The Victims of Options Backdating

Sam Gustin, it turns out, contra my earlier assertion, does know who the victims of options backdating are after all. They're Mr and Mrs Investor Confidence, and apparently they're both "nebulous" and also "a pillar of the market system".

Which is all fine and good, except for one thing: there's no evidence that the options backdating scandal had any impact on investor confidence whatsoever. Indeed, investor confidence steadily improved all the way through the months that the scandal was unfolding, and only really started falling apart at roughly the same time that everybody pretty much forgot about it.

I'm afraid that Gustin, here, is falling victim to a common fallacy: the idea that where there's a crime, there must be a victim. And that if there's no obvious victim, there must be a "nebulous" one instead.

At the most basic level, I suppose that's true. A crime is a violation of the law, and every violation of the law reduces the public's faith in the lawfulness of society, or something like that. But it's all very theoretical and ex ante. Ex post, on the other hand, there really isn't any indication that society or anybody else has been harmed to any significant degree by options backdating.

Remember (and I've said this before, but it's worth repeating) that options backdating isn't illegal. Insofar as any crime has occurred, it's a question of companies not reporting something they were meant to report, either to the IRS or to their shareholders.

Which means that Gustin's being very unfair when he accuses boards of "rigging" options grants, and "exploiting their insider status". In reality, the boards did exactly what boards were meant to do: they decided on a compensation package for their senior executives. One part of that compensation package was a certain number of options with a certain strike price, and there's nothing unusual about that: options grants are SOP in contemporary executive compensation.

So where's the scandal? Simply and only here: that the board meeting was not held on a day when the share price was the same as the strike price, but someone at the company made it look as though the board meeting was held on a day when the share price was the same as the strike price.

Now at this point I think Sam and I part company. My view is that in most of the backdating cases, the number of options and the strike price would have been exactly the same if they had been reported accurately. Here's David Harper:

I think what some people don't understand is that a lot of these backdating gaffes were (irresponsible, for sure) simply oversights. I saw it many times; e.g., company intends to make a grant on Jan 1st, delays ensue, tries to backdate merely to stay on the original plan.

My guess is that Sam, on the other hand, reckons that the companies would never have wanted to admit to granting in-the-money options, and that therefore the strike price would have been higher.

But here's the thing: even if the companies had awarded options with a higher strike price, that doesn't mean the executives would have been less well remunerated. Why? Because compensation comittees generally work backwards from a value. They decide that they want to award an options grant worth $1 million, say, and then they calculate how many options that should be. So if they had awarded options with a higher strike price, chances are they would just have awarded more of them.

In a couple of the most egregious cases, there was outright fraud aimed at deceiving shareholders and the taxman in order to illegally line the pockets of senior executives. But in the vast majority of the options backdating cases, the only fraud was that options were reported as at-the-money when in fact they were in the money when they were awarded. And shareholders really don't care whether options grants are at the money or in the money, all they care about is how much they're diluted. Which is why this particular crime is so close to victimless.