CEOs and Squeegie Men

Those of you who live in New York City doubtless recall how Mayor Rudolph Giuliani initially secured his reputation. The city was perceived to be out of control. Crimes, petty and not so petty, were rampant. Most people felt a bit anxious on the street at night. Couples, once they had children, decamped to the suburbs because they were safer.

Giuliani brought in a new police chief, William Bratton, who used a combination of innovative policing (putting more police on the street, shifting resources to neighborhoods that had higher crime rates) and the now-famous “zero tolerance policy.” Zero tolerance was based on the theory that petty crimes, like broken windows in vacant buildings and graffiti, were a potent sign that illegal behavior was tolerated, and could also feed an escalation of crime (the broken window could lead to trespassing which could lead to further vandalism and theft).

So the police also went after petty crimes, such as the notorious squeegie men, who’d come up to your car say, while you were waiting to pay a toll, clean your windshield, and then demand payment.

And it worked. The squeegie men and graffiti artists went into retreat, the city started to look better, crime went down, and residency and tourism soared. New York is now ranked as the safest big city in America.

So what do squeegie men have to do with CEOs? Well, we now have people who should know better arguing that supposedly petty crime, the equivalent of a squeegie incident, shouldn’t be pursued. And that supposedly petty crime (it isn’t even acknowledged to be a crime, but a mere scandal) is backdating by CEOs.

A recent post in Ideoblog. by University of Illinois law professor Larry Ribstein, argues that the CEO backdating scandal is overdone, that (without citing statistics) in some cases the amounts at isssue were small and the powers that be are criminalizing something that isn’t that big a deal.

Sorry, I don’t buy it. First, in some cases it is a big deal. By happenstance, shortly after this post, the Wall Street Journal provided an update, “Former KB Officials Face Backdating Probe” on KB Home:

Last year the Los Angeles-based company said an internal investigation found that Mr. Karatz had backdated his own option grants to increase his pay. He agreed to leave the company and forfeit about $13 million in gains from the backdating, becoming one of the highest-profile and best-paid CEOs to be forced out in the options scandal….Earlier this month, KB Home restated seven years of financials, reducing its profit by $41.1 million over the period to account for the backdated options and related taxes.

By any standards, these are material amounts and they have been material at some other companies too. Broadcom’s earnings reductions due to “options irregularities” were $1.5 billion. United Health’s case has yet to be resolved, but its CEO, William McGuire was forced to resign and give up options with a face value of hundreds of millions of dollars. At Comserve, former CEO has been charged with multiple counts of mail fraud, money laundering, wire fraud, and securities fraud, all related to options backdating. He fled the country and was finally caught in Namibia. Comserve has been unable to file its financials, and has therefore been delisted and removed from the S&P 500. The magnitude of these examples says the SEC is correct to be investigating.

But that isn’t what Ribstein would have us believe. The title of his post, “How the media produced the backdating scandal,” makes his position clear.

Let’s first remember the basic profile of these alleged misdeeds (alleged since many companies are under investigation). The companies in question are public companies. Executive option grants are a form of compensation that are are issued pursuant to a formal option plan approved by shareholders at the annual shareholder’s meeting. It’s common for these plans to require that the option exercise price be set no lower than the price at the time the options are granted. But in the cases where backdating occurred, the options grant documents were drawn up with an earlier date than the true grant date so as to give a lower exercise price (for example, the true grant date might have been October 1, when the stock was trading at $22, but a more favorable date, say August 30, when the stock closed at $19.50, was chosen instead.

Why does this matter? Well, first, the idea of these options was to motivate performance, to align their interests with that of the company. The recipients are supposed to earn any profits from them. But instead they are given a running start. Second, if the exercise price is below the stock’s current price, the option is deemed to be income to the executive. This creates tax and reporting issues for the company (not the case if the exercise price and the price on the issue date are the same). Similarly, the executive can obtain capital gains treatment if he exercises the options after a two-year holding period and also holds the stock a year; this treatment isn’t available if the options were issued “in the money.”

So how many types of fraud do we have here? Let’s see, shareholder fraud, accounting fraud, and tax fraud, all in the name of getting the CEO a little more (in some cases a lot more) compensation.

Nevertheless, Ribstein mounts a defense, citing some math from which in turn comes from

Consider that a $10-in-the-money backdated option has an exercise price of $90. Without backdating, let’s say, it would have been set at $100. Under the Black-Scholes option-pricing model, assuming a risk-free rate of a 5 percent return, the backdated option has a theoretical value only $1.80 higher than the non-backdated option. The backdated option with a 119-month term would be worth $68.88, while the regular option with a 120-month term would be worth $67.08.

He uses this example to argue the amounts gained by backdating are trivial.

It’s simply staggering how people who know nothing about options go fearlessly bandying factiods about (I happen to have had a top options trading firm as a client, one that regularly traded 5% of the NYSE’s total volume to hedge its book, so I do have some knowledge here). The example is complete and utter crap. First, even though most companies do use Black Scholes to price employee options, it is suffers from a huge number of shortcomings (it’s for pricing European options, which can be exercised ONLY at maturity, while employee options are American options, which can be exercised BEFORE maturity; it assumes the price of the underlying, in this case the stock, is normally distributed, when stocks have negative skewness; it assumes the option is freely tradeable, which it isn’t, and there is no allowance for the fact that the option has to vest), to the point where various employee groups have called for research into how to price employee options. About 350 companies instead use a lattice model, which is a variant of the binomial pricing approach used by professional traders for American options.

Second, even if you do use Black Scholes, the biggest uncertainty in pricing an option is the volatility, which is the assumed future volatility of the stock. Stress on “assumed” and “future”. That means an example per above is meaningless. You can’t make a blanket statement like that without discussing how the volatility assumption affects the price. It varies greatly between, say, a utility, versus a biotech company.

Third, and most important, even if the amount at issue in some cases were small, this doesn’t argue for giving a free pass. It’s saying that malfeasance is OK, as long as you are a big guy. That sounds ominously like Richard Nixon’s “If the President does it, it isn’t illegal.”

CEOs are where the buck stops. They have a duty of care, which means it is their job to assure that the shareholder’s assets are managed well and lawfully. That means, if anything, they should be held to a higher standard than your rank and file employee. If an employee embezzled $100,000 (the dollar plus option value above times say 100,000 options) he’d certainly be fired and would have to pay the money back. prosecuted. Why should a CEO get better treatment?

It is all too evident that we have two standards of justice in this country: one for the rich, the other for everybody else. Complacency about backdating just confirms how widespread this attitude is. It’s the squeegie man in reverse. Instead of the rule of law flouted at the bottom of the food chain, it’s disregarded at the top, and even worse, also attracts defenders. The squeegie men had no cheerleaders.

Now if this isn’t bad enough, the discussion devolves further (note the Carney that Ribstein cites is from DealBreaker):

Second, even the correctly disclosed figure is misleading because it only gives the value at the date of disclosure, not reflecting any later fluctuations.

The options are priced when they are dated, and future increases or decreases in the stock price don’t change that number. So the officially disclosed numbers have only a theoretical, best-guess, most-likely, pretty-much-ish relationship to what executives may actually make from their options.

Indeed, says Carney, “the urge to backdate is in part created by the “one-off” nature of this disclosure.”

Carney concludes:

[M]any companies found it irresistible to fudge a number that didn’t reflect actual values anyway. This doesn’t mean that fudging the numbers is okay but it does give us good reason to be skeptical about some of the hysteria over backdating. And, at the very least, to wonder whether this is really a matter for prosecutors and criminal trials.

To see whether it should be a criminal matter, Carney says, we would have to know whether the misrepresented values were material, and

something about the mindset of the people dating the grants. Were they trying to secretly smuggle more money to the executives without telling shareholders or were they backdating the options for more innocent reasons? Are there innocent reasons for backdating? Well, the fact that backdating seems to have been so widespread provides one innocent reason. If it was the standard industry practice, it’s easy to imagine that a compensation committee would assume it was acceptable.

Please. The issue is not accounting for the options going forward; it’s that the executives have engaged in some chicanery to get the options on terms more favorable to them. This is a transfer from the shareholders to officers of the company, and one NOT approved by the shareholders. How hard is that to understand?

And according to Former Corporate General Counsel, it’s reasonably likely that most comp committees weren’t in on this. The options grants approved generally specify the number of options. It isn’t likely that many were in on the mechanics.

And of all people, for a law professor to use “everybody was doing it (maybe)” as a justification is lame.

Lastly, he perversely cites Goldman Sachs, which hasn’t engaged in backdating, as a bizarre defense (quoting a different DealBreaker post):

Goldman, for example, doesn’t have backdating problems because, as Dealbreaker reports, “it has no shame. Blankfein and Co. just put it all right out there: our guys make more than everyone you know.” Goldman apparently doesn’t have to worry about media criticism of backdating. Firms that sell to ordinary consumers need to worry about the image they’ll get in the papers if they pay their people what the journalists view as “too much.”

The company that had the most overcompensated CEO for years on end was Disney, and the only reason Michael Eisner eventually stepped down was that he was listed repeatedly in Fortune as THE worst sinner, and the whole thing became hugely embarrassing. When I last checked, Disney, which persisted years on end with Eisner’s indefensible pay package, sold its products to consumers. Conversely, the companies with the most egregious problems to date, United Health, KB Home, Comserve, are hardly major household names.

No, the reason that Goldman doesn’t engage in this sort of behavior is that Goldman has long lived in a highly regulated industry. The firm is skilled in going up to the very edge, but not over the edge, of regulation. That’s why they haven’t engaged in this sort of behavior. They know breaking the law isn’t worth what it costs.

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