Why all the backdating? Because CEOs think investors are ninnies (and they’re partly right)

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A while back, I wrote that the prevalence of stock-option backdating could be explained in part by the fact that hardly anybody took the accounting rules governing stock options seriously:

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.

I still believe that, but after reading today’s W$J article about companies that backdated options so they appeared to have been granted just after Sept. 11, 2001, I have an additional theory. It’s not just that lots of executives held the options rules in disdain; lots of them held (and hold) outside shareholders in disdain as well.

Bear with me, this isn’t some kind of shareholder-power rant. Outside shareholders deserve to be held in disdain. I mean, what do they know? The professionally managed funds (mutual and otherwise) that dominate the stock market hold on to stocks for, on average, less than a year. To quote a 2005 Financial Analysts Journal article (abstract here) by Al Rappaport, the (semi-) retired Northwestern University accounting professor who coined the phrase “shareholder value” back in 1981:

The shorter the holding period, the more the beliefs of others rather than long-term fundamentals become central to investment decisions. High turnover thus sets the stage for short-term earnings-based decision making or momentum-motivated trading, which is not at all concerned with earnings.

In other words, the bulk today’s investors are ninnies. And so the best-run companies are those where executives don’t pay much attention to the harping of the fund managers and the analysts or the day-to-day (or even month-to-month) movements of stock prices. Think Berkshire Hathaway or (maybe, although the track record is still pretty short) Google.

The puzzle is how to keep that disregard for the short-run opinion of outside shareholders from getting in the way of the long-run goal of increasing the value of the company. Giving employees options that are already in-the-money (that is, the stock price is $20 and you give options to buy that stock for $10) is arguably in keeping with the long-run goal of value creation. Yes, it potentially cuts into the share of the company’s cash flow available to outside investors. But if it’s used to keep valuable employees on-board and motivated during tough times, it’s worth it. And make no mistake, lots of those backdated options, at least at tech companies, went not to CEOs but to engineers and others well down the corporate totem pole.

The problem with backdating as practiced in the late 1990s and early 2000s is that it amounted to granting in-the-money options and then lying about it to outside shareholders in order to avoid accounting complications. That was over the line. But treating shareholders with a certain amount of disdain? That’s just good business.