Mark Stein has an excellent
overview today of exactly what is wrong with options backdating (and I’m
not just saying that ‘cos he’s my editor at Portfolio). Suddenly, after the
vast amount of ink spilled on the topic, it all makes sense to me now.
There’s a simple reason why this issue is hard to understand, and it’s this:
options backdating is not illegal. In fact, there’s really no reason
why options shouldn’t be backdated. Historically, when executives have
been given options grants, they’ve been given at-the-money options: the option
to buy stock at the price the shares are trading at on the day the option is
granted. That way, if the share price goes up, then the executive makes money;
if the share price goes down, the executive makes nothing.
But there are other types of option, too: they can be out of the money, or
they can be in the money. If an executive is granted out-of-the-money options,
a tiny rise in the share price isn’t enough for him to start making money. But
a large rise in the share price can be very profitable. A grant of $1 million
in out-of-the-money options is actually much more valuable if the share
price goes up a lot than a grant of $1 million in at-the-money options would
be.
Alternatively, executives can be granted in-the-money options. These options
have value even if the share price goes down a little, although they lose their
value if the share price goes down a lot.
The different types of options create different types of incentive for executives.
An executive with out-of-the-money options has every incentive to take big risks,
because only if the share price rises a lot does he get the big payout. An executive
with in-the-money options, on the other hand, has an incentive to prevent the
share price from falling. That’s one reason to grant in-the-money options. Another
reason to grant in-the-money options is to reward executives for increases in
the share price which have already happened, under their watch, in the recent
past.
Backdated options are a form of in-the-money option. And if there are good
reasons to award in-the-money options, what’s wrong with backdated options?
Up until now, the best answer I’ve received to that question is that it’s all
about taxes. The tax implications of an options grant which is at-the-money
or out-of-the-money are different from the tax implications of an options grant
which is in-the-money. And if a company backdates an options grant instead of
simply awarding an in-the-money option at today’s share price, it’s essentially
trying to pull one over on the IRS, and get away with paying at-the-money taxes
on an in-the-money options grant.
So is this just a question of tax accounting? It turns out that in
fact it’s bigger than that: the people currently being indicted are guilty not
only of scamming the taxman, but also of fraudulently deceiving their own shareholders.
Carole Argo of SafeNet, in fact, is accused of deceiving not
only the company’s shareholders but even its directors as well. When the options
grants were announced, they were accompanied by a public statement that "no
gain to the options is possible without stock price appreciation, which will
benefit all shareholders." Which is fraudulently deceptive, if you ask
me.
Similarly, shareholders of KLA-Tencor were never informed that options grants
to CEO Kenneth Schroeder were in the money when they were made.
Reports Stein:
Over all, KLA-Tencor, a semiconductor-equipment maker, used backdating to
hide more than $200 million in stock-option compensation. The S.E.C. said
it did so to avoid reporting the expenses to investors…
"Corporate executives who deliberately backdate options grants and skew
their books to hide compensation expenses are misleading shareholders and
investors about the earnings of the company and painting a false picture of
executive pay," U.S. Attorney Michael J. Garcia said in a statement.
That’s what’s wrong with backdating. Companies can incentivize their
executives any way they like. But they can’t lie about it to shareholders.