A great deal has been written about executive compensation in the wake of the SEC’s new rules on the subject.  In many instances, articles on the subject are critical of the large amounts paid to senior executives.  The current stock option backdating scandal has fueled this debate.  In two enforcement actions, the DOJ and the SEC, respectively, have alleged criminal and civil violations in connection with the backdating of options issued at least in part to senior executives.  It looks like these executives profited plenty from such practices.  For example, in the Brocade case one executive got 500,000 backdated options that are described as having an immediate paper profit of $2.5 million.  But “paper” may be the key word there.  The question is what factors should be analyzed in determining how much the executive profited and how much shareholders may have lost?    

The answer is anything but clear.  The enforcement actions seem to talk about the profits to executives as if one can simply take the difference between the price the options should have been issued at and what the backdated price was as the profit.  Critics argue that this practice misaligns the interest of shareholders and the executive because options are suppose to be an incentive to improve the stock price in the future, not give an instant profit.  No doubt this is true. 

Backdating options, however, may not necessarily give any executive an “instant profit.”  Most options are not immediately exercisable.  If the options are not exercisable for a period of years, the executive may or may not make a profit depending on what happens to the stock price.  If the price goes down below the price at which the options were issued there will not be any profit.  Thus, the executive has an incentive to keep the stock price up to at least the issuance price and more – the greater the stock price the greater the profit. 

A working paper of Boston University Law School Professor David Walker argues that, in fact, the profits to executives are not as large as they appear and that profits cannot be determined by looking at the difference between the backdated stock price and the stock price on the actual date of issuance.  Rather, Professor Walker argues that actual profits from backdating are much smaller than the amount determined from this calculation. The paper is available at www.bu.edu/law/facutly/scholarship/workingpapers/2006.html.
Now this is not to say backdating is good.  But the question is, what did the executives get and what is the harm to shareholders?  One University of Michigan study reported in the New York Times on September 6, 2006, estimates that the average executive’s pay was sweetened by about 1.25% or about $600,000 per year.  At the same time, recent disclosures about option dating practices have caused shares to drop about $500 million, according to the study.  

On the other hand a Bloomberg study released on September 27,2006, estimates that investors have lost about $7.9 billion in market cap.  Loss of market cap, however, may be the impact of a temporary drop in share price based on market reaction.  Consider for example the report in the New York Times on September 29, 2006 about Research In Motion, maker of Blackberry wireless e-mail devices.  RIM disclosed that it had begun an investigation into its handling of stock options.  The company went on to report that it expected to restate its financial statements and reduce its net earnings since 1997 by $25 million to $45 million.  The news, according to the Times report, “did not faze investors.”  This may be because the market anticipates that the adjustments will be in the past and the news about RIM’s current earnings is good.  But that leaves the questions of what did the executives make from these practices and what did shareholders lose?

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On September 26, 2006 the Commission’s Division of Enforcement announced a cease-and-desist proceeding against Scott G Monson, former general counsel of J.B. Oxford Holdings, Inc. (JBOH), and its wholly owned broker-dealer firms, J.B. Oxford & Co. and National Clearing Corporation (NCC), for his role in a late trading scheme facilitated by NCC. http://www.sec.gov/litigation/admin/2006/ic-27497.pdf. The Commission alleged that as General Counsel, Monson drafted late trading agreements that provided NCC’s institutional customers with the ability to confirm, cancel, or revise mutual fund trades after 4:00 p.m. Eastern time, utilizing information that was not available to other fund shareholders required to make trading decisions before 4:00 p.m. http://www.sec.gov/litigation/admin/2006/ic-27497-o.pdf. The Enforcement Division also alleged that Monson failed to properly analyze the agreement to determine whether it complied with SEC rules and regulations or whether it was appropriate for NCC to accept mutual fund trades after 4:00 p.m. On January 18, 2006, in a related proceeding and without admitting or denying the allegations against them, JBOH, NCC, and three former NCC officers agreed to a settlement for their participation in the late trading scheme. http://www.sec.gov/litigation/litreleases/2006/lr19641.htm. NCC disgorged over $1 million in the settlement, paid a civil penalty of $1 million, and paid prejudgment interest in the amount of $69,000. JBOH agreed to cease and desist from future violations of the federal securities laws and to refrain from having a controlling interest in or operating a firm engaged in the broker-dealer clearing business for a period of five years. The three officers each paid civil penalties and, among other sanctions, were barred from associating with any broker dealer for a period ranging from three to five years.

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