Getting Exercised Over the Backdating of Stock Options
Did you know Congress is partially responsible for the scandalous runup in CEO pay?
Yup. By capping the deductibility of officers’ salaries at $1 million, companies who wanted to retain talent had to come up with creative ways of delivering compensation. (BTW, why are CEO salaries any less deductible that those of professional athletes and entertainers?)
This led to a widespread increase in the use of stock options. If a CEO did a great job, he or she could, and thanks to the great markets of the mid-1990s sometimes did, make tens of millions of dollars by exercising them.
Enter the mostly yucky markets, relatively speaking, of the last 6 years. Companies still need to have their CEOs around, yet don’t want to pay any more non-deductible salary than they have to (Shouldn’t the $1 million should at least be indexed to inflation?). Some boards have cut corners by backdating CEO options to dates when the company’s stock price was lower, enabling the CEO to make a profit, or more of a profit, when he or she exercises. This is a move that almost certainly isn’t legal (many criminal probes are in progress) and is a breach of fiduciary duty to shareholders.
But it all goes back to the fact that companies are not able to simply pay out deductible compensation, as The Wall Street Journal noted in a subscription-only editorial last weekend:
Which brings us to Congress, the villain of this tale that the rest of the press corps wants to ignore. Executive greed is an easier story to sell, we suppose. But the same Members of Congress who most deplore big CEO paydays are the same ones who created the incentive for companies to overuse options as compensation.
In 1993, amid another wave of envy over CEO pay, Congress capped the tax deductibility of salaries at $1 million. To no one’s surprise except apparently the Members who passed this law, most CEO salaries have since had a way of staying just below $1 million year after year. But because companies still need to compete for and retain top talent, they have found other forms of compensation — notably stock options.
And one of the problems with options is that they give executives every incentive to capitalize all company profits back into the stock price — thus contributing to their own pay — rather than paying out dividends to shareholders. As SEC Chairman Chris Cox has noted, the 1993 law deserves “pride of place in the museum of unintended consequences.”
In a better world — one in which Congress kept its nose out of wage decisions — corporate directors could pay the salaries they wanted and wouldn’t rely so much on options to motivate executives. This, in turn, would reduce the incentive for companies to stoop to such dubious pay practices as option backdating. But as long-time observers of Washington, we can say with certainty that backdating will cease as a corporate practice long before Congress admits its mistake.
UPDATE: This MarketWatch article in IBD has a lot of noise about how the backdating of options, which mostly occurred between 1996 and 2002, would not have taken place if Sarbanes-Oxley had been in effect. Give me a break - the ability to detect the backdating goes back to 1992, thanks to rules on executive compensation mandated by the Bush 41 SEC. Nice try, no sale. If SarBox increased disclosure in this area, great, but SarBox fans know darn well that the tedious and mostly-worthless mandated extra internal control work brought about by Section 404 is where all the contention is.
