Greed, Not Firms’ Well-Being, Was Motive for Backdating

The San Jose Mercury News recently published my op-ed piece on the recent criminal conviction of Greg Reyes, the former CEO of Brocade, for securities fraud in connection with options backdating.  The op-ed runs as follows:

Greed, Not Firms’ Well-Being, Was Motive for Backdating

In a recent high-profile trial, former Brocade CEO Greg Reyes was found guilty of criminal securities fraud arising from options backdating.  Many pundits have questioned whether criminal charges were appropriate.  They argue that Reyes, like other CEOs caught in similar scandals, did not personally benefit from backdated options.  According to The Economist, for example, Reyes “made no financial gain from backdating.”  Rather, Reyes–like other backdating CEOs–manipulated option grant dates just to attract talented employees.  But the view that options were backdated solely to benefit the firm, and not to enrich executives, is absurd.

A stock option gives an employee the right to buy the firm’s stock at some point in the future by paying the option’s “exercise” price.  The lower the exercise price, the more likely it is that the option can be exercised profitably and the larger the profit will be.  In almost all employee options, the exercise price is set to the market price on the grant date of the option.  The main reason: Until recently, such options did not have to be recorded as an expense against the firm’s reported earnings.  In contrast, options with a lower exercise price–one below the grant-date price–had to be expensed, just like cash salary or bonus.

Option backdating enabled Brocade and other firms to offer lower-priced options disguised as non-expensed options.  Reyes, with the benefit of hindsight, picked a day when the stock price was much lower than on the actual grant date.  He then pretended that the options were granted on that hindsight-chosen date, and set the option price to that date’s low price.  So Brocade awarded options whose exercise price was below the market price on the true grant date, while accounting for the options as if they had been issued at the grant-date price.  The result: The options were not expensed, boosting Brocade’s reported earnings.  The Reyes jury concluded that this deception constituted securities fraud.

Were Brocade and other companies forced to engage in secret option backdating to recruit top-tier workers?  No.  Had firms wished to openly award lower-price options to their employees, they were free to do so.  To be sure, these options, like the workers’ cash salaries, would have had to be expensed, but that would not have prevented firms from attracting high-quality workers.  Employees care about how much they are paid, not how their compensation affects reported revenues.  No worker has ever turned down a cash bonus because it has to be expensed.

So why, then, did Reyes and other CEOs engage in option backdating?  Because it enabled them to directly and indirectly boost their own pay.  Over a million of Brocade’s backdated options ended up in Reyes’ own hands.  True, the criminal charges against Reyes focused on his backdating of other employees’ options.  But the government’s civil complaint against Reyes shows he also personally received backdated options, including an October 2001 mega-grant of 1.2 million options.  The backdating appears to have lowered the exercise price on the mega-grant by about 50 percent.  This manipulation boosted the value of Reyes’ compensation in 2001 by millions of dollars, none of which was reported to shareholders.

While boosting his actual pay, the backdating of the 2001 mega-grant also enabled Reyes to hide a large amount of his compensation that year.  Brocade disclosed this grant to investors in its 2002 proxy statement, indicating that the exercise price was set to the grant-date market price.  Using this information and a standard formula for calculating option value, analysts tabulating Reyes’ 2001 compensation valued the option grant at $13.2 million.  Had Brocade provided accurate information, the option grant would have been valued at $28 million.  By camouflaging around $15 million of his compensation, Reyes reduced the likelihood that shareholders would find his pay excessive and pressure the board to reduce it.

Even if Reyes had not received backdated options himself, Reyes gained indirectly by backdating other employees’ options.  Much of CEOs’ bonus pay is tied to reported earnings.  So is the price at which executives can unload their stock.  The firm-wide backdating of options jacked up earnings, and the amounts involved were not trivial.  Backdating firms have so far acknowledged over-stating earnings by an aggregate of more than $12 billion.  These inflated earnings, in turn, enabled CEOs like Reyes to fatten their bonuses and increase their profits from selling shares.

The fact that backdating CEOs lined their pockets does not mean that criminal prosecution against them is necessarily warranted; civil liability may be more appropriate.  But one cannot determine the right legal remedy for backdating without a clear understanding of why it occurred: CEOs backdated options to directly and indirectly inflate their own pay, not to benefit their firms.

Editor’s Note: The Reyes case is just one example of the implications of option backdating for firms, regulators, directors, and CEOs.  Lucian Bebchuk, Yaniv Grinstein, and Urs Peyer have described the broader backdating trends in Lucky CEOs and Lucky Directors, which examine the likelihood that CEOs and directors of about 6,000 firms backdated options over a recent 10-year period.  The authors summarized their findings in a December 2006 Financial Times op-ed urging that backdating “deserves all the attention it has been getting and more.”