Yesterday, the SEC bought the first criminal charges against a Gregory Reyes, the CEO of Brocade Communications, the company’s CFO, and Brocade’s VP for human resources for options backdating. This is the first criminal action brought with regard to the growing option backdating scandal. The SEC also indicated that at least 80 companies are under investigation. On Wednesday, the Wall Street Journal had an article on how the big law firms are generating huge fees as companies prepare for investigations into their options practices. So, this seems like a good time to review what the problems are here.
There are two problems: lying and theft, as to be discussed after the break.
A primer on backdating is helpful: The shareholders of a corporation authorize paying executives with stock options. These options give the executive the right to buy the employer’s stock at a fixed price at a set future date. That price usually is the price that the stock is trading at on the day that the option is awarded to the executive. Customarily, the employee loses the option if her employment terminates before the option can be exercised. The shareholders usually authorize management to award options. The idea underlying options is that they give key employees an incentive to work harder — particularly to work harder to get the company’s stock price up — by letting the employees share in any increase in the value of the company.
With backdating, a company’s management grants options to an employee, say at year end, but pretends that the options were awarded at an earlier day when the company’s stock was at a lower value. This gives the employee an option to buy the stock at the old, low price on a day when the stock is trading at a higher price.
Which gets us to the lying.: The shareholders’ authorization was to grant options at the stock price on the award day, not on an earlier day. Thus, management had to lie (“backdate”) for these options to seem valid. Also, even under the old rules for accounting for stock options, the discount was accounted for as an expense (prorated from the grant day to the exercise day). Backdating hid this expense, making these companies seem more valuable. For example, in Brocade’s case, for 2002, proper accounting under the old rule turned the improper, originally-reported $68 million profit into a $951 million loss. (In some cases, the fraud also kept the companies from claiming huge, legitimate tax deductions, while hiding the employees’ tax liability.)
And then there is the theft: First, the employees were buying stock at unauthorized discounts. Second, the employees didn’t earn what they were taking. By the time the options really were awarded, services already had been performed. The options could not have incented the employee to work harder from the backdated day to the real grant day, as the employee did not own the option in this period, yet the employee got to enjoy any stock value run-up in value during this period. (The employee was with the company during this time and could well have contributed to the run-up, but the later-granted option played no role in motivating this performance.)
Some argue, including commentors to my earlier posts, that stock options cost nothing, as no cash is consumed, so that compensatory options really aren’t a problem. The same logic would suggest that if an employee was paid in gold there is no expense. Options are a valuable resource that the company otherwise could sell for cash, just like gold. The metaphysical weirdness that a company cannot own options on itself should not distract from the fact that options are every bit as much a resource as gold bullion. (An option is a contingent claim on a share of the corporation’s “real” assets.)
A related scandal is worth note. Companies granted a lot of options after 9/11, when the value of all companies was low. No fraud or theft was involved, per se. But, this practice still is troubling, as any run-up in stock values from 9/11 to a more normal economic climate reflected general market conditions more than the performance of the company. The executives were using company resources to bet on the economy as a whole, not to be incented to work harder. I do not know if any companies had to go beyond their shareholders’ authorizations to grant these 9/11 options.