Tavakoli Structured Finance LLC

The Financial Report

By Janet Tavakoli

The Golden Fleece Award For Optional Integrity

William Alden’s February 6, 2014, NYTimes article explained how Ben Horowitz at Andreessen avoided the stock options backdating scandal. Whether you believe that executives should have been prosecuted or not, there is more to this than meets the eye. Specifically, there are questions of integrity, manipulation, accounting issues, valuation issues, consistency, corporate hypocrisy when it comes to backdating and share buy-backs, and appropriate disclosure. Here’s a retrospective.

This commentary was published in LIPPER HedgeWorld on October 6, 2006 with permission. Tavakoli Structured Finance retains the copyright for this article:

U.S. Corporations Under Investigation for Manipulation

An assistant professor at the University of Iowa, Eric Lie, has identified anomalies in the strike prices of employee stock options that suggested the prices were intentionally manipulated to give greater value to employee recipients. As of September 2006, more than 120 U.S. corporations are under investigation by U.S. regulators for backdating employee stock options, and many more will follow.

Stock options give an employee the right to buy stock in the company at a future date at a set price and are a form of compensation. The theory is that if the employees work hard, the value of the company will increase, the stock price will rise, and employees can exercise the options—buy the stock at a reduced price to the future higher market value—and pocket a nice gain.

Employee stock options are usually restricted, meaning that employees must wait for a period of time until the options are “vested.” Once vested, if the options have value and are exercised, the company receives a tax deduction. For example, suppose an employee were given an option to buy 100,000 shares of the company; the shares vest in three years; and the shares have a strike price of $10. In three years, the option will be worth nothing if the option price is below $10, but if the price of the company stock rises to $15, the employee pockets a gain of $500,000, and the company deducts this amount. It is very simple to figure out the value in three years, and the options have a positive value today since it gives the employee the right to a potential gain tomorrow. Most stock options give the employee a window of time in which to exercise the option after it vests, so even if the option cannot be exercised for cash when it first vests, it may become valuable before the window of time is up, also known as the expiration date. Figuring out exactly what the value of the option is today, before the option vests and before the expiration date, is more difficult. One has to estimate the probability of a future gain and the timing of a future gain, and it makes sense to come up with a standard way of estimating today’s value.

Stock Option Backdating and Resistance to Valuation

Backdating ensures the most advantageous value possible to employees receiving stock options, no matter how one calculates the value. For example, if the rational strike price based of the stock option based on business value were $10 at the time the stock option was awarded, but what if three months prior, the stock had traded at its lowest price for the past year, a price of only $3, the backdating executives set the strike price of the option at only $3, thus giving themselves a much better chance of realizing a future gain. The option is therefore much more valuable.

Many executives resisted expensing the value of employee stock options complaining there is ambiguity in how one values them. But accounting practices are rife with ambiguities. As long as the rules are understood, accounting helps paint a picture of corporate value with a semblance of consistency. For example, corporations depreciate expensive factory equipment according to accounting rules. While depreciation does not precisely capture the exact cost and timing of equipment replacements, it highlights the fact that there is a significant cost to stay in business. The rules of depreciation create some ambiguities, but one cannot use this as an excuse to ignore a real cost of doing business.

In his 1985 letter to Berkshire Hathaway shareholders, Warren Buffett challenged those who complain about the ambiguities of valuing employee stock options. Berkshire Hathaway offered to pay a substantial cash sum to any executive granted a restricted stock option in exchange for the right to any future gain the executive might realize. Mr. Buffett trained a spotlight on the fact that employee stock options are a real cost of doing business.

In April of 2004, the Financial Times published a letter (“FASB in error on options valuation“) I wrote to the editor about the Financial Accounting Standards Board’s (FASB) proposal requiring companies, whose stocks are listed on U.S. exchanges, to show the value of employee stock options as an expense. Treating all employee stock options as an expense helps clarify whether the hit to reported earnings is justified by the projected increase in shareholder wealth needed to compensate shareholders for the cost.

My letter applauds the FASB’s belated proposal to expense the options, and focuses on which option model provides more flexibility. The Black-Scholes model has deficiencies in valuing long-dated stock options, and I felt the FASB was right to recommend the Binomial model for valuing options. The Binomial model was more flexible for doing scenario analyses on corporate earnings and assessing risk, but I was still concerned about the potential for corporate officers to manipulate the system. Whichever model a corporation used, the biggest fudge factor in determining value is the volatility assumption. Volatility is related to the price of the stock. One proposal had surfaced suggesting that one could assume zero volatility. Have you ever heard of a stock price that never moved?

Freddie Mac: Allegedly Manipulated Volatility Assumptions

Freddie Mac, a corporation chartered by Congress, had come under fire in the first five years of this century for manipulating volatility inputs to its option models, among other accounting issues. Since Freddie Mac’s mission was to increase funds and liquidity to the U.S. homeowner mortgage market, its problems drew political attention, and several of its senior officers were fired. At issue were options on derivatives, not employee stock options, but Freddie Mac’s problems suggested potential future manipulation of employee stock option reporting. Freddie Mac’s officers arbitrarily decided that volatility calculated based on the then current market prices did not reflect fair value. Instead, it used historic prices as the basis on which to calculate volatility when it revalued its options. The result was astounding; Freddie Mac eliminated $731 million from its 2001 accounting transition adjustment gain (through adoption of a new accounting rule, SFAS133) by choosing an opportunistic methodology for determining volatility. The FASB had not yet set guidelines for calculating the assumed volatility used in the models, but it would have to if it wanted results that were both internally consistent and reproducible across corporations.

Tavakoli, Buffett: Stock Options Are an Expense Item

In July of 2004, Warren Buffett wrote to the Washington Post with a more fundamental concern. Incredibly, the U.S. House of Representatives proposed a bill that would allow corporations to expense only those stock options awarded to the chief executive and the other four highest-paid officers. Other employee stock options would not be expensed. Obviously, this would have created a huge accounting distortion. Mr. Buffett admonished Congress: “Legislators should remember that it is better to be approximately right than precisely wrong.” Derivatives specialists called this Mr. Buffett’s Kill Bill article.

Academics Claim Stock Options Aren’t Expense Items

In 2006, Milton Friedman (who later died on November 16, 2006) and Harry Markowitz, both former University of Chicago professors and winners of the Nobel Prize in Economics, called for an end to the expensing of stock options; George Schultz and Paul O’Neill, former U.S. Treasury secretaries, agreed (they and 26 others signed a statement calling for a halt to expensing stock options). They argued that stock prices reflect the liability overhang of employee stock options, implying that shareholders know how to efficiently value these stock options. But shareholders shouldn’t have to make an independent correction for material information that has been omitted from financial statements.

The idea of stock options is to align the incentives of the shareholders and executives, although even when option strike prices are set correctly, the executives get the better deal. Stock option holders have an incentive to take risks an owner might avoid, because option holders will not shoulder losses while participating in potential upside. Some executives have taken the initiative to increase the probability of their realizing upside without taking additional risk, and this calculating “creativity” deserves recognition.

Corporate Hypocrisy: Diluting Shareholder Value v. Buybacks

In a rational world, options would have a realistic strike price reflecting the true business value after building in carrying costs and retained earnings. Creative executives responded with backdating, and stock options were given a strike price that in hindsight was usually the lowest market price in the relevant historical time period. Yet if you asked the executives to sell the company at the same dip in the market price (thus potentially jeopardizing their jobs), they would balk, protesting the depressed market price didn’t reflect the true business value. After all, they would argue, they have a duty to the shareholders. In fact, some of these dips may reflect prices at which executives should have considered buying back the company stock, not the price at which executives should consider diluting shareholder equity after exercising executives’ stock options. Executives’ ability to ignore financial logic when it is personally beneficial demonstrates mental flexibility that rivals the gymnastics of Cirque du Soleil. The millions of extra dollars many corporate executives reaped due to stock option backdating hardly seems adequate reward for this “progressive” thinking.

Choosing the lowest possible strike price skews the value of the option in favor of the executive option holder. Apologists have attempted to “educate” rationalists that executives in no way “inflated” their pay or “stole” from shareholders when they backdated options, since one shouldn’t assume that the alternative package consisted of an identical number of options at a less advantageous price. As “evidence” of the honesty of corporate executives, apologists claim it is likely that companies correctly reported the number of options and the strike price to shareholders. Never mind that these same corporate officers, most of them stewards—not founders or owners—of these corporations, failed to explain to corporate directors that the strike prices were advantageously backdated, even while shareholder value was diluted more than a reasonable man would have expected had the option strike prices been set in a rational manner. Indeed, sometimes executives used the lowest feasible strike price for a given time period, something no reasonable business owner would have countenanced.

Light on Disclosure

Likewise, these corporate executives failed to clearly and specifically disclose the strike prices were backdated, material information to shareholders. Apologists claim that in an efficient market, shareholders will figure this out on their own absent these clear disclosures. This claim suggests that shareholders are omniscient. The apologists’ claim is especially ironic given that many corporate executives formerly resisted expensing stock options claiming they were too difficult to properly value even when they possessed transparent information about the terms and conditions. Yet shareholders are apparently so skilled, they can price options when the terms and conditions are opaque.

Some of the same corporate executives who vigorously resisted expensing stock options also engaged in backdating, but one must consider their point of view. Accounting properly for stock options would probably have stunted their creativity. When stock options are immediately expensed, the cost becomes transparent. The methodology employed in expensing the options would very likely have exposed backdating. More employees would have been involved, making it very difficult to keep this sensitive information contained in the small circle of senior executives with the most to gain from backdating. Furthermore, it is likely that the corporate accountants would have required clear and specific disclosure of the backdating practice and its implication of additional compensation.

Golden Fleece Award

It is difficult to find an appropriate reward for this creativity, but the SEC is trying its best. The actions of the U.S. Congress suggest an interim step. The former U.S. Sen. William Proxmire (D-Wisc.) initiated a custom of awarding U.S. public officials the Golden Fleece Award, for Congressman who showed similar creativity with public funds. The award was aptly named for the mythological golden fleece swiped by the very creative Jason. Since finance doesn’t have a comparable award, I will initiate one now. The Golden Fleece Award for Optional Integrity goes to the corporate executives who backdated the employee stock options they awarded themselves and failed to specifically disclose this material information to their corporate directors and shareholders. It would be appropriate if Harry Markowitz, the surviving Nobel Prize winner who supports not expensing stock options, bestow the award.

See also: “Madoff Deserves Lots of Company

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