PUBLIC RADIO'S MARKETPLACE COMMENTARIES:

Back-Dating the SEC (Update)

Robert B. Reich

Marketplace, July 20, 2006

More than 60 companies have disclosed investigations, including 40 grand jury investigations, into whether they’ve back-dated executive options to coincide with days when their stock prices were low. And a raft of shareholder lawsuits have been filed. At least 17 people have been fired or quit in connection with the unfolding scandal.

One lawsuit, for example, alleges that Apple Computer backdated stock option grants to 14 current and former officers, dating each grant just after a sharp drop and just before a substantial rise in Apple’s stock price.

What’s the big deal? Just this. If Apple or any other company back-date options for when share prices are especially low, executives who exercise the options get a windfall. They can buy shares at that extra-low price and then sell them after their price has risen. Seems unfair, right? Like insider trading, or outright stock manipulation, or worse.

Christopher Cox, chairman of the SEC, says the agency is poised to bring the first option-backdating case. But it’s unclear exactly what the SEC will find to be illegal. Cox says forging documents and lying to corporate directors and shareholders about option grants could be the basis of criminal as well as civil charges. But Cox’s fellow SEC commissioner, Paul Atkins, argued in a recent speech that companies that manipulate the timing of their executive options may not even be guilty of violating the securities laws to begin with.

According to Atkins’ logic, back-dating executive stock options, or timing them so they can be exercised just before the company issues a positive quarterly earnings report that raises share values, does create a windfall for executives. But precisely because of this windfall, companies are able to compensate their executives more cheaply. They can issue fewer stock options or provide lower salaries. So by timing stock options this way, companies end up saving money, and investors pocket the savings. Get it?

Extending this logic, Atkins' argument would seem to make back-dating completely legal. Back-dating creates a huge executive windfall, which means companies can get by with even lower executive compensation costs.

But this logic completely ignores the purpose of executive stock options in the first place. They’re supposed better align executive incentives with the interests of investors – inducing executives to work harder to raise share prices.

Yet stock options have this effect only if executives don’t know what their option will be worth in the future. If they can go back in time and pick a date when the share price was especially low relative to what it is now or will surely be when a positive quarterly earnings report is issued, the incentive disappears because the future is no longer the future. It’s the past.

If the incentive that’s supposed to be in a stock option disappears, shareholders are worse off. More stock has been issued, which dilutes the value of their own shares. And they get nothing in return. Anyone who believes companies will reduce executive compensation by the inflated value of a stock option has not been paying much attention to what’s happened to executive compensation in recent years.

So will the SEC follow Commissioner Atkins’ illogic? I don’t know, but when I find out I’m going to back-date my answer to make it sound as if I knew all along.