rises should be able to pay lower cash salaries than a board that makes options grants without taking into consideration likely prospective changes in the stock price, precisely because there is a greater chance of the options being worth something and achieving their intended objective.

So, basically, if a company's board knows good news is about to be released, it might decide to issue the stock options first, because then it won't have to give the executive in question quite so many. When you think about it, it's a shame these boards tried to keep this practice secret from their shareholders. After all, I'm sure shareholders would be proud of their boards for their foresight and economy.

But that's not what's really going on, is it? And, in this regard, Robert Reich's recent NPR column gets it right. In particular:

...Atkins' logic is it completely ignores the purpose of executive stock options in the first place. They're supposed better align executive incentives with the interests of investors, inducing executives to work harder to raise share prices. Yet stock options have this effect only if executives don't know what their option will be worth in the future. If they can go back in time and pick a date when the share price was specially low relative to what it is now or will surely be when a positive quarterly earnings report is issued, the incentive disappears because the future is no longer the future. It's the past. If the incentive that's supposed to be in a stock option disappears, shareholders are worse off. More stock has been issued, which dilutes the value of their own shares. And they get nothing in return. Anyone who believes companies will reduce executive compensation by the inflated value of a stock option has not been paying much attention to what's happened to executive compensation in recent years.


Mukund Mohan said...

Dont want to be rude, but do you have a point here you want to make? :)

Or just flapping?


M.D. Fatwa said...

Most of what I write is just flapping.

But in this case, my point is that Atkins is just a shill for the Chamber of Commerce. He's not pro-market. He's just anti-regulation. His logic is so absurd that only a public relations firm could spout it off without snickering.

ryan said...

If the goal is to give the executives a bonus, then why is the board trying to reach this goal? If they're controlled by the CEO and he's essentially just handing himself money from the till, then the problem isn't backdating but that the board is controlled by the CEO, right? And if that's the case, then isn't it also the case that it really is just another way of paying a salary (a salary that already was going to be high, mind you)? So Atkins is right and, ultimately, you're just complaining about the manner in which executives are paid X dollars?