Alan Reynolds

During the euphoric high-tech boom of the 1990s, America Online offered my daughter a thousand stock options to recruit her away from another firm. In 2001, after four years of vesting, that gave her the right to buy those shares at the price on the day the options were granted. But what day should that be?

Weeks passed, as usual, between her initial interview and subsequent appointments with various supervisors, the time a formal offer was approved and transformed into a written contract, and the time (after due notice to her current employer) she finally started the new job. Which of those dates would have been the correct one for AOL to use as the grant date for her stock options? Should it be the day she was first interviewed, the day she started work, somewhere in between or perhaps a few weeks later?

Be careful how you answer, because some eager reporter is likely to dub any of those choices as "spring loading" or "bullet-dodging" or "backdating." A prospective employee, on the other hand, might view the wrong choice as unfair, or even as reneging on the original deal.

Millions of rank-and-file employees, not just top executives in the S&P 500 firms, have gladly accepted the unavoidable tradeoff between risk and reward by accepting part of their pay in the form of stock options. If the stock does well, shareholders and employees will share in the gain -- if not, they share the pain.

A 2001 study by Federal Reserve economist Nellie Liang and Scott Weisbenner of the University of Illinois found that by 1999 the top five executives received only 14 percent of all stock options grants. The Fed's Survey of Consumer Finances reported, "In 2004, 9.3 percent of families reported having received (employee) stock options, a share 2.1 percentage points below the (11.4 percent) level in 2001."

Employee stock options are obviously very important to millions of people. Yet the press keeps trying to equate stock options with a few dozen overpaid CEOs and to demonize options in general with the so-called "scandal" of backdating. Any presidential candidate who contemplates jumping on that bandwagon had better be prepared to lose votes from 9 percent to 11 percent of America's families.

Journalists use the word "scandal" to convert legal and sometimes sensible business practices into something vaguely immoral. Backdating of employee stock options is defined as a "scandal" precisely because efforts to criminalize possible accounting indiscretions have become so chaotic and quixotic.

Until 1992, the Securities and Exchange Commission (SEC) did not even bother to ask firms to report what date they put on stock options, because no sensible investor gives a hoot about that. What investors care about is how many options were granted at what price -- information that has always been readily available in every annual report.

Since Aug. 29, 2002, companies have been required to report new option grants within two days, which does not leave much opportunity for changing the date. So the alleged "backdating scandal" -- an artifact of capricious changes in tax and accounting regulations between 1992 and 2002 -- is ancient history by now.

The Wall Street Journal almost single-handedly created the "backdating" crusade, with the admirable exception of Holman Jenkins. That paper's latest article says: "Amid the stock-market swoon that followed the Sept. 11, 2001, terrorist attacks, dozens of companies granted stock options to top executives or other employees. Now, some of those companies are saying the grants were in fact made weeks later -- and backdated. The disclosures are the latest wrinkle in a backdating scandal that involves more than 140 companies."

To say the investigation "involves" more than 140 companies does not mean any have been proven guilty of anything. The Wall Street Journal's list is closer to 120, including some who have been cleared, such as Altera, Asyst, Chordiant, Equnix, Intuit, Macrovision and Xilinix. Only three former CEOs have been charged with criminal violations and only one plead guilty.

Because federal investigations impose huge legal costs on firms, some have tried to placate regulatory sharks by tossing their best executives overboard. Their stock then falls for two reasons -- loss of executive talent and legal bills. The ritualistic restatement of past earnings is irrelevant: Investors do not invest in past earnings.

The Journal article shows graphs for nine NASDAQ companies that "granted options dated soon after Sept. 11, 2001." The NASDAQ stock index fell to 1,423.2 by Sept. 22, but bottomed a year later at 1241.9 in October 2002. Yet the Journal quotes Harvey Pitt, former chairman of the SEC, who finds it "offensive for companies to capitalize on the market panic caused by 9-11."

Offensive to whom? There were only two parties involved -- not companies, but stockholders and employees. If the 2001 stock options had been dated Sept. 10, rather than Oct. 1, that might have been less offensive to shareholders, but it would be hugely unfair to employees. If the options had been dated a year later, in October 2002 rather than October 2001, that would have been a much better deal for employees but apparently less offensive to Pitt.

All such mindless moralizing about backdating starts with two key misunderstandings. One is that this overblown and costly accounting issue affects only top executives rather than millions of U.S. families. Among semiconductor firms, who dominate the backdating list, David Walker of Boston University found that "13.8 percent of the shares covered by options granted by backdating firms each year went to the top five senior executives."

Another key myth is that there is something inherently unfair about receiving stock options "in the money" (priced below some later market price). This is particularly absurd considering the halo reporters have placed on restricted stock, which is the ultimate in-the-money option with an exercise price of zero. In November 2005, the lead author of the latest Journal article, Mark Maremont, wrote that "by tying strike prices to earlier, more favorable dates, executives granted options can instantly lock in a paper gain."

But a lower strike price does not "lock in" any gain at all because options cannot be exercised until they are vested, typically after three or four years. And the issue mainly concerns non-executives.

Whenever you read about some new "scandal" in business or finance, you can be sure the story is not about any criminal acts because those are called "crimes." Business journalists rely too heavily on the word "scandal" to describe complex activities they do not fully understand.


Alan Reynolds

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