Ground Floor: In previous Ground Floor columns, I've mused that the bar was often set too low for senior executives who received stock options as part of their "compensation" packages. And it's still the case that sometimes underperforming companies see their leaders receiving generous payola because they've reached easily achievable targets.
But at no time did I think that the options bar was actually set after the event. However, in the latest bombshell to hit an already scandal-plagued Wall Street, it appears that a number of high-profile companies might have backdated their allocations of stock options to executives.
The whole concept of stock options is to reward the management team for outstanding performance. The idea behind them is that as a result of innovative action and excellent management, the company's share price goes up and the executives who have made that happen reap the rewards. They'll have the option to buy company stock at a set price and, hopefully, after that their brilliance will drive the share price up. The happy owner can then exercise the option to buy the shares at the lower price and sell them at the new, higher price, thus raking in a tidy profit.
Many executives eschew higher pay packets and accept stock-option allocations instead, on the basis that this will ultimately be of much greater benefit. There is a risk, of course. And that is that, regardless of what the executives do, if the share price remains rooted at its original level, the options themselves are worthless.
However, for most people, stock options are a very lucrative part of the remuneration process. The important part of the process is that there is this element of risk. Stock options are only worth it if the share price goes high enough. The company's chiefs are not supposed to be getting a free ride. Now it seems that maybe some of them are.
Over 30 companies are currently being investigated, either internally or by the US securities and exchange commission, after it appeared that they manipulated the timing of stock option grants to provide risk-free returns to their employees.
The issue has been brought into the public focus following research by Erik Lie, an associate professor at the University of Iowa. He has published a number of papers on stock option awards, including one that queries whether backdating the options can explain the stock price pattern around option grants.
While there is a definite correlation between rising share prices and the awarding of grants, Lie wanted to explore the cause and effect of how this happened. Instead of showing that price rises occurred well after the stock options had been granted, Lie's studies pointed to the possibility that the options were actually awarded to executives immediately before prices went up; or that the dates that the companies granted the options to their executives coincided with annual lows in the share price.
However, Lie eventually came to the conclusion that it was likely the companies were actually backdating the option allocations so that the recipients got the benefit of lower prices than were actually in force at the time of receiving them.
Most concerned about the whole issue are technology companies where, traditionally, stock options were awarded throughout the industry and where many small companies developed into very big ones. The idea was that they were involved in innovative areas and that things could go spectacularly right or spectacularly wrong and that everyone was sharing the risk. But if people were awarded stock options at backdated prices, there wasn't any risk at all and it was the shareholders who were losing out.
The whole thing is just another basket of dirty laundry for corporate governance and only underlines the scepticism that so many people feel about what goes on at boardroom tables.
As far as the US is concerned, the stable door has been closed, if not bolted, since most of the issues raised in Lie's research occurred between 1997 and 2002. Since then, legislation has tightened the rules on how options can be awarded and requires that companies record the expense of stock options in their annual reports.
However, Lie has estimated that about 10 per cent of corporate stock options were backdated, which leaves Wall Street with yet another governance problem. It appears that in the technology sector, companies showed an average of 5 per cent return on the dates after stock options were granted, which is more than twice the S&P 500 average.
Lie's research is clear cut and readable (you can check it out at http://www.biz.uiowa.edu/faculty/elie/backdating.htm) and his case is pretty compelling. Although he suggests that the number of companies involved in backdating was relatively small, the cost could run into billions of dollars. One of the companies identified was Affiliated Computer Services. Its chief executive was awarded stock options on the one day in the year when the company's share price was at its lowest. A week later, the stock was trading 27 per cent higher. The pattern was the same every time the stock options were awarded, although the chief executive in question, Jeffrey Rich, said that he was "lucky".
Stock options are a legitimate way of rewarding executives and employees for exceptional performance, although analysts have always been concerned about the possibility that providing too much compensation by way of stock options encourages executives to take too much risk in order to drive share prices higher. It seems that they needn't have worried on that score at all. Many executives weren't inveterate risk takers. They just cashed in on the easy money. You don't need an Ivy League qualification to do that.
