Wednesday, May 31, 2006

Backdating of Options

Do you believe options were purpously backdated so that top executives could get rich at the expense of shareholders? ---see WSJ article Monday, May 22

Top executives are granted options ---the right to buy the underlying stock at a determined "strike" price--- to align their incentives with the shareholders': managers gain from these "call" options if the stock price is grater than the strike price by pocketing the difference between the two. Thus, they have the incentive to increase the value of the company. When options are granted, the strike price is usually equal to the price of the stock on that day. That is, the option is at the money.

Does an option at the money provide a good incentive? From the executives' side, what if the price of the stock drops from the strike price for reasons beyond their control. What if some shock affects the entire industry or the economy and as a result the share price drops despite the managers' best effort?
Or, the current price at the time of the grant could be "abnormally" high, so that some downward adjustment is expected by the board.

It would seem that in these cases, aligning managers and shareholders incentives would call for a strike price lower than the stock price at the time of granting: the option should be in the money.

But, under accounting rules that were long in effect until recently, issuing a below-market option would trigger extra compensation expense, reducing a company's net income. By granting options at the same price of the stock, until recently, a company could avoid expensing options completely, thus not affecting earning figures.

Given accounting rules, and the importance of meeting or exceeding earnings expectations, backdating seems an easy way to grant options with a lower strike price without the need of expensing them. So, it's very possible that some or much of the backdating is another form of accounting schemes to improve the earning outlook of a company. This possibility should be one more reason to favor the expensing of stock options by corporations.