Some of my favorite bloggers (Ribstein, Josh Wright and Geoff Manne (aka TOTM) are rather harshly attacking Matt Bodie's recent post about options backdating. Matt believes that options backdating allowed executives to extract more pay than they would have otherwise. TOTM argues that prices (incl both stock market and labor market prices) are set by a mostly efficient market, so talk about "pay norms" is irrelevant and counterproductive.
Hmm. What would have happened if firms hadn't backdated? Would executives have simply left for competitors where they would get paid their market rate? Certainly not in all cases -- labor markets are sticky and lumpy. It's not costless to switch jobs, and a new job will have unique duties that may or may not match up with your current job. Options backdating wasn't just about recruiting or retaining talent. Sometimes it was about executives manipulating documents -- departing from shareholder-approved plans -- to maximize the value of their compensation.
I think Matt should be praised, not vilified, for raising the issue of norms. Still, TOTM is right that we need more precision for "norms" to have explanatory power. So let's talk about it and work towards precision, and I'm happy to refrain from calling anyone greedy.
Yes, market forces explain a huge chunk of executive pay. But other things (like institutional practices, path dependence, regulation) also matter. Moreover, market forces are better at explaining the amount of pay than the form of pay. What, then, are the implications of options backdating? Is it merely a technical footfault? A victimless crime? Or is it something we should be concerned about?
I'll be exploring options backdating in a new tax paper; what follows are my preliminary thoughts. Civil comments and feedback would be appreciated, on or off line.
Culture of Noncompliance. Options backdating matters not just because proper disclosure might affect the form and substance of executive pay (as Matt and those other zany folks like Christopher Cox and Jeffrey Gordon would argue) but also because the manipulation may reflect a culture of noncompliance. A company that is willing to violate one set of rules (however silly those rules may be) is more likely to violate other, not-so-silly rules. Options backdating is a perfect example of overly-aggressive regulatory gamesmanship. It not only violates accounting rules, but, in many cases, tax law. Say what you will about accounting fraud, but can one really call tax fraud a victimless activity? Am I guilty of fetishization of tax law because I expect companies to pay taxes?
And I don't think it's crazy to think that "technical" violation of rules matter. Lots of rules are ticky tack. Most of securities, ERISA, 40 Act, and corporate finance law, taken piecemeal, is ticky tack. But companies should comply with the law, and when they don't it's the sign of a potential problem.
The Reverse Willie Sutton Fallacy. Ribstein and TOTM are willing to dismiss the stealing-from-shareholders argument because an efficient market ought to be able to look through the accounting treatment. This is the reverse-Willie-Sutton defense: it can't be stealing if there isn't any money in the bank. (This reminds me of the immortal words of H.I. McDonnough (Nicolas Cage) in Raising Arizona, "Nawww, honey, it ain't armed robbery if the gun ain't loaded.")
The empirical evidence here is mixed (look for an upcoming paper from BU taxprof David Walker). Most accounting experts believe, contrary to what Ribstein and TOTM suggest, that accounting does matter, at least to some firms. The inflated earnings from options backdating, for example, allowed some firms to avoid violating debt covenants; it allowed managers with earnings-based compensation bonuses already in place to get higher bonuses. There was a little money in the bank, and some executives took what they could when they thought no one was looking.
Tax Fraud. Regardless of where you come out on accounting compliance and the stealing-from-shareholders debate, I fail to see a reasonable argument for dismissing the tax consequences of options backdating as a victimless activity.
[A brief tax primer: Section 162(m) requires that a corporation may take a deduction for compensation in excess of $1 million, with respect to covered employees, only if the compensation is performance-based. Companies normally take a deduction for the spread between the exercise price and strike price of an option. But options are performance-based -- and the deduction allowable -- only if "the amount of compensation attributable to the options ... would be based solely on an increase in the corporation's stock price" (Committee Report; see also the 162 regs). In the money options don't count, since the stock price could decline and yet still provide compensation to the employee. The Committee Report also notes that the maximum number of options that an executive may receive during a specified period must be predetermined.
In simple terms, then, the rule is that in-the-money or backdated options are not deductible with respect to covered employees. (I should note that if in-the-money or restricted stock grants are subject to performance-based vesting rules, it's possible that the deduction is okay. Vesting based solely on continued employment is not enough. See 1.162-27(e)(2)) Additionally, to qualify as performance-based, the material terms have to be determined by a compensation committee of outside directors and disclosed to shareholders prior to payment. (162(m)(4)(C)).]
In the typical case, then, it appears that companies that were backdating options were also violating the tax law. This is stealing from the government. (Or, if you prefer, stealing from you and me by depleting the public fisc.) In the best case, companies may have forgone the deductions in order to comply with the tax law, in which case they are guilty of bad tax planning, but not tax fraud. (From a tax perspective, in these cases it would have been better to provide more at-the-money options rather than fewer in-the-money options.)
Wherever you come out on the accounting debate, I fail to see how you can dismiss the scandal, as Manne does, by saying "There's just no harm in the practice." Regulatory compliance matters. Should all these executives go to jail? I doubt it. But ignoring the problem would be irresponsible.
The next interesting question in my mind, then, is whether, as I assumed above, companies that violate some rules are more likely to violate other rules. Common sense suggests that they are. Cf. Enron, WorldCom. On the other hand, companies like Google and Apple have violated some technical rules (remember the Playboy interview by the Google founders?) without big skeletons lurking in the closet. So what's going on?
Cultural Differences. My tentative theory is one of cultural differences. Some companies rely regularly on outside counsel for advice. These sorts of companies (Google, Apple, Microsoft) might make regulatory mistakes, but when they do, they fix them. They work within the legal system. They seek the advice of counsel. They conduct internal investigations. Other companies (Enron, Comverse) disregard the advice of counsel, sift through gatekeepers until they find the one with the answer they want, distort the information they provide to counsel, or simply act behind their backs. I suspect that options backdating, like tax shelters and other forms of regulatory noncompliance, cannot normally be accomplished with the assistance of informed and reputable counsel.
It's worth noting that, as with Enron, the tax fraud here was collateral fallout from the accounting gamesmanship. Any tax lawyer would have spotted the issue. So what happened? We're not talking about complicated corporate tax shelters that have some slim chance of success in the courts and are worth a lot of money to the company. We're talking about petty noncompliance, picking up nickels in front of bulldozers just because you think you deserve that extra nickel. As an outsider, I don't care who owns the nickel. It's the lack of judgment that troubles me.
What causes the cultural differences? That's a harder question. There's some anecdotal suggestion that tech companies were more likely to be cavalier. (On the other hand, they may have just had more to gain given the volatility of stock prices for these stocks; backdating was worth more to them.) The practices may have spread through networks of directors serving on comp committees, or the networks of executives demanding it. This is something I'll be looking into more carefully in the next few weeks as I work on this paper.
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