The Scandal of Options Backdating

One of the reasons Sam Gustin is underwhelmed by the Fake Steve Jobs book is that its author doesn't take options backdating seriously enough. It's "nothing short of an epidemic", he says, and "there is something slightly unfunny about basing a satire on the single largest corporate scandal of the past year".

Well, I'm not sure about that. I'd say the single largest corporate scandal of the past year was the way in which mortgage originators, having made millions of dollars in the housing boom by selling inappropriate mortgages to people who couldn't afford them and then flipping the paper to Wall Street at a profit, quickly declared themselves bankrupt or out of business when the mortgage market turned, thereby holding safely on to all of their earlier ill-gotten gains. That corporate scandal, as we are now seeing, is having enormous real-world repercussions in the form of bankruptcies, foreclosures, and even a possible recession. Options backdating? Not so much.

But Gustin is on the lookout for victims of options backdating all the same. He's not sure who they are, but he's sure they must be out there somewhere:

It’s easy to chalk the story up to yet another esoteric corporate-accounting scandal, but in the zero-sum game of stock market investing, for every ill-begotten dollar obtained through illegal backdating, there is a loser on the other side of the deal.

Stock-market investing is not a zero-sum game: in fact, it's probably the best example the world has ever seen of a positive-sum game. Stock prices generally go up over time, for all investors: if I buy Google shares at $200 and they go to $300, I might have made $100 per share, but there isn't someone else on the other side of the trade who is sitting on a $100 loss.

Derivatives are a bit different: traded options are a zero-sum game. But options issued by companies are not. If a company sells its stock for $200 when the market price is $300, that company is not losing money. And if its shareholders know the details of the company's option scheme, and they know that the company is going to have to sell a certain number of shares at $200 after a certain date, then they're not losing money either: all the dilution should be priced in to the stock price.

If there is anybody losing dollars from options backdating, it's Uncle Sam, and even that's debatable. As David Harper said on an earlier post about options backdating, "I don't understand how the IRS ever lost here; the gains are taxed one way or another."

Options backdating is bad because it involves senior management lying to shareholders. It's illegal, and it's deceptive. But it causes very little in the way of financial harm.