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Thursday, August 17, 2006

The WSJ: Three Strikes on Options

I've commented previously

The WSJ: Wrong, Wrong, Wrong
The WSJ: Still Wrong on Options

on the sheer lunacy of prior op-ed columns written by Holman Jenkins of the Wall Street Journal regarding options backdating and executive compensation. Since Mr. Jenkins last settled in for a pitch, the following events have taken place:

August 11, 2006 -- Juniper Networks announces that investigations into its accounting of options treatments indicate that none of its financial results prior to 1/1/2003 should be relied upon and that it will likely face de-listing by NASDAQ. (#1)

August 16, 2006 -- Geoff Tate, who already resigned as CEO of troubled Rambus, resigned from the board as well after the firm announced a week prior it would not be able to release its quarterly results on time, potentially leading to it being de-listed by NASDAQ. (#2)

August 17, 2006 -- Dell Computer announces an SEC probe into its revenue recognition practices the same day it announces a 51 percent drop in earnings for the same quarter last year. (#3)

Despite a torrent of reader feedback to the WSJ on his prior columns and despite more announcements of options related investigations and related financial chicanery since, Mr. Jenkins decided to step into the batter's box once again and take a swing at the options backdating issue in his August 16, 2006 column.

Let's see how he did.

POINT: The most recent indictments of officers at Brocade and Converse don't prove the CEOs were out to inflate their pay, only that document fraud and improper accounting were involved in an otherwise legitimate corporate goal. This is a restatement of a point from his prior columns that compensation committees primarily focus on trying to find the optimal incentive dollar amount to drive the desired executive behavior, then use the variables at their disposal (options quantity, grant date, grant price and vesting periods) combined with an estimate of future stock price to create that incentive.

COUNTERPOINT: WRONG. Jenkins basically believes that if these CEOs were intending to profit exorbitantly from the abuse of options pricing, the vast majority of their compensation would have been derived from the artificially cooked grant prices on these options. From his column,

Look at the Converse complaint: Of the $138 million in option profits collected by Kobi Alexander, a mere $6.4 million was the result of backdating.

Wow. A "mere" $6.4 million. I stand corrected.

If the owner of a home isn't smart enough to watch his house, a thief will come and go as he pleases using the front door, the back door, the garage door, or the sliding patio door on the basement walkout. In reality, these executives (and MANY executives) are equal opportunity thieves. They will take unwarranted compensation in the form of inflated salaries, artificially priced options, country club memberships, low-interest loans to their personal account and family members, you name it. Fudging the paperwork on the grant dates and prices just makes all the numbers add up in Excel to avoid or delay a tip-off that prompts someone to start asking questions.

POINT: A bird in the hand beats two in the bush. Jenkins argues that employees psychologically prefer options which seem to have some immediate value (e.g. options granted today at $4.00/share with the company stock trading at $5.00) rather than par-priced options (options granted today at $5.00/share). His example cites the fact that an employee will prefer 1000 options at $4.00 over 2000 shares priced at $5.00 even though the employee would come out ahead if the stock only goes up $1.00 to $6.00 since the employee is "ahead" the entire time until the stock reaches $6.00/share. He argues that compensation committees understand this and simply want to utilize that psychological factor when granting options to promote performance that grows the firm.

COUNTERPOINT: WRONG. Jenkins grossly overestimates the patience and long-term approach of the executives who profited most from these backdated options. I doubt if most of these CEOs really cared about the company stock price more than 2-3 years out (typically at the point where the first chunk of a grant begins vesting). They are in it for CASH in the SHORT TERM, PERIOD. Many stories have been written recently about the growing unease of the CEO that wears the crown, as boards grow more impatient during company slumps and sack executives with increasing regularity. There is a growing contingent of "mercenary executives" (management gypsies?) who profit handsomely by moving from one company to another for a 2-4 year stint, negotiating a nice exit package on the way in, sucking down a nice $200-$400k salary and enjoying a few perks and taking a few meetings at the 19th hole at Pebble Beach. If the company manages to tread water or improve a bit, that first chunk of backdated options starts paying off around year 3 or 4. If things go south, there's that exit package with a few lovely parting gifts and a year's salary to tide them over while they wait for a buddy to bring them in at another victim, I mean firm.

POINT: A flawed accounting rule encourages firms to issue options at par rather than below par. Jenkins' theory is that the compensation committees of all of these fine, upstanding companies sat down and carefully decided the optimal amount of likely dollar compensation they wanted to pay these executives based upon current stock price and expected future price to encourage the desired behavior, THEN AND ONLY THEN attempted to set a grant price to yield that amount THEN rigged the paperwork and grant date to make them par grants due to this accounting rule. In other words, that last little trick with the pen and the calendar was just a teensy little illegal step in the otherwise perfectly legitimate exercise of making compensation decisions.

COUNTERPOINT: You're kidding, right? Jenkins argues that executives wouldn't bother spending the time going back to backdate the options of every employee just to boost their own pay by reducing expenses hitting the bottom line. This thinking completely overlooks two facts. First, I doubt that any of these dozens of cases actually involved HR going back and altering paperwork of grants that had been already issued and disseminated to employees. That would have exposed the practice to too many people outside the compensation and audit committees. Instead, the paperwork was first distributed WELL AFTER the supposed grant date so no "guessing" of the low-point or rework was involved. Second, executives absolutely DO have an incentive to systematically distort earnings on the plus side by avoiding below-par options because another abused portion of their immediate compensation (their BONUS) is based upon quarterly results. Rigging the grant prices of options to appear as par-priced options takes advantage of the flawed accounting rule to help this quarter's earnings and their bonus pay. Getting to pick the date with the lowest price to set the "par price" provides the artificial (and undeserved) bump in the options' value 3 or 4 years out when the first chunk of the options begin vesting.

Though options backdating itself has not been mentioned as part of Dell Computer's SEC woes, the "par-priced options" accounting treatment that avoids an expense hit becomes important when looking at Dell's financial performance over the years. There are several excellent recent commentaries about how an analysis of Dell's stock buybacks over the past few years to recover shares paid to employees for options effectively inflated their income by deferring what are essentially employee salary expenses to future quarters. If the same dollars spent on stock buybacks were deducted from earnings in prior quarters as salary expense, Dell's numbers would look FAR less profitable and would have merited smaller bonus compensation for executives.

In the final paragraph of his piece, Jenkins says this:

And embroiled are not just a few bad apples (pun alert) but Apple, Pixar, Microsoft, Juniper Networks and, if Professor Lie is to be believed, 29.2% of all listed companies. In such circumstances, "the CEO is a crook" is an explanation that quickly loses its power.

We live in a world where obscenely overpaid executives are supposed to be capable of managing a multi-national business and make decisions with complicated accounting and tax implications yet need help figuring out how to minimize the taxes on their own ill-gotten booty. Did you know many executives get free tax advice included as part of their compensation package? Why would you hire an executive to manage a billion dollar company who can't handle the tax implications of $5 million in personal income?

In this world, I have no trouble believing 29.2% of America's executives aren't smart enough to recognize a fraud as obvious as options backdating. However, "the CEO is an idiot" is not a valid legal defense.

Holman, step away from the plate. You're out.


#1) http://news.com.com/2100-1014_3-6104579.html

#2) http://news.zdnet.co.uk/hardware/chips/0,39020354,39281026,00.htm

#3) http://today.reuters.com/news/articlenews.aspx?type=businessNews&storyID=2006-08-17T201840Z_01_WEN4203_RTRUKOC_0_US-DELL-EARNS.xml