Wednesday, September 13, 2006

David Walker on the Option Backdating Scandal

_mg_4681 David Walker posted on SSRN today an essay entitled Some Observations on the Stock Option Backdating Scandal of 2006.  One of his suggestions: consider replacing options with simplified long-term incentive programs that are less susceptible to manipulation, such as tying compensation to gains in yearly average share prices.  Here's the abstract:

The corporate stock option backdating scandal has dominated business page headlines during the summer of 2006. The SEC is currently investigating more than seventy-five companies with respect to the timing and pricing of stock options granted during the boom years of the late 1990s and early 2000s, and the number of firms caught up in the scandal seems to increase every day. This essay contributes to our understanding of the backdating phenomenon by analyzing the economics of backdating and the characteristics of the firms under investigation. Its main points are the following: First, given the high volatilities of the stocks of the technology companies that dominate the list of firms under investigation and the fact that options granted to executives and employees typically may not be exercised for several years, press reports that focus on the size of the strike price “discounts” achieved by backdating significantly overstate the value of backdating. In some cases, reducing the strike price by a dollar per share by backdating increased the Black-Scholes value of the option by less than twenty cents per share. Second, completely unnoticed in the discussion so far is the fact that in many cases backdating dramatically reduced the apparent value of options. Because the size of executive stock option grants often is determined first by establishing the value to be delivered and then by calculating the number of shares to be covered by the option, reducing the apparent value of option shares may have substantially increased the size and true economic value of backdated executive option grants. Third, comparison of semiconductor firms under investigation for backdating with peer companies that are not suggests an association between backdating and the use of options in compensating non-executive employees. This essay considers several explanations for backdating non-executive options, including share limitations, minimizing apparent rank and file compensation, and cognitive biases. Finally, this essay argues that the backdating phenomenon is really not an accounting scandal. Backdating has accounting consequences, but it is unlikely to have been accounting driven.


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Comments

ISS, the Institutional Investors Service, has put together a wonderful overview of the options backdating scandal. What I find very egregious is the way some of the companies have exploited investors - particularly technology companies - by fattening the wallets of executives at the expensive of individual investors.

High Tech Executives Create Volatility In Their Stock to Enable Options BackDating

Posted by: Mr Wave Theory | Sep 18, 2006 3:38:15 AM

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