Backdating Options Reward Mediocrity

Many companies are in the net for taking the backdating options route; a move that actually sends out a wrong message to all their employees

Agorgeous woman slinks up to a CEO at a party and through moist lips purrs, “I’ll do anything — anything — you want. Just tell me what you would like.” With no hesitation, he replies, “backdate my options.”

So goes a new rendition of the jocular tale that Warren Buffet used in his annual letter to Berkshire Hathaway Investors a few years ago. In a fit of blatant pandering, boards have acted foolishly to give top management an unearned perk. More than 100 companies are under investigation for charges related to backdating executive stock options. Executive departures related to backdating have already taken place at Apple Computer Inc., software firm Comverse Technology, computer-security firm McAfee, CNet Networks, and the UnitedHealth Group. Who will be next?

The most dramatic is the case of Dr. William W. McGuire, a medical entrepreneur who built the UnitedHealth Group into a colossus. He was forced to resign from the company recently and forfeit a portion of the US$1.1 billion in stock he holds.

Stock options give executives, or other workers, the benefit of buying stock at the price it was sold one time — the exercise price — and then selling them for a presumably higher price based on the company’s successes, where the workers and executives presumably contributed. Companies that backdate their options select a date for the option that is often earlier than when the grant is made. This allows them to choose a date when the value of the option is more favourable to the employee receiving it, inflating executive payouts when the options are exercised.

I realise their temptation. I am on the board of a public company (TWL Knowledge Group) that offers stock options to board members and executives. Just last month, I received some stock options and the transaction was appropriately filed with the SEC. The value of the options was determined by the stock price on the day of its granting. By sheer bad luck, the stock price was down on that day. A week earlier and my options would have had more value. So what do you do?

The option backdating story broke several months ago when the Wall Street Journal looked at companies’ grant dates for executives and found that in several companies, these usually took place on days when the stock price was much lower than normal, and in some cases, these occurred on the day when the stock was at its lowest for whole fiscal year. The WSJ calculated that the probability that these grant dates were selected by chance was extremely low, with the odds in some cases being 1 in 6 billion.

At UnitedHealth, there was strong evidence that options were backdated for employees between 1994 and 2002. It’s not surprising that Silicon Valley is ground zero for the stock options fiasco. It developed an entrepreneurial culture that held up stock options as the best way to get rich quick. John Coffee, director of the Center on Corporate Governance at Columbia Law School, calculates that approximately 29 per cent of all companies between 1996 and 2005 manipulated or backdated their stock options in at least one or more cases.

The practice of secretly backdating options hurts us all — it cheats all investors and undermines public confidence in the capital markets. The irregularities are far-reaching. They may force the companies to erase reported earnings, which will turn years of profit into an illusion. Perhaps, most important of all, backdating options sends out the wrong message to every employee. Stock options were meant as rewards for actual performance. It is hard to hold non-executive employees to standards of excellence when their leaders are patted on the back for mediocrity.

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