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Wednesday, July 12, 2006

The WSJ: Still Wrong on Options

The July 12, 2006 Wall Street Journal contained a follow-up column by Holman Jenkins discussing reader feedback to his column from June 21, 2006 which downplayed the legal, financial and moral issues associated with the "backdating" of stock options granted to CEOs.

The original column and the follow-up column rejecting the criticism from WSJ readers about the first column both focused on one key point. Per Jenkins' rationalization, the option grant price is only one variable of many that dictate the value of an options package (the others being the vesting period, expiration date, number of options granted, and "exit" rules governing vesting in the case of the CEO leaving). Options themselves are then only one part of the larger compensation package (no kidding, larger…) paid to the executive.

He concludes his piece with the following statement:

None of this is to prejudge, in any given corporate case, whether backdating was designed into the compensation as a matter of policy or done so on the sly when the board thought it had signed off on something else. You'd want to note, however, that the systemic way many companies adopted a lowest price from the prior period does not betoken an obvious attempt to cover their tracks as if they believed at the time they were doing something improper.

Hmmmm. …as if they believed at the time they were doing something improper.

Once again, the timing of Jenkins' piece couldn't POSSIBLY better demonstrate the gap between the Journal's editorial board and reality. The top story on page 1 of the July 12, 2006 Wall Street Journal was:

SYCAMORE EMPLOYEES discussed how they could manipulate the dates of stock-option grants to make them more lucrative while keeping their actions hidden from the firm's auditors, according to an internal memo attached to a recent lawsuit. Separately, Monster Worldwide said it may need to restate results due to past options practices.

What everyone on the planet seems to understand except Holman Jenkins and the WSJ editorial board is that option grants are supposed to be a purely FORWARD looking compensation scheme aimed at aligning employee behavior with the long-term financial interests of the firm's shareholders. Altering terms of an option grant (ANY portion -- the grant price, the number of options, the vesting period, the expiration date) does not produce FORWARD looking incentives to the employee. Altering terms of a grant after the fact changes the compensation into BONUS compensation that normally rewards employees for PAST performance or hard work in challenging circumstances, etc.

Properly designed bonus and option compensation schemes for employees of large firms are CRUCIAL in establishing the proper balance between short term survival / tactical strategy and the long term health and growth of the company. Too much bonus compensation can encourage management to promote short term profits at the expense of long term product development, capital investment, etc. and destroy a company's future. Poorly structured options with too short a vesting period can produce the same behavior. Compensation plans with nothing but lucrative long term options but poor short term bonuses and mid-term options will inevitably produce lackluster performance or a mass exodus of the best talent.

In virtually every case that's come to light about companies which backdated options, the terms of the options package did not appear to be on some performance incentive "fence" reflecting a company making a judgment call about the trade-off between short-term and long-term performance of the company. Most involved CEOs already well compensated (over compensated?) who were granted additional "sweetheart deal" options timed around periods where the stock price jumped significantly. If the board wants to reward the executive for suddenly educating Main Street on the true intrinsic value of the company's stock, then FINE, pay them a bonus. However, don't claim the incentive was put out for the executive on some prior date, the executive met the challenge and delivered, and file accounting and tax statements furthering the fiction. Shareholders need to know whether the management team can consistently set meaningful goals and achieve them and monitoring "options" compensation is an important part of that process.

The boards of these firms are systematically distorting the information used to judge the performance of their executives and attempting to make the cost of the lavish compensation packages easier to swallow for shareholders by claiming the compensation wouldn't have been paid if the company had not been so incredibly successful. See? No downside cost to the company.

The problem is that anyone could become a billionaire trading stocks in some bizarre Land That Time Forgot by being able to select stocks based upon today's information using yesterday's prices. That's not the management problem executives are hired to solve. They are supposed to set the proper direction for the company and execute on that plan with no time-traveling "mulligan" to reset the starting point of their journey.

Backdating options is a complete, ethical and moral fraud. Unsurprisingly, though, I'm sure we'll find it's perfectly legal. What's even less of a surprise is that the Wall Street Journal is 100% in favor of the practice.