Backdating: A little less than meets the eye

October 31, 2006, 3:44 PM UTC
Fortune

I’m not defending it, but …

In a recent conversation about options backdating that I had with Stanford law professor Joseph Grundfest, who heads its Rock Center on Corporate Governance, he kept having to use that phrase as he explained an interesting point I hadn’t really appreciated until then. Now I’ll need to make liberal use of that phrase too.

Though recipients of backdated options received unfair gains, and shareholders were deceived–and I’m not defending either injustice–in each case the extent of the harm may be a little less than some of us are assuming.

Suppose a company gave you, in 1999, one option to buy one share of stock whose closing price that day was $20. Suppose further that the company backdated the grant by a week, so that it could give you an exercise price of only $19. You haven’t received $1 of profit yet, however, because your option won’t vest for at least a year, and you don’t know what the price will be then. In Silicon Valley, options typically vested over a four or five year period, with a one-year “cliff” before the first of them started vesting. Because of the bursting of the tech bubble, a great many, if not most, were out-of-the-money and worthless by the time they vested.

One way to measure what you’ve received would be to calculate the difference between a Black-Scholes valuation of the $20 option and a Black-Scholes valuation of the $19 option. When we were talking, Grundfest then went to one of the many Black-Scholes calculators on the web, filled in some hypothetical parameters–the calculation will vary a little depending on factors like volatility and expiration date–and found that the fair market value of his hypothetical backdated option (with a $19 exercise price) would have been $13.31, while the fair market value of the non-backdated $20 option would have been $13.06. So, in a sense, you were given about a quarter, not a dollar. Of course, a lot of quarters can mount up to real money, so I’m not defending this practice.

When it comes to trying to figure out the degree to which shareholders were deceived, the computations are difficult, in part because, at the time, the biggest piece of the accounting deception was lawful: companies could pretend that at-the-money options bore no cost at all, requiring no expensing at all. In addition the accounting methodologies for expensing in-the-money options in 1999 and at-the-money options today are different, making comparisons difficult.

Indeed, just doing the proper calculation for in-the-money options in 1999–a process called variable accounting–was hellishly difficult. The company theoretically would have had to recalculate the amount to expense each quarter, based on the fluctuations of the stock price vis-a-vis the strike price. The process was so complex that most companies avoided having to do it, and many accountants still aren’t sure about how to handle certain details of the process.

For a company now to do a retroactive restatement applying that methodology over a period of years for multiple grants of thousands of options will typically require that it miss its quarterly filing deadline. Missing the filing requirement will probably cause the company to receive a delisting warning from its stock exchange and put it in technical default on its bank loans. So there is a snowball effect that, in some cases, may be disproportionate to the crime.

But I’m not defending it.