Criminal Excess: Backdating Stock Options Commentary
Criminal Excess: Backdating Stock Options
Edited by: Jeremiah Lee

JURIST Contributing Editor Douglas Branson of the University of Pittsburgh School of Law says that the latest US corporate scandal involves disclosures of backdated stock options upping the already-disproportionate compensation of CEOs and other senior managers, with criminal charges being laid against five corporate executives so far…

A November 17, 2006 Wall Street Journal headline reads “Backdated Options Pad CEO Pay By Average of 10%.” Daily, stories like this appear in the Journal and the business sections of newspapers. Most recently, Corinthian College, Inc., the for-profit education provider, announced that the company had backdated 4 sets of option grants in 2001 and 2002, at least one set to reap further gain out of the stock market slide after September 11, 2001. CEOs of many major corporations such as Corinthian have fallen from grace, in this our latest corporate scandal.

In 1990, the average Japanese Chief Executive Officer (CEO) made 16 times, and the average German CEO 21 times, what the average worker made in the CEOs’ corporations. Graef Crystal, a famous compensation consultant, found the ratio in the U.S. to be 150. In 1991 he published In Search of Excess, a parody of a well know management tome of the time, In Search of Excellence.

Today the U.S. ratio is over 500 and heading north, as they say. Some peg the number at around 535. The average U.S. CEO made $14 million in compensation in 2005. As an expense item, compensation to senior management reduced corporate profits by over ten percent last year. In 1998, CEO Michael Eisner took home $585 million form the Walt Disney Company. In 2002, CEO and founder Larry Ellison took home $735 million from Oracle, Inc., mostly from exercise of stock options and sale of the stock. Across the board, the stock options “overhang” (options granted but not yet exercised by senior executives) is said to be equivalent to 14% of shares outstanding.

As if those numbers did not speak loudly enough, Corporate America has recently had to bare – or bear – yet another scandal, involving stock option grants to senior managers, mostly CEOs. So far, beginning with Summer 2006, over 130 public corporations, Corinthian included, have confessed to backdating stock option grants so as to increase the “take” by upper echelons of management. A subset of corporations admits to having “spring loaded options,” timing grants of options to just before corporate announcement of material favorable developments, likely to spike the price further. So far prosecutors have brought criminal charges against 5 corporate executives. The average take is estimated at $1.3 million to $1.7 million per grant manipulation.

As the principal element of long term compensation for their executives, corporations grant options to purchase the corporation’s stock (salary as the short term and annual bonus as the medium term currently are the two other principal elements of executive compensation). The price at which the options are exercisable (the “strike price”) has to be at or near the current market price. In such a case (the vast majority of cases), the option is thus “qualified,” meaning that, although the executive has received an element of compensation at the time of receipt, any income and payment of income tax is deferred to the date of sale in the stock market (following exercise). The executive’s contract may vest options only over several years (say, 200,000 per year over 5 years, beginning with the first anniversary of employment) and contain performance hurdles as well (for example, increase in sales, increase in profits, etc.)

So if the executive has 100,000 options, with the a strike price at $20, and two years out the stock price has reached $40, she might exercise them. She pays $2 million, receives the shares, sells them in the market for $4 million, and pockets $2 million. The $2 million is a longer term reward for a job well done, or a rising stock market, or both.

As if that were not enough, a number of large corporations have come forward to reveal that they could not resist “gaming the system.” As noted, corporations backdated the options to a date when the market price, and therefore the strike price, was even lower, say, $10 in our example. Now the executive has a gain of $3 million rather than $2. One feels that CEOs, or advocates on their behalf, have played a role in all of this.

The consequences due to the discovery of backdating can be devastating. One large publicly held company announced that is will have to go back 10 years, restating financials for each of those years. It has also fired its chief financial officer (CFO) and its chief legal officer (CLO), presumably for not detecting the offenses. One suspects that there is a degree of corporate scapegoating going on. Fifty corporate executives, not all CEOs, have lost their jobs. Based up last year’s numbers (1,195 restatements, an all time high), option grant monkey business will account for 11 percent of 2006's restatements.

Needless to say, CEOs who benefitted from backdating and spring loading have been forced into resignation. Moreover, because financial statements have to be restated, and restatement is due to “misconduct,” under the 2002 Sarbanes-Oxley legislation the CEO and the CFO, whether or not implicated in the wrongdoing, have to forfeit all incentive based compensation (options proceeds, bonuses, etc.) for the past year.

What a fine mess all of this is, as Stan would say to Ollie. But options have been a little understood phenomenon for many decades. Many onlookers believe that options are an unalloyed good as they result in larger stock holdings by corporate managers, aligning the executives’ interests more closely with those of owners (viz., other shareholders). The foregoing may be true, especially in areas such as high tech and information technology in which, needing cash to develop ideas and products, corporations have substituted generous option grants for cash salary and bonuses. Experience shows that high tech entrepreneurs, such as the founders of Google, put less value on immediate cash compensation, compared to main stream corporate executives. Many keep their shares.

With most U.S. corporations, however, the popular belief does not accord with senior executives’ practices at all. Options and the stock obtained by exercising them do not tie managers to companies, or align their interests with those of other owners, for the simple reason that common practice is to sell the shares in the stock market right away. To take the example above, the executive would first borrow the $2 million exercise price from her bank, which puts some pressure on her to re-pay the loan. If she then sells the 1000,000 shares obtained, she will receive $4 million, enabling her to re-pay the loan and related transaction costs of, say, $2.1 million. She also must make income tax payments of, say, 35 % of the gain, or $700,000, more or less. She then spends the $1.2 million obtained on re-modeling the kitchen (which will cost more than the house originally did) and purchasing new Mercedes Benzs for her and her spouse.

This usual scenario may be subject to further abuse. At Enron, CEO Ken Lay made $200 million exercising options without ever going to the bank. He received his loans from the Enron treasury, also known as "Ken Lay’s ATM." He repaid the loans with Enron stock, thus enabling him to delay for up to 12 months disclosure of his exercise of options.

Palliatives suggested have include
d imposition of a holding period. The executive would have to hold shares received pursuant to the exercise of options for 1 year prior to selling. Another palliative long suggested has become de rigeur. Accounting principles now require corporations to expense (count as a cost) the cost of options at the time the corporation grants them. Using the "Black-Scholes," the aptly named "Monte Carlo," or other formulae, the corporation can guesstimate the options’ value, usually at 15-20 % of the stock’s market price. Generous use of options, and the according deductions, can result in a reduction in profits, especially for high tech and Silicon Valley enterprises who have historically used many options. Now that corporations must make a deduction the number of options granted has declined moderately.

Of course, the real cost to the corporation of stock options comes at exercise, not when they are granted. Instead of selling the shares in the market for cash, the corporation must give them to the executive who has exercised options. The difference (the market price foregone less strike price received) is a very real opportunity cost for corporations. The momentum, and the adoption of a governing accounting principle, however, opts for expensing options at the time issuing corporations grant them, ending any debate for now.

In registering option grants, U.S. corporations have always had a number of choices. They could list grants chronologically: last to first, or first to last. Or they could list them by size of grant: smallest to largest, or largest to smallest. Now, or so the events of the last several months reveals, they can list them by legality: illegal to legal, or legal to illegal.

Douglas M. Branson holds the W. Edward Sell Chair in Business Law at the University of Pittsburgh and is the author of Corporate Governance (1993). His newest book, No Seat at the Table, about the dearth of women directors in the Fortune 500, will be published by NYU Press in December.

Opinions expressed in JURIST Commentary are the sole responsibility of the author and do not necessarily reflect the views of JURIST's editors, staff, donors or the University of Pittsburgh.