"Backdating Executive Stock Option Grants: An Agency Problem or Just Optimal Contracting?"

In a recent paper titled "Backdating Executive Stock Option Grants: An Agency Problem or Just Optimal Contracting?", the authors argue that backdating was a legitimate way to optimize compensation vs. management incentive, a rational response to enacted tax policy, and not a failure of the agency duties that management owes shareholders.

What about the fact that the shareholders didn't know what management was so graciously doing on their behalf, that it was against GAAP, and often involved fraud, forgery and illegality? The authors seemed to have missed those points, and focus on the economic rationalization for skirting the rules in the first place.

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"Therefore, issuing “at-the-money” options via backdating is an effective way to achieve a low strike price without suffering any tax or accounting disadvantages."

And an executive obtaining corporate assets via forgery is an effective way to achieve a positive net-asset position without the downside of any capital leverage or borrowing costs.

I am quite sure there is an economic justification for securities fraud. It's just that I'm not sure that rationalizing the economics behind the 'dishonesty' exculpates the underlying criminality.

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"This [agency] explanation treats the compensation packages as being exogenously determined. Once the packages are set, managers then backdate their option grants to increase the value of their option pay. However, why don’t shareholders adjust the whole compensation contracts, like offering less cash or less number of options, when their managers are backdating?"

Isn't that the whole point? No one knew that backdating was going on? (And to get semantic, no one COULD immediately know when an award was effectively granted, due to the nature of the backdating.)

One of the necessary assumptions of a free market is that the parties have necessary, relevant information. If shareholders don't know that that managers were getting backdated awards, how were they supposed to adjust salary down to compensate? A major purpose of most of the backdating is that it AVOIDED the public disclosure that in-the-money options would generate. Was this to fool the street about earnings, or the shareholders about total comp? I don't know.

Put another way: in 2006, how do you offer a lower salary for FY2003 because of knowledge recently obtained that in 2004 senior management caused backdated options to be granted to them as of 2003?

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"Consistent with our model, we find that backdating is negatively related with the CEO’s total annual compensation and his cash compensation. This evidence suggests that shareholders simultaneously grant less cash payment to CEOs when allowing them to backdate their option grants. What is more important, the total compensation cost is actually reduced in the presence of option backdating, which is contradictory to the view that backdating makes shareholders overpay."

Correlation doesn't equal causation. Another explanation could be that backdating occurred when managers felt they were being underpaid (low salary and/or prior options that are underwater), and rationalize the backdating as "only getting what I'm due anyway". That is a common occurrence in white collar fraud.

In addition, I take issue with the suggestion that shareholders ALLOWED executives to backdate option grants. I did a public-company stock option investigation, and in no way, shape or form did shareholders, or even most senior management, have knowledge that backdating was going on, much less affirmatively allowing it.

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"A legitimate question arises alongside our optimal contracting model. Consistent with increasing the executive incentive, why doesn’t the board of directors assign in-the-money options to the CEO instead of allowing backdating, so that there wouldn’t be any need to be dishonest with the investors?"

Isn't the silence an answer to the rhetorical question? Either the Board did know about the backdating (supporting the agency problem), or it didn't (which undermines the optimum contract model).

The Board didn't assign in-the-money options, because they were kept in the dark or actively lied to by management, or they wanted to increase the compensation structure without recognizing any additional expense. That's why they did it.

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"We show that allowing CEOs to backdate their options can lower their risk, and thus it can decrease the cost associated with compensating CEOs for bearing risk. In other words, managerial option backdating can reduce the total compensation cost imposed to the shareholders."

- Does the paper take into account the compensation expense that should have been recognized, but wasn't, for the in-the-money options that were granted?
- Does it include the costs associated with any investigation and/or restatement, due to the foreseeability of these potential issues?
- Does it include any long-term cost for the loss of an effective compliance culture focused on doing the right thing, in the right way? How much does it cost the company if senior leadership is viewed as not caring about fraud, ethics and governance? That expense won't be borne now, but will negatively affect the company over time.

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Source: Ideoblog