As noted earlier here, the mainstream media-driven scandal over the fairly common practice of backdating stock options has been more about demonizing the unlucky businesspeople who engaged in the practice more than anything else. Inasmuch as there is nothing inherently illegal or damaging financially to granting backdated stock options, the real issue has always really been whether the company granting the backdated options disclosed them properly.
Unfortunately, the proper perspective toward that non-disclosure issue has been overwhelmed amidst the demonization of the backdating practice by mainstream media and avaricious prosecutors, many of whom did not bother to learn about how backdating options can be a legitimate tool to provide incentive to key employees. To this day, even many businesspeople and professionals who I talk with don’t understand backdated options. One can only imagine the level of confusion among the vast majority of American citizens who probably equate a backdated option with a backdated check.
The sad part about all this is that backdated stock options are really quite straightforward. Traditionally, management has provided key employees “at-the-money” options — that is, the option to buy stock at the price at which the shares are trading on the day the option is granted. Thus, if the share price goes up, then the key employee makes money. On the other hand, if the share price goes down, then the key employee makes nothing on the options.
But “at-the-money” options aren’t the only type of options. There can be “out-of-the-money” options or “in-the-money” options, and each type of option serves to provide a different type of incentive for key employees. If a key employee is granted out-of-the-money options, then a small increase in the share price won’t allow the employee to make any money on their options. Rather, it’s going to take a large increase in the share price for the employee to make money on the options. However, that large increase in share price can be very profitable for the employee — a grant of $100,000 in out-of-the-money options is much more valuable if there is a substantial increase in share price than a grant of $100,000 in at-the-money options would be under the same circumstance.
On the other hand, consider “in-the-money” options. These options continue to have value to the key employee even if the share price decreases slightly (because they are still “in-the-money”). But if the share price goes to hell in a handbasket, the options lose their value completely.
So, the different types of options provide management with flexibility in tailoring differing incentives depending on the circumstances that a company faces. A key employee with out-of-the-money options has incentive to take big risks because the only way that those options will become valuable is if the share price rises dramatically. On the other hand, a key employee with in-the-money options has little incentive to take big risks; rather, he wants to prevent the share price from falling because that’s the only way the options can lose their value.
Backdated options are simply a form of in-the-money option. Inasmuch as in-the-money options are a legitimate way to incentivize key employees, what’s the big deal about backdated options?
Well, there are different tax implications to these types of stock option grants, but whether there is any clear tax benefit from backdating options is far from clear. Heck, how many executives who were involved in backdating options based their decision on the tax implications of the grants? Probably not many. For years, accounting firms advised companies that, so long as the options were issued with formulaic pricing, then backdating the options was not a problem from a tax standpoint. Thus, for example, where companies granted options priced ìat the lowest trade date in the month granted,î accountants would routinely advise the companies that these were at-the-money options that need not be expensed.
Moreover, just because backdated options are in-the-money options doesn’t mean that the company or its shareholders are losing money. Options are not a zero-sum game where someone wins and someone loses. If management decides to sell the company’s stock for $50 when the market price is $100, then that does not mean that the company is losing money. So long as the shareholders know about management’s option program and that the company is going to be required at some point to sell a certain number of shares at $50, the shareholders aren’t losing money, either. The efficient market will price the dilution into the share price. This point was reinforced late last week when U.S. District Judge Charles R. Breyer of San Francisco concluded in the sentencing phase of the backdating criminal case against former Brocade CEO Gregory Reyes that the government had failed to “quantify any amount of loss that can be attributed to Reyesí conduct” (see related Roger Parloff post; Peter Henning also comments on the ruling here).
Which brings us around to the disclosure issue. Some of these backdated options were either not disclosed at all or were disclosed with a public statement such as “no gain to the options is possible without stock price appreciation, which will benefit all shareholders.” As can be seen from the above analysis, such a disclosure is wrong or at least misleading.
So, the question is what should be done about such a bad disclosure? Professor Ribstein took the lead early on in the blawgosphere by noting that criminalizing such conduct was akin to using a sledgehammer where surgical precision is needed. In this recent post examining the deal in which former UnitedHealth Group executive William McGuire agreed to return $620 million in compensation to settle backdating claims, Professor Ribstein contrasts McGuire’s deal with what happened to Brocade’s former human resources director Stephanie Jensen, who was found guilty of two criminal counts relating to backdating options even though she did not personally benefit from them. “In one [case,] the chief executive and main beneficiary likely will walk away with hundreds of millions of dollars,” notes Professor Ribstein. “In the other, an underling who didn’t profit from the offenses likely will go to jail.”
And the foregoing disparity doesn’t even address the Apple Rule as it relates to backdating stock options.
The reality is that criminalizing the practice of backdating stock options was a bad idea from the beginning, the equivalent of mob violence against unpopular businesspeople. The result is more of what Professor Ribstein has coined the “corporate crime lottery” where the winners pay a fine or fade the heat entirely while the losers go to jail. Professor Ribstein concludes his recent post in with the following observation:

[The McGuire and Jenson] cases are only the most recent examples of the lottery in action. Not much is gained from criminalizing this conduct over the many remedies, including the corporation’s own right of recovery, available for any wrongs that occurred (mostly inadequate disclosure). But much is lost from the odor of injustice that wafts over these disparate results.

And as Peter Henning reports, that odor of injustice may include the prosecution’s use of false testimony to convict Reyes.