The real options-backdating culprits

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Almost every day there’s another one, a top executive thrown out of his job for backdating options. These are some otherwise perfectly respectable people we’re talking about: William McGuire at United Health, Shelby Bonnie at CNET, Andrew McKelvey at Monster. Even Apple‘s Steve Jobs has gotten tangled in the backdating web, although there are no signs that he’ll lose his job over it.

When supposed wrongdoing is this widespread, one can’t help but wonder: Are there really this many willful rule-breakers in corporate America, or did somebody change the rules on these guys in midstream?

I’m tempted to lean ever-so-slightly toward the second answer. What was done was clearly against the rules, but those rules were until recently treated with such disdain in the business world and even by many investors that it’s perhaps understandable that so many executives saw no harm in breaking them.

First, a brief explanation of options backdating: Say your company’s stock is trading for $15, and it gives you 100 options–expiring in 10 years–to buy that stock at $10 a share. So far, so good. As Holman Jenkins argued in The Wall Street Journal last week (not available online unless you have a financial relationship with Dow Jones & Co.), there’s nothing intrinsically wrong with giving employees’ in-the-money options. It’s just like giving them restricted stock, or cash.

What’s wrong is reporting in a company’s financial statements that the $10 options were granted at some time in the past when the stock happened to be selling for $10 a share. Until this year, options priced at the money (that is, with the stock trading for $10, you get an option to buy a share for $10) were considered free for accounting purposes–while an option granted in the money (with the stock at $15, you get an option to buy it for $10) was counted as a compensation expense.

This accounting distinction was of course entirely loopy. When last I checked this afternoon, United Health stock was trading at $48 a share. Meanwhile, an option to buy a share of United Health for $50, expiring in Jan. 2009, was selling on the American Stock Exchange for $10. That is, even out-of-the-money options have value.

In 1993, after long deliberation, the members of the Financial Accounting Standards Board–the people who determine what constitutes a General Accepted Accounting Principle–acknowledged this truth with a proposed accounting standard requiring that all employee options be valued with one of the mathematical models widely used in the options-trading world (the Black-Scholes model or the related binomial model).

Then all hell broke loose. In what should go down as one of the most shameful episodes in modern business history, corporate America bullied FASB into backing down. Silicon Valley was loudest in its opposition, but all the big business groups joined in. Joe Lieberman was enlisted as the chief hatchet man on Capitol Hill (his more vocal allies included Bill Bradley, Barbara Boxer, and Phil Gramm), sponsoring a 1994 resolution–which passed 88-9–urging FASB not to change accounting for options, and making threatening noises about effectively shutting the board down if it didn’t comply.

There were and still are valid objections to the method FASB proposed for valuing options. It takes a fleeting estimate–the valuation set by the Black-Scholes or binomial model on the day the option is granted–and sets it in earnings-statement stone.

But you can’t make a serious accounting case for treating options as free, which is what most of FASB’s opponents were after. So they couched their argument in economic terms: By motivating employees and aligning their interests with shareholders, options were promoting economic growth. Expensing options would thus hurt the economy, which made it a bad thing. The same argument can be made about expensing cash paychecks, of course, but that didn’t seem to bother anybody at the time.

This victory of politics over accounting logic had consequences. As Warren Buffett, a lonely voice in support of FASB back in 1994, told me in 2002: “Once CEOs demonstrated their political power to, in effect, roll the FASB and the SEC, they may have felt empowered to do a lot of other things too.” Buffett was referring to the accounting shenanigans at Enron and Worldcom, but the connection to the options backdating scandal is much more direct.

After the Enron and Worldcom meltdowns, the political climate shifted. More and more companies began expensing options voluntarily, and in 2004 FASB finally pushed through its rule. Starting this year, all options granted to employees have to be expensed.

But the backdating offenses coming to light now (thanks to the work of University of Iowa business school professor Erik Lie) almost all predate 2002. They were committed back in a day when virtually every significant business organization in the country was arguing that options shouldn’t be expensed, a view endorsed by the Big Six accounting firms (yes, there were six back then), Congress, and even a lot of big money managers. In such an environment, it wasn’t all that out of line for the people at United Health and CNET and Monster and Apple and Comverse and Broadcom and Brocade to think tweaking the grant date of an option was a mere technicality.

I am not saying don’t blame them, blame society. I’m saying blame them and society–society in this case consisting of the American Electronics Association, the Business Roundtable, the big accounting firms, Joe Lieberman, you name it. The guilt is shared pretty widely here.

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