Unpacking backdating: Economic analysis and observations on the stock option scandal

Boston University Law Review

Volumn 87, Issue 3, 2007, Pages 561-623

  Walker, David I ^a  

^a BOSTON UNIVERSITY   (United States)

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EID: 34548608263     PISSN: 00068047     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (240)

1. See Perfect Payday: Options Scorecard, WALL ST. J. ONLINE, http://online.wsj.com/public/resources/documents/info- optionsscore06-full.html (last visited June 12, 2007) [hereinafter Perfect Payday]. Companies subjected to SEC investigation with respect to the pricing or timing of stock option grants through June 12, 2007, are listed in Appendix A.
2. See Lucian Bebchuk et al., Lucky CEOs 16-17 (John M. Olin Ctr. for Law, Econ. & Bus., Discussion Paper No. 566, 2006), available at http://www.law.harvard.edu/programs/olin_center/papers/pdf/ Bebchuk_et%20al_566.pdf (finding that 9% of CEO option grants made between 1996 and 2005 were manipulated to achieve a strike price equal to one of the three lowest priced days of the month);
3. Randall A. Heron & Erik Lie, What Fraction of Stock Option Grants to Top Executives Have Been Backdated or Manipulated? 12 (Nov. 1, 2006) (unpublished manuscript), available at http://www.biz.uiowa.edu/faculty/ elie/Grants-11-01-2006.pdf (estimating that 18.9% of unscheduled grants - grants not made on a certain date each year - were backdated or manipulated).
4. See, e.g., Charles Forelle & James Bandler, The Perfect Payday: Some CEOs Reap Millions by Landing Stock Options When They Are Most Valuable, WALL ST. J., Mar. 18, 2006, at A1.
5. See infra Part II.A.
6. For example, the value of options granted to the CEOs of Fortune 500 companies are reported annually in The New York Times and The Wall Street Journal. See, e.g., CEO Compensation Survey/2005, WALL ST. J., Apr. 10, 2006, at R8;
7. Executive Pay: A Special Report, N.Y. TIMES, Apr. 9, 2006, § 3, at 8.
8. See infra note 132 and accompanying text.
9. See infra Part II.F.
10. See infra Part II.C-D.
11. See infra notes 117-19 and accompanying text.
12. See infra Part II.E.
13. See, e.g., Complaint at 1, SEC v. Reyes, No. C-06-4435 (N.D. Cal. July 20, 2006) [hereinafter Brocade Complaint] (alleging that executives at Brocade Communications Systems falsified paperwork to avoid recording expenses for options);
14. Charles Forelle et al., Brocade Ex-CEO, 2 Others Charged in Options Probe, WALL ST. J., July 21, 2006, at A1 (discussing allegations in the Brocade case).
15. See ACCOUNTING FOR STOCK-BASED COMPENSATION, Statement of Fin. Accounting Standards No. 123, ¶¶ 306-16 (Fin. Accounting Standards Bd. 1995) [hereinafter SFAS 123 (1995)]. The original SFAS 123 was subsequently revised in 2004.
16. See SHARE-BASED PAYMENT, Statement of Fin. Accounting Standards No. 123R, ¶ 3 (Fin. Accounting Standards Bd. 2004) [hereinafter SFAS 123R (2004)].
17. See infra Part II.C.
18. See Executive Pay: A Special Report, N.Y. TIMES, Apr. 7, 2002, § 3, at 8.
19. See Executive Pay: A Special Report, N.Y. TIMES, Apr. 6, 2003, § 3, at 8.
20. See Kevin J. Murphy, Executive Compensation, in 3 HANDBOOK OF LABOR ECONOMICS 2485, 2507-10 (Orley Ashenfelter & David Card eds., 1999). Compensatory stock options of this nature are referred to as call options, specifically American call options. A European call option is similar, but the exercise of that option must occur, if at all, on a fixed date.
21. Certain ubiquitous features of stock options are puzzling economically, including the consistency of at-the-money grants, the failure to adjust option payouts for market movements unrelated to company performance, and the formerly popular practice of lowering or "resetting" strike prices after downward moves in the market. See LUCIAN BEBCHUK & JESSE FRIED, PAY WITHOUT PERFORMANCE 137-73 (2004);
22. Lucian Arye Bebchuk et al., Managerial Power and Rent Extraction in the Design of Executive Compensation, 69 U. CHI. L. REV. 751, 796-824 (2002).
23. See I.R.C. § 422(b)(3) (2000).
24. See infra note 94 and accompanying text.
25. See Murphy, supra note 16, at 2509 tbl.5 (finding that out-of-the-money grants comprised about 1.5% of grants in a sample of CEO options issued in fiscal year 1992).
26. See ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, Opinion of the Accounting Principles Bd. No. 25, ¶ 10 (Am. Inst. of Certified Pub. Accountants 1972) [hereinafter APB Opinion No. 25].
27. Although at-the-money options resulted in no adjustment to reported earnings, this does not mean that there was no disclosure of option compensation. Senior executive option compensation was disclosed in corporate proxy statements and, since 1995, company-wide option compensation has been reported in footnotes to annual financial statements. See infra notes 117-19, 183 and accompanying text.
28. See SFAS 123 (1995), supra note 12, ¶¶ 306-16.
29. See I.R.C. § 421(a)(1) (2000) (providing that the taxpayer shall not recognize income on the receipt of shares on the exercise of a qualifying ISO). The result of deferring income recognition on option exercise is that the entire gain on an ISO is taxed at the more favorable rates applicable to long-term capital gains. However, the tax advantage enjoyed by the ISO recipient comes at a cost to the employer. Companies are not allowed a tax deduction for compensation expense arising from options that qualify as ISOs. See id. § 421(a)(2).
30. See id. § 422(b)(4).
31. See id. § 162(m).
32. See Treas. Reg. § 1.162-27(e)(2)(vi)(A) (as amended in 1996).
33. See Bebchuk et al., supra note 17, at 818.
34. Although options that are granted somewhat in the money are strongly disfavored, no one seems to object to the ultimate in-the-money option, which is known as restricted stock. Like options, restricted stock typically vests over time and is analogous to an option with zero exercise price. Of course, an executive should not expect to receive the same number of restricted stock shares as he would shares covered by an at-the-money option.
35. Given the recent revisions to the accounting rules for options, today there would be no accounting or tax penalty associated with granting in-the-money options to employees below the senior executive ranks, as long as the options were not intended to qualify as ISOs. However, I am not aware of any company that has taken advantage of the opportunity to openly grant in-the-money options. While this fact might be taken as evidence rebutting an efficiency explanation for backdating, see infra note 171 and accompanying text, it is likely that the issuance of in-the-money options would be met by a level of outrage that would overwhelm any efficiency benefits.
36. To perfectly mirror the effect of backdating, the vesting date would have to be adjusted as well.
37. However, few backdating companies would have issued in-the-money options even absent these rules; doing so would have eliminated the stealth compensation achieved through backdating. See infra Part IV.B.
38. See, e.g., Brocade Commc'ns Sys., Inc., Registration Statement (Form S-8), exhibit 4.1, at 4-6 (Jan. 28, 2000) [hereinafter Brocade Form S-8].
39. See, e.g., id. at 6-8. Limitations are placed on exercise prices of options that are intended to qualify as ISOs or as performance-based pay under I.R.C. § 162(m).
40. See, e.g., id. at 12 ("The date of grant of an Option . . . shall be . . . the date on which the Administrator makes the determination granting such Option . . . or such other later date as is determined by the Administrator."). At some firms, option grants are scheduled to occur on the same date or dates each year. Obviously, pre-committing to a grant date eliminates the potential for grant timing manipulation. As a result of the scandal, more firms are adopting this practice. See Joann S. Lublin, Untainted Firms Alter How They Offer Options, WALL ST. J., Dec. 11, 2006, at B1 (reporting that more than two dozen companies are estimated to have tightened option grant policies in the wake of the scandal).
41. Such trickery was facilitated by a practice of approving executive option grants through soliciting written consents from the committee members, often after the fact, rather than convening a meeting of the committee to approve a grant. See infra note 138 and accompanying text (describing how compensation committee members at Comverse Technology were tricked into signing consent documentation for backdated options).
42. Under the pre-2005 accounting rules for options, compensation expense was recognized to the extent that the market price of the stock on the "measurement date" exceeded the option exercise price. The "measurement date" was defined as the first date on which both the number of shares subject to the option and the exercise price were known. See APB Opinion No. 25, supra note 21, ¶ 10. Because the exercise price of Andy's hypothetical option would not be determined until January 31, expense would have been recognized for the option unless the market price for the company's stock on January 31 was equal to the monthly low price.
43. In this scenario, a company would have recognized compensation expense to the extent that the market price of the company's stock on the date on which the number of option shares was determined exceeded the option exercise price. See id.
44. See Eric Dash, Inquiry into Stock Option Pricing Casts a Wide Net, N.Y. TIMES, June 19, 2006, at C1;
45. Charles Forelle & James Bandler, During 1990s, Microsoft Practiced Variation of Options Backdating, WALL ST. J., June 16, 2006, at A1;
46. David Reilly, Moving the Market: Micrel Says Deloitte Approved Options-Pricing Plan, WALL ST. J., June 1, 2006, at C3.
47. See Dash, supra note 39; Reilly, supra note 39.
48. See Forelle & Bandler, supra note 39.
49. See, e.g., Forelle & Bandler, supra note 3.
50. See id. (reporting the odds of certain option pricing patterns occurring by chance at Affiliated Computer Services as one in 300 billion, at UnitedHealth as one in 200 million, at Brooks Automation as one in 9 million, and at Vitesse Semiconductor as one in 26 billion).
51. See generally David Yermack, Good Timing: CEO Stock Option Awards and Company News Announcements, 52 J. FIN. 449 (1997).
52. Id. at 470.
53. See Steve Stecklow, Options Study Becomes Required Reading, WALL ST. J., May 30, 2006, at B1 (quoting Yermack as stating that he initially didn't believe the backdating explanation because "'[t]he whole idea was so sinister'").
54. See Erik Lie, On the Timing of CEO Stock Option Awards, 51 MGMT. SCI. 802, 810 (2005).
55. See Randall A. Heron & Erik Lie, Does Backdating Explain the Stock Price Pattern Around Executive Stock Option Grants?, 83 J. FIN. ECON. 271, 272 (2007).
56. Compensatory stock option grants are exempted from the reach of the "short-swing" trading rule, Securities Exchange Act of 1934 § 16(b), 15 U.S.C. § 78p(b) (2000), by Exchange Act Rule 16b-3(d), 17 C.F.R. § 240.16b-3(d) (2006). Prior to passage of the Sarbanes-Oxley Act, these exempted transactions were excluded from Form 4 filing requirements and were instead required to be reported annually on Form 5. See Exchange Act Rule 16a-3(f)-(g), 17 C.F.R. § 240.16a-3(f)-(g) (2001) (amended 2002).
57. See Exchange Act Rule 16a-3(g)(1), 17 C.F.R. § 240.16a3-(g)(1) (2006) (requiring Form 4 reporting of "transactions exempt from section 16(b) of the Act pursuant to § 240.16b-3(d)").
58. Heron & Lie, supra note 48, at 273.
59. See id. at 294.
60. Heron & Lie, supra note 2, at 11. The authors found further that 18.9% of unscheduled grants (i.e., grants not made on a certain date each year) were backdated or manipulated and that 23% of unscheduled at-the-money grants were backdated or manipulated in the period before the two-day filing requirement took effect. Id. at 12-13.
61. Bebchuk et al., supra note 2, at 13-18. The authors found a monotonic relationship between the likelihood that a date was selected as the grant date and the relative price on that date; in other words, the lowest price of the month was mostly likely to be selected, the second lowest was the second most likely to be selected, and so on. Id. at 14-15.
62. Id. at 16-17.
63. Id. at 30.
64. See Perfect Payday, supra note 1.
65. See Forelle et al., supra note 11.
66. See Charles Forelle & James Bandler, Dating Game: Stock-Options Criminal Charge, WALL ST. J., Aug. 10, 2006, at A1.
67. See Steve Stecklow, Options Trial Could Set Path of Future Cases, WALL ST. J., June 18, 2007, at C1.
68. See Perfect Payday, supra note 1.
69. See id.
70. See Brocade Complaint, supra note 11, at 12.
71. Unless otherwise indicated, Standard & Poor's Compustat database is the source of all stock prices used in this Article.
72. See Brocade Complaint, supra note 11, at 5. Because Brocade's 2001 fiscal year ended on Saturday, October 27, any compensation expense associated with an October 30, 2001, option grant would be included in Brocade's 2002 fiscal year financial statements. See id. at 4.
73. Under the accounting rules in force at the time, the compensation expense reported for an option on a fixed number of shares at a fixed price is equal to the number of shares subject to the option multiplied by the difference between the exercise price and the fair market value of the stock on the date of the grant, here two million shares times about $12/share, which equals $24 million. See APB Opinion No. 25, supra note 21, ¶ 10.
74. See I.R.C. § 83(h) (2000). Depending on Brocade's tax status, this may be an advantageous tradeoff, and, of course, Brocade may reimburse its employees for the additional taxes they incur as a result of ISO disqualification. See David I. Walker, Is Equity Compensation Tax Advantaged?, 84 B.U. L. REV. 695, 735-36 (2004).
75. During the period in question, the deduction limitation pursuant to § 162(m) applied to non-performance-based pay provided to a company's CEO and the four most highly compensated employees other than the CEO. See I.R.C. § 162(m)(3).
76. See Bebchuk et al., supra note 2, at 2; Heron & Lie, supra note 2, at 4.
77. See Perfect Payday, supra note 1; Occupational Safety & Health Admin., SIC Division Structure, http://www.osha.gov/pls/imis/sic_manual.html (last visited June 12, 2007).
78. Companies subject to SEC investigation with respect to the pricing or timing of stock option grants through mid-June 2007 are listed in Appendix A.
79. See Gary Rivlin & Eric Dash, Silicon Valley Was Calming Down. Now, an Options Scandal, N.Y. TIMES, July 22, 2006, at C1.
80. Bebchuk et al., supra note 2, at 29. We do not know the extent to which manipulation equates to backdating (as opposed to opportunistically timing grants prior to the release of good news), although the authors produce some evidence suggesting that manipulation was more likely the result of backdating. See id. at 18-21.
81. See Heron & Lie, supra note 48, at 276 (quoting an anonymous source).
82. See Gretchen Morgenson, At the Options Buffet, Some Got a Bigger Helping, N.Y. TIMES, July 23, 2006, § 3, at 1 (recounting Ciesielski's findings).
83. This difference was statistically significant at the 5% level. See infra app. C.
84. This difference was not statistically significant. See infra app. C; see also Murphy, supra note 16, at 2511-15 (providing an overview of the Black-Scholes option pricing model).
85. The Black-Scholes value of options granted to the top five executives of backdating companies averaged 4.72% of annual company revenues; for the control group, the average was 3.07%. See infra app. C.
86. See infra Part II.A, II.C.
87. See infra app. C. Backdating companies were estimated to have provided options worth about $125,000 per employee per year during the period. The comparable figure for the control group was $42,500. This difference was statistically significant at the 1% level. Given the uniformity of option grants, one would not expect any bias in the per share value of at-the-money options granted to executives and the rank and file. If executive stock options were more frequently or significantly backdated than options granted to the rank and file, the reported value of executive options would be lower per share, and the difference between the value of grants to the rank and file of backdaters versus their non-backdating peers would be even greater. Unfortunately, the value of company-wide grants can only be estimated. Only the value of options granted to senior executives is publicly available.
88. After eliminating Intel and Texas Instruments (average annual revenues of $28.5 billion and $9.3 billion, respectively), the average annual revenue of the control group was $661 million, compared to $606 million for the backdating group. Unless otherwise indicated, the data reported in this section and similar data reported throughout this Article were acquired from Standard & Poor's Compustat database.
89. On average, employment among the backdating firms increased 212% between 1998 and 2002, whereas employment growth among the control firms over the same period averaged 176%. This difference was not statistically significant.
90. Average annualized stock price volatility was almost identical for the two samples: 86% for the backdating firms and 83% for the control group. This difference was not statistically significant. The volatility figures used throughout this Article refer to the standard deviation of continuously compounded returns, expressed as an annual percentage.
91. See Lucian Bebchuk et al., What Matters in Corporate Governance? 14, 39 tbl. 1 (John M. Olin Ctr. for Law, Econ. & Bus., Discussion Paper No. 491, 2004), available at http://www.law.harvard.edu/ programs/olin_center/papers/pdf/Bebchuk_et%20a1_491.pdf. The entrenchment index is based on six provisions that are a subset of twenty-four governance provisions tracked by the Investor Responsibility Research Center. Bebchuk, Cohen, and Ferrell found that this subset of provisions best correlated with firm value and shareholder returns. Id. at 33. Bebchuk, Grinstein, and Peyer analyzed a large number of CEO options granted between 1996 and 2006 and found that strike price manipulation was more likely to occur when the company did not have a majority of independent directors on its board and when the CEO had a longer tenure. Bebchuk et al., supra note 2, at 24-26. Both factors are associated with CEO control over the executive pay-setting process. Id.
92. Most of the analysis in this Part applies equally to backdated options received by non-executive employees. However, there are sufficient differences to warrant separate consideration of that case in Part III.
93. See, e.g., Forelle & Bandler, supra note 3.
94. Heron & Lie, supra note 2, at 3-4.
95. Most press reports have focused on the strike price discounts achieved through backdating or on earnings restatements, which are equivalent. See, e.g., Forelle & Bandler, supra note 3. However, there are exceptions. See, e.g., Roger Parloff, Backdating: A Little Less Than Meets the Eye, FORTUNE: LEGAL PAD, http://money.cnn.com/blogs/legalpad/2006_10_01_archive.html (Oct. 31, 2006, 06:44 EST) (analyzing the impact of backdating on the Black-Scholes values of options).
96. Brocade's options dated October 30, 2001, would not have become exercisable prior to October 30, 2002. See Brocade Form S-8, supra note 33, exhibit 4.1, at 17. Brocade's stock has not closed above $24/share since May 14, 2002. The stock closed at $8.51/share on June 12, 2007.
97. See Murphy, supra note 16, at 2511-13.
98. See id.
99. See RICHARD A. BREALEY ET AL., PRINCIPLES OF CORPORATE FINANCE 577 (8th ed. 2006). One reason the value boost from backdating is less than the strike price discount is time value. Even if an option were certain to be exercised, the value at grant of a strike price reduction that would be enjoyed several years hence is less than the nominal amount of the discount. See id. at 16.
100. See id. at 576-77.
101. Market traded options are rarely exercised prior to expiration, because the value of an option always exceeds the option's intrinsic value (the difference between the market price of the underlying asset and the option exercise price). Thus, prior to expiration, an option holder can sell the option for more than the gain she would derive from exercise (assuming there is no difference in transaction costs). See id. at 582. Compensatory options, however, cannot be sold or otherwise transferred, and the recipients of these options bear a great deal of firm-specific risk. For both of these reasons, compensatory options typically are cashed out well before exercise, often forgoing significant value. See J. Carr Bettis et al., The Cost of Employee Stock Options 3 (Mar. 2003) (unpublished manuscript), available at http://ssrn.com/abstract=376440.
102. Weighted average expected option life typically is disclosed in the footnotes to firms' annual financial statements. See, e.g., Analog Devices, Inc., Annual Report (Form 10-K), Exhibit 13.2, at 20 (Jan. 26, 2001) (disclosing that the weighted average expected lives of options granted in fiscal years 1998, 1999, and 2000 were 6.1 years, 6.1 years, and 4.9 years).
103. See Bettis et al., supra note 94, at 19 (finding that CEOs tend to hold onto options longer than lower-level firm executives).
104. All Black-Scholes values reported in this article were determined using an online calculator available at http://www.option-price.com. A 3% risk-free interest rate is assumed throughout. The presence of dividends complicates the Black-Scholes analysis. I assume throughout that there are no dividends, which is a reasonable assumption for young technology companies. One can get a sense of the value forgone through early exercise by rerunning the Black-Scholes analysis using the ten year contractual option life instead of the five year expected life. The option value increases to $41.18/share. The difference of over $8/share reflects the riskiness of holding options on the stock of one's employer and the value of liquidity.
105. Even readers who are well versed in option valuation may be surprised by the minimal impact of the strike price reduction on option value in this example. It is difficult to explain the intuition, but the outcome is a function of the riskiness of options on highly volatile stocks.
106. I have made one simplifying assumption that, if relaxed, would marginally increase the value of backdating. Assuming that vesting periods were not adjusted, backdating an option by a month effectively accelerates vesting by a month, which would be valuable to a risk averse option recipient. I have not attempted to factor accelerated vesting into my analysis, but anecdotal evidence suggests that in most cases backdating was limited to several months or less. The impact of accelerating vesting by a month or two would not be significant. Of course, backdating an option to create a grant that is well in the money and providing for immediate vesting would be very valuable to the recipient. However, I have read of only one case thus far in which backdating was combined with immediate vesting. See Forelle & Bandler, supra note 60 (describing a backdated option grant with immediate vesting made by Comverse Technology to a disgruntled executive).
107. See Bebchuk et al., supra note 2, at 17. This figure could over- or under-estimate the average strike price discount from backdating. On the one hand, the authors show that it was more likely that options actually issued on monthly highs were backdated than options issued on monthly averages, and in some cases firms apparently looked back beyond the month in backdating options. See id. at 1. On the other hand, not all backdaters were so aggressive as to select the date of the monthly low price as the purported grant date. The difference between the strike price of CEO options purportedly granted on the second lowest priced day of the month and the median stock price for that month was 8%. See id. at 49 tbl.6.
108. The 20% strike price discount used in the Tech Inc. hypothetical is roughly supported by the analysis of Professors M.P. Narayanan, Cindy Schipani, and Nejat Seyhun, who have attempted to quantify the incremental value conferred on option recipients as a result of backdating. M.P. Narayanan et al., The Economic Impact of Backdating of Executive Stock Options, 105 MICH. L. REV. (forthcoming June 2007) (manuscript at 42-45), available at http://www.bus.umich.edu/NewsRoom/pdf/backdating082006.pdf. By examining stock price patterns over a period ranging from five to ninety days following purported option grant dates and assuming that backdating occurred when it would have been profitable, the trio calculate an upper bound on the potential benefit from backdating during the pre-SOX era as 1.25% to 3.66% of the grant value of options. Id. at 58 tbl.4. Because the authors used contractual option life instead of expected life in calculating values, this data is roughly consistent with the results of the Tech Inc. hypothetical based on contractual option life. In subsequent versions of their paper, the authors plan to recalculate values under a more realistic assumption regarding expected option life. E-mail from Nejat Seyhun, Professor of Bus. Admin., Univ. of Mich. Ross Sch. of Bus., to author (Oct. 25, 2006, 13:25 EST) (on file with author). The impact will be to increase the value boost from backdating consistent with the Tech Inc. analysis.
109. Heron & Lie, supra note 2, at 3.
110. For further discussion of the diminished value boost from backdating associated with increased stock volatility, see Martin Dierker & Thomas Hemmer, On the Benefits of Backdating 9-10 (Mar. 14, 2007) (unpublished manuscript), available at http://ssrn.com/abstract=960286. While informative, the Tech Inc. example provided above is unrealistic in that it continues to assume a three year average option life despite the reduction in volatility. This point is picked up in the following paragraph.
111. Consider the Brocade example. If the stock had zero volatility, the stock would always trade at $36.56/share. The recipient of an option with a strike price of $24.20 would be assured of collecting the $12.36 difference on exercise. As the volatility increases, the certainty of collecting the discount fades.
112. See Bettis et al., supra note 94, at 16, 49 tbl.3 (studying a sample of 100,000 option exercises at over 3000 companies and reporting that, on average, employees of companies in the highest volatility quintile exercised options over a year earlier than employees of companies in the lowest volatility quintile).
113. See id. at 12.
114. Forelle & Bandler, supra note 39.
115. Actual volatilities during the periods at issue were comparable.
116. See Jennifer N. Carpenter, The Exercise and Valuation of Executive Stock Options, 48 J. FIN. ECON. 127, 138, 139 tbl.1 (1998) (analyzing option exercises at forty firms from 1979 to 1994 and finding that the average option was exercised 5.8 years after grant (6.1 years median)); Bettis et al., supra note 94, at 48 tbl.2 (finding for their large sample that the number of years between option vesting and exercise averaged 2.4 (1.8 median)). If options vest on average between one and five years following grant, these figures are roughly comparable, but they may reflect shorter average holding periods during the late 1990s when Bettis and his colleagues collected their data.
117. Analog Devices, Inc., Annual Report (Form 10-K), at 57 (Jan. 29, 2003).
118. Backdating at Brocade Communications allegedly ranged between a quarter and a week. See Brocade Complaint, supra note 11, at 7. Although one might think that higher volatility would be increasingly beneficial for backdating as the look-back period increases (because of the steeper discounts available), that does not seem to be the case, at least with respect to these three companies investigated over the 2001 to 2002 period. Repeating the analysis discussed above, but comparing quarterly low closing prices to quarterly averages, results in a rough doubling of all of the figures reported. For IBM, the average difference between quarterly lows and quarterly average prices was 17.54%. The average benefit to backdating looking back over the quarter was 16.11%, assuming six year average option life. For Analog Devices, the average discount was over 24%, but the average backdating benefit increased to only 7.57%, assuming six year average option life (8.92% assuming five year average life).
119. Heron & Lie, supra note 2, at 3. Bebchuk, Grinstein, and Peyer find that firms were more likely to grant options at the lowest price of the month when the spread between the lowest price and median price was greatest. Bebchuk et al., supra note 2, at 23. This evidence, which the authors view as suggesting that manipulation was opportunistic rather than routine, is consistent with the foregoing analysis. All else being equal, including volatility, the larger the strike price discount, the larger the expected payoff from backdating.
120. In the graphic, the solid line represents the value boost from backdating assuming a six year expected life for all options. The dashed line departing from the solid line reflects an alternative assumption of a five year expected life for the Analog Devices options.
121. Media reports have focused on the effect of backdating on reported earnings, but in terms of compensation disclosure, earnings reports were irrelevant. Because options granted at the money did not result in a charge against earnings, and almost all options were granted (truly or fictitiously) at the money, earnings statements prior to 2005 told us nothing about the level of option compensation. Proxy statements were where the action was in terms of executive option compensation disclosure.
122. Brocade Commc'ns Sys., Inc., Proxy Statement (Schedule 14A), at 18 (Feb. 25, 2002) [hereinafter Brocade Proxy Statement].
123. Id.
124. Id.
125. See SEC Reg. S-K, 17 C.F.R. § 229.402 (2006).
126. Brocade Proxy Statement, supra note 114, at 18. Regulation S-K requires disclosure of the expiration date, not the grant date. 17 C.F.R. § 229.402(f)(2)(vi). However, since most options expire ten years from the date of grant, one can easily infer the grant date from the required disclosure.
127. 10 - 12.90]. See 17 C.F.R. § 229.402(c)(2)(vi).
128. Regulation S-K requires companies granting options in the money to also report the option's inherent value as of the grant date. 17 C.F.R. § 229.402(c)(2)(vi). Because Brocade purported to have granted these options at the money on October 1, 2001, they did not include this additional information.
129. 10 - 12.90].
130. Standard & Poor's makes the ExecuComp database available by subscription. The data can also be accessed through Wharton Research Data Services, which is available to the faculty of many academic institutions. ExecuComp utilizes a modified Black-Scholes methodology that assumes an option life equal to 70% of contractual life and reduces exceptionally high volatilities to the 95th percentile of the volatilities of all stocks in their database. Other analysts might have produced slightly different values depending on their assumptions about the expected life of the option, volatilities, etc.
131. The remaining ExecuComp assumptions are maintained or estimated, i.e., option life equal to 70% of contractual life and volatility equal to 94%.
132. Bebchuk et al., supra note 2.
133. Narayanan et al., supra note 100.
134. Editorial, Backdating to the Future, WALL ST. J., Oct. 12, 2006, at A18 ("[O]ther things being equal, granting options at a lower price allows the company to issue fewer options.").
135. Holman W. Jenkins Jr., Op-Ed., The 'Backdating' Witch Hunt,
136. See, e.g., Posting of Geoffrey Manne & Josh Wright to Truth on the Market, http://www.truthonthemarket.com/2006/09/03/no-matt-executive- compensation-is-not-all-about-norms (Sept. 3, 2006, 15:50 EST) (suggesting that backdated options might have been an efficient form of compensation);
137. Larry E. Ribstein, The Other (Non-Tabloid) Side of Backdating, IDEOBLOG, http://busmovie.typepad.com/ideoblog/2006/08/the_other_nonta. html (Aug. 16, 2006, 06:35 CST) (same).
138. Depending on risk preferences and other factors, it could be more efficient for a company to compensate its executives with fewer option shares granted in the money rather than a greater number of option shares granted at the money. See infra note 170 and accompanying text.
139. See infra Part II.E.2.
140. $1 million / $32.82 per share = 30,469 shares.
141. All else being equal, i.e., volatility, expected life, and the risk-free interest rate, the Black-Scholes value of an at-the-money option is proportional to the market price of the underlying shares. Volatility is expressed in percentage terms. Variations of an equal percentage around a greater and lesser mean will produce proportionally greater deviations and greater potential option gains for the higher priced stock. See ZVI BODIE ET AL., INVESTMENTS 709-10 (5th ed. 2002).
142. 38,095 shares x $34.77/share = $1,324,563.
143. Heron & Lie, supra note 2, at 3-4.
144. The Financial Accounting Standards Board has required detailed footnote disclosure of the value of options granted to all employees since 1995. See infra note 183 and accompanying text. This footnote disclosure was elevated to an expense against reported earnings beginning in 2005 and 2006. See infra Part IV.B. However, as with cash compensation, these disclosures simply tell us how much compensation was conferred; they tell us nothing about how companies arrived at the levels of compensation conferred. Item 402 of the SEC's Regulation S-K requires detailed disclosure in the annual proxy statement regarding the compensation of a company's CEO, CFO, and the three most highly compensated executives other than the CEO and CFO. SEC Reg. S-K, 17 C.F.R. § 229.402(a)(2)-(3) (2007). The required disclosures include tabular data detailing the size and value of executive option grants, exercises, and holdings. The regulations also require a report by the board's compensation committee discussing the committee's compensation policies and "the factors and criteria upon which the CEO's compensation [for the most recently completed fiscal year] was based." Id. § 229.402(k)(2). However, this regulation has not been read as requiring detailed disclosure of the method (value-based vs. share-based) by which specific option grants were determined. Moreover, it is not clear that recently adopted enhanced executive compensation disclosures will require this level of disclosure. See Executive Compensation and Related Person Disclosure, Securities Act Release No. 33-8732A, 71 Fed. Reg. 53,158, 53,163 (Sept. 8, 2006).
145. See supra note 39 and accompanying text.
146. As in the case of CEO options, Bebchuk, Grinstein, and Peyer find that exercise prices of options granted to outside directors were more likely to be set equal to monthly low stock prices than random assignment of grant dates would predict. Lucian A. Bebchuk et al., Lucky Directors 15 (John M. Olin Ctr. for Law, Econ. & Bus., Discussion Paper No. 573, 2006), available at http://www.law.harvard.edu/programs/olin_center/papers/pdf/ Bebchuk_et%20al_573.pdf. However, manipulation of the timing of director options appears to correlate with CEO option manipulation, and it is possible that the director grants, which would be small by comparison, were simply included in the general backdating event. Thus, this evidence does not demonstrate that outside directors knowingly participated in or sanctioned backdating. The effect of knowing participation in backdating by non-managerial directors on grant size is ambiguous as well. Companies could have granted backdated options firm-wide as a means of increasing compensation efficiency; inside and outside directors may have colluded in backdating as a means of surreptitiously increasing compensation generally; or directors may have knowingly sanctioned backdating without thinking through the consequences. Only in the first case would we expect a reduction in the size of option grants to compensate for the value boost from backdating.
147. Affidavit in Support of Arrest Warrants at 15-17, United States v. Alexander, No. M-06-817 (E.D.N.Y. July 31, 2006) [hereinafter Comverse Affidavit].
148. Id.
149. Press Release, Affiliated Computer Servs., ACS Concludes and Reports Results of Stock Option Investigation (Nov. 27, 2006), available at http://www.acs-inc.com (follow "Press Releases" hyperlink; then follow "11/27/2006" hyperlink).
150. Id.
151. See Murphy, supra note 16, at 2515.
152. Suppose that on 10/1/06 the compensation committee of Tech determines that its CEO should receive an at-the-money option on 50,000 shares on 1/1/07, 1/1/08, and 1/1/09. The 50,000 share figure would have been based on the Black-Scholes value of an at-the-money option on 10/1/06, the average stock price for the year, or perhaps even a share price target, but the actual market value of Tech's shares on January 1st would have no bearing on the size of the option grant.
153. See Brian J. Hall, The Design of Multi-Year Stock Option Plans, J. APPLIED CORP. FIN., Summer 1999, at 97, 102 n.8.
154. See id. Kevin Murphy interpreted the results of the survey slightly differently. According to Murphy, 40% of large company respondents granted options on a fixed-value basis, 40% on a fixed-share basis, and the remainder used a variety of other methods. Murphy, supra note 16, at 2515.
155. SEE Hall, supra note 144, at 102 (classifying a fixed-share plan as any that resulted in a CEO being granted an option on the same number of shares in any two years). One might conclude from the fact that the number of shares subject to particular executive option grants disclosed in company proxy statements often are round numbers that these grants are not value-based, but this may not be the case. Grant size may be largely determined by value and Black-Scholes calculations and then adjusted up or down to a round figure based on other factors.
156. This information is based on a telephone interview with a principal at Mercer Human Resource Consulting who asked not to be identified. The interview was conducted on September 26, 2006.
157. Semtech Corp., Proxy Statement (Schedule 14A), at 13 (May 7, 2003).
158. The situation with respect to options granted to rank and file employees may be very different. Again, I suspect that options granted to hire or retain key employees generally are value-based. However, routine annual option grants to the rank and file may be share-based. Option overhang or potential dilution clearly plays a limiting role in option compensation at some companies. Companies often make references to this concern in their proxy statements. For example, Altera Corporation notes that it "monitor[s] dilution related to [its] equity incentive program by comparing net grants in a given year to the number of shares outstanding." Altera Corp., Proxy Statement (Schedule 14A), at 14 (Apr. 3, 2006). More specifically, Analog Devices noted in its most recent proxy statement that it planned to limit dilution related to its option program to 2.3% for fiscal year 2006. Analog Devices, Inc., Proxy Statement (Schedule 14A), at 23 (Feb. 8, 2006).
159. See supra Part II.A, II.D.
160. Assuming that backdating resulted in a reduced strike price, the gain from exercise would always exceed the gain that would have been realized on an option issued at the money.
161. See SFAS 123 (1995), supra note 12, ¶ 108 (reporting that employers and compensation consultants use grant date option values in determining the total value of compensation packages); see also Executive Compensation and Related Person Disclosure.
162. Securities Act Release No. 33-8732A, 71 Fed. Reg. 53,158, 53,163, 53,169 (Sept. 8, 2006) (asserting that disclosure of grant date value of options gives shareholders an "accurate picture" of value and calling the Summary Compensation Table, which includes grant date option value, the "principal disclosure vehicle" for executive compensation); Executive Compensation Disclosure, Securities Act Release No. 33-8765, 71 Fed. Reg. 78,338, 78,339 (Dec. 29, 2006) (amending previously announced disclosure rules by requiring that the Summary Compensation Table list a pro rata portion of option grant date value but requiring that the full grant date fair value of option awards be disclosed in a separate table).
163. See, e.g., Herb Greenberg, Seeking Out Firms That Don't Bother with Stock Options, WALL ST. J., Aug. 26, 2006, at B4 (pointing to CompuCredit as an example of a company that ended executive stock option grants because the existing equity holdings of executives provided effective performance incentives).
164. Not only is it unlikely that executives were forced to pay for the value boost achieved through surreptitious backdating, but in the case of fixed-share grants, the depression of the apparent value of backdated options may have led to additional compensation in future periods. Consider the Tech Inc. hypothetical discussed above and assume that the company's CEO received a backdated option on 100,000 shares of stock. An option granted at the money on March 15, when the stock closed at $50/share, would have been worth $3.3 million and would have been reported as being worth $3.3 million. Reducing the strike price through backdating to $40/share results in the option being worth $3.5 million, but being reported as worth only $2.6 million. Assuming that the members of Tech's compensation committee were unaware of the backdating, the CEO could use the (relatively) small $2.6 million figure in arguing for a larger option grant or other compensation in the following year. The smaller reported option compensation figure would reduce the CEO's reported pay relative to that of her peers and provide ammunition for these negotiations.
165. Boards may have been aware of backdating but inactive because the outside directors benefited from backdating themselves, thought of the additional value conferred as free money, or simply failed to attach importance to the event.
166. See, e.g., Holman W. Jenkins Jr., The Backdating Molehill, WALL ST. J., Mar. 7, 2007, at A16; Posting of Geoffrey Manne to Truth on the Market, http://www.truthonthemarket.com/2006/03/19/i-look-pretty-young- but-im-just-backdated-yeah (Mar. 19, 2006, 10:45 EST); Manne & Wright, supra note 128.
167. This calculation is based on a minimum closing price of $12.90/share, a maximum closing price of $26.38/share, and ExecuComp methodology.
168. Prior to Sarbanes-Oxley, compensatory option grants were disclosed on SEC Form 5, which had to be filed on or before the forty-fifth day after the end of the issuer's fiscal year. Today, option grants must be reported on Form 4 within two business days of the grant. See supra notes 49-50 and accompanying text.
169. This may be easiest to see by contrasting this situation with a "backdated" option on an imaginary zero volatility stock. Imagine that the stock of Low Tech always trades for $25/share and that the CEO falsified paperwork to grant herself an option with a $20/share strike price. (Obviously this could not be accomplished by backdating, since the stock is assumed to always trade for $25/share.) One would not have to know the grant date to know that the CEO had procured an option that was $5/share in the money. Once the market learns the strike price of this option, the fraud is obvious, and it continues to be obvious through the date of exercise, since by definition this option remains $5/share in the money.
170. Firms complying with Sarbanes-Oxley must now report options within two days of grant, which reduces the noise problem and the potential for creating stealth compensation through backdating. See supra note 50 and accompanying text.
171. See, e.g., CEO Compensation Survey/2005, supra note 5; Executive Pay: A Special Report, supra note 5.
172. Much has been blogged about market efficiency and backdating. See, e.g., Manne, supra note 156 (arguing that backdating was not stealing because option parameters were fully disclosed); Manne & Wright, supra note 128 (arguing that the actual value/cost of backdated options was incorporated into share prices on disclosure or before and that investors could track the value of individual grants); Larry E. Ribstein, Bodie on Backdating, IDEOBLOG, http://busmovie.typepad.com/ideoblog/2006/09/ bodie_on_backda.html (Sept. 2, 2006, 21:23 CST) (arguing that backdating did not hinder pay comparisons because parameters ultimately were disclosed);
173. Larry E. Ribstein, More on the First Backdating Article, IDEOBLOG, http://busmovie.typepad.com/ideoblog/2006/09/more_on_the_fir. html (Sept. 22, 2006, 09:53 CST) (stating that the key question in determining whether backdating produced stealth compensation is "what happened to the affected firms' shares when the backdating was disclosed"). It appears to me that two distinct issues are being conflated in these discussions: first, whether stock prices accurately reflected the cost of backdated options despite the fraud, and second, whether the size of option grants or other elements of executive pay would have been adjusted to reflect the increased value associated with backdating. As for the first, I think it unlikely that stock prices were affected by the fraud. Market makers would only be concerned about the current aggregate expected cost/dilution resulting from outstanding options. Disclosure of accurate information regarding strike prices, shares covered, vesting, and expiration would allow the market to constantly update and incorporate the cost of options into share prices. Moreover, arbitrage opportunities provide a strong driving force for market participants to undertake the effort. However, assessing the aggregate cost and value of options is a far different matter from assessing the level of executive pay and generating useful peer-to-peer comparisons. In adjusting a company's stock price for option compensation, the market participants need not concern themselves with individual employee option value or with distinguishing between luck, success, and other factors contributing to current option value. Moreover, there is much less reason for the market participants to care. There is no arbitrage opportunity in accurately assessing CEO pay. Thus, I can easily imagine that stock prices were unaffected by backdating, but that recipients captured most or all of the value boost from surreptitious backdating, at least until the fraud was discovered.
174. See BEBCHUK & FRIED, supra note 17, at 64-66; Bebchuk et al., supra note 17, at 784-89. The arm's length bargaining view is generally referred to as the optimal contracting view and has a much longer pedigree than the managerial power view. See id. at 753 n.4, 762 n.8 (sampling optimal contracting thinking in legal scholarship and listing a few important works by economists working in the optimal contracting framework).
175. See Bebchuk et al., supra note 17, at 789.
176. See Daniel Kahneman & Amos Tversky, Prospect Theory: An Analysis of Decision Under Risk, 47 ECONOMETRICA 263, 274-77 (1979).
177. See id. at 265-67.
178. See id. at 271-72.
179. There is an extensive literature on overconfidence and optimism biases and their applicability to managers. See Simon Gervais et al., Overconfidence, Investment Policy, and Executive Stock Options 3-5 (July 24, 2003) (unpublished manuscript), available at http://faculty.haas. berkeley.edu/odean/papers/Managers/GervaisHeatonOdean0703.pdf (citing several studies). There are several reasons that CEOs, and tech firm CEOs in particular, might be susceptible to such biases. First, individuals have been shown to take too much personal credit for successful outcomes. Thus, overconfidence rises from past success.
180. See Dale T. Miller & Michael Ross, Self-Serving Biases in the Attribution of Causality: Fact or Fiction?, 82 PSYCHOL. BULL. 213, 223 (1975). CEOs typically have been successful and tend to be overconfident. Second, overconfident managers are more likely to take risks and either win (or badly lose) the tournament to become CEOs.
181. See Anand Mohan Goel & Anjan V. Thakor, Rationality, Overconfidence and Leadership 3-4 (Univ. of Mich. Ross Sch. of Bus. Working Paper Series, Working Paper No. 00-022, 2000), available at http://hdl.handle.net/2027.42/35648 (developing a theoretical model that suggests that overconfident managers are more likely to be selected as leaders than otherwise identical managers who are not overconfident). Third, selection bias leads optimistic or overconfident managers to seek risky managerial jobs. See Gervais et al., supra, at 5. Being a CEO of a young technology firm is obviously highly risky.
182. To see this more concretely, suppose the Tech Inc. executive referred to in Part II.A views her company as being 50% undervalued at $50/share. If the executive assumes that the true value of the stock is $75/share, and given the other assumptions made in that Part, the executive would value a $50 strike option at $54.41/share. Reducing the strike price on this option to $40/share would increase the value to $56.99, about a $2.50 increase for a $10 strike price reduction. On a percentage basis, the effect of backdating for this executive is even less than it would be for an executive whose price outlook matched the market. Of course, if an executive were certain that an option would wind up being in the money, a $1/share strike price discount would translate into a $1/share increase in value. But an economically sophisticated executive would not be certain of a positive payoff, no matter how bullish she might be.
183. For example, Dennis Kozlowski of Tyco was infamous for the personal items he charged to the company, including a $445 pincushion. See Andrew Ross Sorkin, Tyco Details Lavish Lives of Executives, N.Y. TIMES, Sept. 18, 2002, at C1.
184. See Brian J. Hall & Kevin J. Murphy, Optimal Exercise Prices for Executive Stock Options, 90 AM. ECON. REV. (PAPERS & PROC.) 209, 213 (2000) (indicating that although the optimal range of option exercise prices generally includes the grant date market price, in-the-money options would be more efficient in some circumstances). More direct efficiency explanations for backdating also have been offered. For example, Dierker and Hemmer have argued that backdating may have mitigated agency problems and led to improved timing of operational decisions. See generally Dierker & Hemmer, supra note 102. However, this benefit could be achieved only by informed directors negotiating with option recipients at arm's length. This assumption seems questionable, at least with respect to the majority of cases under SEC investigation for backdating.
185. See Bebchuk et al., supra note 2, at 37 (finding a positive correlation between CEO pay and receipt of manipulated stock options).
186. See Victor Fleischer, Options Backdating, Tax Shelters, and Corporate Culture 2 (Univ. of Colo. Law Sch. Legal Studies Research Paper Series, Working Paper No. 06-38, 2006), available at http://ssrn.com/ abstract=939914 (suggesting a link between backdating and a loose, creative corporate culture focused on innovation). Surely not all instances of backdating constitute fraud. Attempts at companies such as Microsoft and Micrel to level the playing field between option grants to new employees would not be considered fraud, and violation of accounting rules in these cases may have been inadvertent. Even Bebchuk, Grinstein, and Peyer's evidence that CEO option strike prices correspond much more frequently to monthly low stock prices and much less frequently to monthly highs, see supra note 54 and accompanying text, does not demonstrate fraud. Although executives clearly did defraud their own boards in several of the high profile backdating cases that have received the SEC's most urgent attention, we may find that some cases are explained by weak controls or by unfamiliarity with accounting and tax rules.
187. See supra Part I.C.2.
188. See supra Part I.C.1.
189. During the late 1990s and early 2000s, technology companies generally utilized broad-based option plans that covered most or all employees. See NAT'L CTR. FOR EMPLOYEE OWNERSHIP, EMPLOYEE STOCK OPTIONS FACT SHEET (2005), http://www.nceo.org/library/optionfact.html ("Broad-based stock options are now the norm in high-technology companies . . . . Research by Joseph Blasi at Rutgers University found that 97 of the top 100 e-commerce companies offer options to most or all employees."). Options are also popular outside the tech sector, but the frequency of broad-based plans is much lower. See id. ("A 2003 WorldatWork study showed that options are popular in all kinds of public companies, with 15% of public companies offering options to most or all employees.").
190. See supra note 80 and accompanying text.
191. See supra notes 39-41 and accompanying text.
192. Brocade Complaint, supra note 11, at 6-8, 11-13.
193. Id. at 8-13.
194. See supra note 12 and accompanying text.
195. See, e.g., Comverse Tech., Inc., Annual Report (Form 10-K), at F-16 to -17 (Apr. 30, 2002) [hereinafter Comverse 2001 Annual Report] (disclosing option grants to employees covering 8.6 million, 9.3 million, and 9.9 million shares for fiscal years 1999, 2000, and 2001).
196. See, e.g., id. at F-16 to -18 (reporting a weighted average exercise price of $18.03/share, volatility of 76%, risk-free interest rate of 4%, and average expected life of 4.3 years for options granted in fiscal year 2001). Because these options were purportedly granted at the money, analysts would have used the reported strike price as the market price of the stock on the dates of the grants. Under these assumptions, the average Black-Scholes value for options issued by Comverse for fiscal year 2001 would have been $10.92/share.
197. SFAS 123 (1995), supra note 12, ¶ 69; see also Comverse 2001 Annual Report, supra note 181, at F-17 (disclosing that the company's net income for fiscal year 2001 would have been reduced by $181,837,000 if option compensation had been expensed).
198. See supra note 24 and accompanying text.
199. See I.R.C. § 421(a)(2) (2000).
200. See MYRON S. SCHOLES ET AL., TAXES AND BUSINESS STRATEGY 76 (2d ed. 2002).
201. See I.R.C. § 422(d).
202. $100,000 / $36.56 = 2735.23 shares.
203. 2735 shares x $ 24.96/share = $68,265.60.
204. See I.R.C. § 422(b)(4).
205. See, e.g., DEL. CODE ANN. tit. 8, § 242(a)(3) (2007).
206. See, e.g., Brocade Form S-8, supra note 33, exhibit 4.4, at 3 ("[T]he maximum aggregate number of Shares which may be optioned and sold under the Plan is one million (1,000,000) Shares.").
207. Shareholder authorization is required for all equity compensation plans adopted by companies listed on the New York Stock Exchange and NASDAQ. See N.Y. STOCK EXCH., LISTED COMPANY MANUAL § 303A.08 (2006), available at http://www.nyse.com/lcm/lcm_section. html; NASDAQ, NASDAQ MANUAL § 4350(i) (2006), available at http://nasdaq.complinet.com.
208. See I.R.C. § 422(b)(1).
209. See Treas. Reg. § 1.162-27(e)(4)(i) (as amended in 1996) (requiring shareholder approval of material terms of performance goals and hence option plans intended to satisfy I.R.C. § 162(m)).
210. See Special Study Group of the Comm. on Fed. Regulation of Sec., Am. Bar Ass'n, Special Study on Market Structure, Listing Standards and Corporate Governance, 57 BUS. LAW. 1487, 1509 (2002).
211. See Joann S. Lublin & Leslie Seism, Stock Options at Firms Irk Some Investors, WALL ST. J., Jan. 12, 1999, at C1;
212. Robert McGough, Tech Companies' Liberal Use of Stock Options Could Swamp Investors, Drain Firms' Resources, WALL ST. J., July 28, 2000, at C1;
213. Phyllis Plitch, Fight Erupts Over Stock-Option Plans, WALL ST. J. ONLINE, Oct. 2, 2000, available at http://proquest.umi.com/pqdweb?did=61667963&sid=2&Fmt=3&clientId= 3740&RQT=309&VName=PQD.
214. See supra Part II.G for a fuller discussion of cognitive biases in the context of executive option grants.
215. Based on self-reported volatility of 112% (2001 and 2002 average), see Brocade Commc'ns Sys., Inc., Annual Report (Form 10-K), at 56 (Jan. 22, 2003), and an anticipated three year life, the Black-Scholes value of a Brocade option issued at the money at $36/share is $24.96/share; the value of a $24/share strike option when the stock price is $36/share is $27.28/share. 100,000 x ($27.28 - $24.96) = $232,000.
216. See Comverse Affidavit, supra note 138, at 19-20. Similarly, James Treacy, the CEO of Monster Worldwide, was the recipient of several suspiciously timed option grants. He participated, for example, in a broad-based grant of options covering over two million shares dated April 4, 2001. Monster's closing price on April 4 was its lowest of the first half of the year. See Charles Forelle & Mark Maremont, Monster Worldwide Gave Officials Options Ahead of Share Run-Ups, WALL ST. J., June 12, 2006, at A1. Monster's option pricing practices are currently the subject of SEC and Justice Department investigations. See Perfect Payday, supra note 1.
217. See Heron & Lie, supra note 48, at 276.
218. See Gary Rivlin, A Counselor Pulled from the Shadows, N.Y. TIMES, July 30, 2006, § 3, at 1 (reporting that the Wilson Sonsini law firm had represented just under 50% of the Silicon Valley companies implicated in the scandal).
219. Roger Parloff, Larry Sonsini: The Man to See in Silicon Valley, FORTUNE, Nov. 17, 2006, at 150, 166. Parloff also notes that the Boston-based law firm Hale & Dorr (now WilmerHale) represented five of the thirteen Massachusetts-based companies under investigation for backdating. Id.
220. Cf. John C. Coates IV, Explaining Variation in Takeover Defenses: Blame the Lawyers, 89 CAL. L. REV. 1301, 1304 (2001) (providing evidence that lawyers determine key terms in the "corporate contract").
221. Comverse Affidavit, supra note 138, at 14.
222. See ROBERT CHARLES CLARK, CORPORATE LAW § 5.2.2, at 171 (1986).
223. See, e.g., State ex rel. Hayes Oyster Co. v. Keypoint Oyster Co., 391 P.2d 979, 986 (Wash. 1964) ("[W]hatever a director or officer acquires by virtue of his fiduciary relation, except in open dealings with the company, belongs not to such director or officer, but to the company.").
224. At Broadcom Corp., for example, the CEO and senior executives received salaries of just over $100,000/year. Over 97% of their total compensation came in form of option grants. See source cited supra note 122.
225. See Int'l Telecharge, Inc. v. Bomarko, Inc., 766 A.2d 437, 441 (Del. 2000) (holding that although a fiduciary should not profit from conduct breaching the duty of loyalty, the Court of Chancery has discretion in crafting an appropriate remedy).
226. See SFAS 123R (2004), supra note 12, ¶ 1.
227. Brocade Complaint, supra note 11, at 2.
228. See, e.g., Manne, supra note 156.
229. As discussed in Part I.A, the optimum relationship between option strike price and the market price of the underlying stock depends on the desired level of pay for performance sensitivity and the risk preferences of the optionees. Backdating aside, however, equity compensation almost always takes one of two discrete forms: options granted at the money or "options" granted with zero strike price, i.e., restricted stock. It is conceivable that some firms would find in-the-money options to be more efficient and would grant them but for the adverse accounting consequences, but I am skeptical of this explanation for backdating. Certainly, I have seen no one purport to show that backdating firms differed from their peers with respect to firm risk or other factors relevant to optimal option design. More importantly, firms that believed that in-the-money options would be efficient compensation tools could closely replicate them through a combination of at-the-money options and restricted stock.
230. In addition, tax rules continue to preclude ISOs and non-qualified option grants to top executives from being granted in the money. See I.R.C. § 422(b)(4) (2000).
231. See Heron & Lie, supra note 48, at 273.
232. See id. at 280.
233. See Securities Exchange Act of 1934 § 16(a)(1), 15 U.S.C. § 78p(a)(1) (Supp. IV 2004) (defining the class of persons required to file reports with the SEC disclosing changes in beneficial ownership of securities).
234. See generally David I. Walker, The Manager's Share, 47 WM. & MARY L. REV. 587 (2005).
235. In addition to cherry picking option grant dates, there is evidence that some executives have backdated option exercise dates in order to reduce their tax bills. See Eric Dash, Dodging Taxes Is a New Wrinkle in the Stock Options Game, N.Y. TIMES, Oct. 30, 2006, at C1 (reporting allegations of exercise backdating at Symbol Technologies and Mercury Interactive);
236. Jennifer Levitz, Comverse Ex-CEO May Have Fudged Option Exercise Dates, Not Just Grants, WALL ST. J., Dec. 6, 2006, at C1 (reporting suspicious exercise timing at Comverse). The exercise of an ordinary compensatory option (not an ISO) results in ordinary income for the owner equal to the difference between the aggregate exercise price and the market value of the shares received. This tax arises whether the optionee retains the shares or disposes of them. If the shares are retained, the market value at the time of exercise becomes the shareholder's basis. By backdating and purporting to have exercised options on a date when the market price was lower than that on the actual date of exercise, an executive would reduce the amount of ordinary income reportable and tax due at the time of exercise. Of course, this also means that the executive would have a lower basis in the shares going forward and would face a larger capital gains tax on the ultimate disposition of the shares, but at the top end of the income scale capital gains are taxed at less than half the rate applied to ordinary income, and the tax bill could be postponed indefinitely. Note, however, that the backdating executive and the IRS are not the only interested parties here. An employer's tax deduction for option compensation is equal to the amount of ordinary income included by the optionee as a result of exercise. See I.R.C. § 83(h). Thus, an executive who reduces her taxable income by backdating option exercise dates increases the taxable income and taxes of her employer. Note also that the simplified compensation plans suggested herein would not have to be limited to cash payouts. Shares could still be the medium for payment by cash-strapped start-ups.
237. See Perfect Payday, supra note 1. Bold font inaicates that the SEC's investigation has been concluded without punitive action being taken.
238. The compilation of the backdating group begins with the SIC 3674 companies listed in Appendix A. Amkor Technology, Marvell Technology, Sigma Designs, and Silicon Image were eliminated from the sample because sufficient data was not available in ExecuComp or Compustat. Nvidia and Micrel were included based on admissions or announced internal investigations.
239. The control group includes all other SIC code 3674 companies that were in existence in 1998 and for which sufficient data was available in ExecuComp and Compustat, except for Intel and Texas Instruments, which were omitted from the control group. Both companies had revenue and employment figures vastly greater than the largest 3674 backdating companies and thus did not provide a proper reference for comparison.
240. 1998 to 2002 data. For each company, five year averages were calculated for each variable. Means and medians reported are based on those five-year averages.