Looking back at Stock Options Backdating: A Debate

The following is a mock debate between John Ruskin and Andrew Carnegie over the problem of whether options should be allowed to be backdated.  The arguments are made based on my interpretation of their individual viewpoints from studying their works.  It was originally composed in 2006, but is being republished as we look back on the backdating scandal that occurred in 2006, namely with Apple and Steve Jobs.

A Debate Between Mr. John Ruskin and Mr. Andrew Carnegie

Commentator: Backdating Stock Options, that is the subject of our discussion and debate

today on our program. The business world has been immersed in discussion over the

ethics of this strategy, and whether or not it should be allowed. With me today, I have

two authorities on business to discuss this very issue, Mr. John Ruskin, and Mr. Andrew

Carnegie, both of whom have commented on creating wealth and the best practices for

So, Mr. Ruskin, I will start with you. How do you see this issue?

Ruskin: I won’t go as far as to say that I am surprised by it, nor will I go as far as to say

it is appalling behavior. However, I am one to study the effects of such behaviors on

organizations and society as a whole, and will say that I don’t believe that backdating

options is good for the creation of wealth.

Commentator: How so? Isn’t backdating stock options a way to help executives stay on

top and be competitive?

Ruskin: It comes down to the fact that backdating these options to buy stock is merely

the way that executives can increase their wealth solely for the purpose of mortal

luxury. They are doing this in spite of any concern to investors in the company, and

even sometimes doing so while the industry in which they operate and the market and

profitability of their business is decreasing. These are ill gotten gains obtained most

often at the peril of many.

Carnegie: If I may, I am going to have to disagree with Mr. Ruskin on a few issues.

I argue that the purposes of backdating options are not always solely to benefit these

industrialists with some form of “ill gotten” gains, as my colleague Mr. Ruskin has

stated. These backdating procedures are in place by executives to keep the businesses,

and the directors, as well as the employees a few cases, competing amongst themselves

and the other companies. Let us not forget, Mr. Ruskin, that the Law of Competition is

in play here, which is absolutely central and essential to the advancement of society and

mankind. Individualism is the best and most fertile field, which always produces the best

fruit, and this fosters individualism.

I think also that Mr. Ruskin has not correctly suggested the idea that these procedures are

somehow adrift from the desires and considerations of the stockholders. In most cases,

these modes of increasing the value of the options have been accepted by the voters as a

means for the option to be exercised at its greatest value and return.

Commentator: Then, aren’t there ethical and moral consequences for gaining greater

wealth in this way, or is this something that, as interest was for so long, will eventually be

viewed as not only acceptable but necessary?

Ruskin: I would never hope such a thing would be seen as necessary, or advantageous

for society, business or mankind. I am somewhat surprised at Mr. Carnegie, whom I

respect as a fellow gentleman and colleague in the science of economic thought, because

he forgets that there is at all times present the question of justice. Backdating stock

options puts a negative value to the wealth gained, and therefore draws downward on

the economy. Already, we are seeing this effect in the figures that show the amount

of money that was lost, or misreported, by these programs. Corporations are having to

go back and restate their financial statements to the public, and the majority of those

reissued statements show a correction for hundreds of millions in losses.

Is putting the benefit and favour of one man ahead of another the proper thing, if the rules

and measures by which it is achieved are not justly or nobly stated, or not fully disclosed

to all parties involved? In my view, this is selling the dying man the loaf of bread.

Although there exists no illegality in the least, one is commercially rich and the other is

commercially poor, and without reason, as I have said, due to the fact that in most cases,

the executive never made the company’s stock rise, or ever increased the market share

during that period of time. Let Mr. Carnegie not forget, and society also, that “Many joys

can be given to men which cannot be bought for gold.”

Commentator: Mr. Carnegie, how does one respond to this idea, and is your view one

that sees these practices as becoming acceptable or necessary?

Carnegie: One could argue the point of whether or not these practices are necessary, or

whether or not they are moral or should eventually be made illegal. I won’t pretend to

know the answer, nor will I sit as a judge of that issue. We’ll let time and the overall

markets dictate that, and they will decide whether or not these things are acceptable.

The rudiments of business are such that sometimes can have the appearance of being

immoral or unjust. But I believe that such costs of injustice within the system, many of

which are allowed injustices, are far outweighed by the benefits that can be produced

as the individual is given his right to obtain, and aspire to new heights, “with none to

make afraid.” As such, I don’t believe laws or legislation should be introduced on such

matters. I strongly advocate the free play of economic forces. The laws and fundamental

theories surrounding the governance of Corporations, and the very purpose for a charter

for such from a State or governmental body, has always been to allow for private

governance of internal business affairs. This is part of the legal right the millionaire

has to his money. He has the right to control it. If the shareholders and directors of that

organization have voted such to allow for these actions, and know about their existence,

then they should be allowed to continue, as they have the rights entrusted to them to

govern the trade and rules of their property and issuance of stock. I would argue that this

inequality of environment and concentration of business is helpful to the overall aspects

of society. The wealth of a few is always beneficial to society if the wealthy know how

to use their wealth correctly.

Commentator: Mr. Ruskin, Mr. Carnegie makes the point that the millionaire must

have the right to control his money, and that these corporate boards and shareholders

are merely voting to allow for these programs by way of corporate law which allows for

corporations to govern themselves with articles and bylaws. How then, Mr. Ruskin, can

we take away from these advantages, and take away such opportunity from the rich? I’ll

give you the last word.

Ruskin: Many men of business hardly know the meaning of what it is to be rich, and

frankly cannot govern themselves to make such decisions without help from outside

thought. I have dealt with the likes of Mr. Carnegie’s argument before. Are these so

called stocks really their stocks, just as I argued in my book that the heathen leads forth

to say “These are MY jewels”?

economy. The blood that comes from fever resembles the ill gotten wealth of these

executives. The grounds have already been made known by which we can judge the

great question of justice, and so Mr. Carnegie’s argument of the need for markets to

determine such is not applicable to this argument. What we need is a system that is

made that will help to develop an honest man. One that will deal with these men, and

send the clear message to the others in the arena of business that if they persist in such

things that we as a society will deal with them just as cunningly as they stole from us and

our economy when backdating their options to reap a seemingly better one.

Remember that economic wealth is the blood of that

Stock Options Backdating: A Look Back At Steve Jobs

With Apple Computer stock reaching the historic highs in recent days, it is interesting that I have seen some people mentioning the "options backdating scandal" that caught up with Steve Jobs, former Apple CEO and Co-founder, back in 2006.  It was then a hot-button issue, and some believe should have lead to his conviction and imprisonment.

At the time, I wrote a paper on the subject describing the issues at hand and also what makes it so enticing to backdate options.  Imagine if you could backdate options on Apple that had a $150 strike price that ended in the money but were issue when Apple was at $110, to a back date when the stock price was around $80.  You would make much more profit from holding that option.  Do it a few times over as the stock price rises, as Apple's has over the last decade, and you would build up a small fortune.

Should these companies have been held more accountable for these actions?  Should back dating be illegal, and not just un-ethical?

First, I will republish the original paper from October 14, 2006.  I will also publish a mock debate on the subject between two experts: John Ruskin and Andrew Carnegie, which can be read here.

Stock Option Backdating

Should Stockholders Be Worried?

The stock option, both powerful in its potential, and complicated in its design, has made

some of the richest investors and businessmen of our times. But the manipulation of their price, a

strategy called backdating, has also recently been in the scope of controversy.

Stock options originate from the idea of purchasing the right to by property or securities

without having to buy the property or security upfront, and within a specified time period. This

type of purchasing power has numerous advantages, and was first used in land and real estate

purchases.

Options, whether it is an option on stocks or a real estate option, allows the party

interested in buying the asset to buy at what is called the strike price. This guarantees the owner

of the asset a specific buying price sometime in the future when the option holder exercises the

option. The option buyer pays an option price to purchase the option, which has an expiration

date, by which time the option holder must exercise the option. The option holder has the right to

sell either the option, or the underlying asset.1

This means that if you buy an option on a stock, currently worth $20, for an option price

of $1 per option, and then a few months later, exercise your option when the price of the stock is

$25, you will make $4 on each option. So, if you bought 100 options, you would have paid $100,

and made $400, because the option would have been what is called “in the money’ which means

the stock is above the strike price. From this we can see that a lot of money can be made from a

small buying price, which helps to minimize risk, and makes a convenient way for investors who

wouldn’t have enough money to put down, to still play off their bets. If we wanted to have made

the same $400 on the above hypothetical example by purchasing the actual stock, you would

have to purchase 100 shares of stock at $20, which is a $2000 investment. Remember, however,

that with the option we made the same amount of money by spending only $100. Similarly, if

the stock were do have gone down instead of going up, say to $10 per share, you would have

(Jim Cramer’s Real Money as well as Characteristics and Risks of Standardized Options)

lost $1000. However, with the option, you would have only lost $100 since your option would

become void and worthless, or what is called “out of the money” which means the stock is below

the strike price, and it cannot be exercised.

Options to buy the underlying stock are called “call” options and options to sell the

underlying stock are called “puts”. Puts are different from calls, in that you make money

on the put option as the price of the stock goes down. Jim Cramer explains in his book Real

Money: “Options are quite handy, and most of us have used them; we just haven’t used them to

buy or sell stock. When we speculate in real estate, we often ask for an option to buy something.

We pay for that option even if we end up not buying the land beneath it. When we buy insurance,

we are buying a put. We are putting a little money… 2. Options are also similar to the way in

which movie producers buy the right to produce a movie from a book; however, they are not

obligated to make the movie because they have only purchased an option.3

From our example, it can be seen how stock options are a great way for companies to

offer incentives and benefits to their employees. These types of stock options, called Employee

Stock Options, are the same as call options on the company stock at which the employee works,

except they have more restrictions.4 The company issues the employee a stock option grant,

which is a grant of a certain number of shares. The grant usually has a schedule that determines

how fast the grant will vest, and also has an expiration period. Because of the vesting schedule,

usually over a series of years, options are seen as a way that companies can attract bright,

hardworking employees, and keep them, due to the fact that the employee may feel obligated or

wish to stay at the company until the options can be exercised. The strike price is determined by

taking the stock price at the time of the grant, or sometimes the average price between the price

on first day of the month and the last day of the month in which the grant was issued. There are

also other ways to do this as determined by each individual company.

Jim Cramer’s Real Money Pg. 266

Wikipedia - http://en.wikipedia.org/wiki/Stock_options - Historical uses of options

4 Wikipedia - http://en.wikipedia.org/wiki/Employee_stock_option - Employee stock option

Employee Stock Options also differ from regular call options, in that the employees are

not required to pay for the option. Normally, the grants are part of the companies’ incentive plans

or their benefit plans, and are granted at the time the employee is hired. This makes Employee

Stock Options an added benefit to the employee, since a good amount of money can be made,

without having to expend any funds. Also, because of the nature of options explained above, the

employee suffers no loss if the options become worthless, because nothing was paid, and nothing

becomes due when the option expires or becomes void.

Adding to this, companies will sometimes offer additional grants to employees who have

outperformed their peers, or to top executives for having great successes. Some of these so-called

incentive stock options have the benefit of being charged reduced taxes.5  They sometimes

even make stock options the method of payment. An example is Gil Amelio, who was made the

CEO of Apple, and five-hundred days later was fired. His stock options became worthless: “

AMELIO 6

There were numerous other examples of this, as dot com companies could not afford

to pay high wages, and attempted to compensate the employees with stock options. For some

companies, this worked fantastically, and stories ran the presses about low level employees

making millions. However, many other employees never made a dime from their grants. As their

companies sank into the whirlpool of dot com destruction; as they were laid off from the ailing

companies, or simply ousted, their options grants became worthless paper. They found out the

hard way, just like Amelio.

To counter these potentially large losses, or the potential that an option won’t meet the

specified strike price, some companies have been involved in the backdating strategy. Although

it is questionable whether backdating is illegal, it has ethical and moral ramifications that must

be considered. Among the frontrunner companies to be investigated for such activities are

SmartMoney - http://www.smartmoney.com/tax/capital/index.cfm?story=options_iso - Taxes on Incentive

Stock Options

6 Gil Amelio On the Firing Line: My 500 Days at Apple

Apple Computer, Brocade Communications, and CNET. These are a few out of some 120 other

companies under investigation by the FBI and the SEC. 7 Interestingly, only a few months ago,

no one was worried –or discussing the issue, of options backdating. Adding to that fact, the main

group finding and reporting options backdating issues as requested by the SEC are the tech sector

companies, the same sector of companies that only a few years ago faced tough declines in stock

prices, and suffered the most from the declines in the overall economy and the crashing dot com

The way backdating works is by manipulating the option’s strike price date. If the strike

price was issued at, say, $20, but the stock then falls to $18, the option becomes worthless.

However, what if the option could be backdated a few months when the stock price as $16? Then

the option is no longer worthless, and can be exercised for a profit. SEC Chairman Christopher

Cox stated before congress: “There are many variations on the backdating theme. But here is a

typical example of what some companies did: They granted an "in-the-money" option-that is, an

option with an exercise price lower than that day's market price. They did this by misrepresenting

the date of the option grant, to make it appear that the grant was made on an earlier date when

the market value was lower. That, of course, is what is meant by abusive "backdating" in today's

parlance.”8 This may be considered unethical, but it is not illegal.

What causes the questions and scrutiny, and potential illegality is how options are

supposed to be reported by the companies in their quarterly reports -–as an expense. It is also

questionable due to the fact that someone was sold a stock, or had the likelihood of being sold a

stock, at a value that was less than what was predetermined by the option grant’s strike price.

This is the reason the SEC is investigating these cases. Since the option grants are

supposed to be reported as expenses on the quarterly balance sheets of the companies that offer

them, if the options are backdated, or manipulated in any way to the benefit of the company

CNN.com and AppleInsider.com

SEC - http://www.sec.gov/news/testimony/2006/ts090606cc.htm - Testimony Concerning Options

Backdating

or option holder, the expense report will not be accurate. In fact, it will show that company

expenses were actually less than what they were, making profits seem larger. This has huge

implications, due to the fact that the stock price of a company is largely based on the earnings per

share ratios. The so-named P/E Ratio is a key determinant of how much an investor should be

willing to pay for a particular stock. If the company appears to be earning more money than it

actually is, then the stock price will not reflect the true P/E ratio, and will be higher than it should,

because investors would, theoretically, bid the price up to the false P/E Ratio. The shareholders

of the company are then being cheated because they are putting confidence in a stock and a

company which they think is earning a lot more money than is actually true.

The SEC Chairman stated further: “A few years ago, the SEC began working with

academics to decipher market data that provided the first clues something fishy was going on.

One of the academics with whom the SEC worked was Erik Lie of the University of Iowa, who

subsequently published a paper in 2005 that showed compelling circumstantial evidence of

backdating.

“Dr. Lie's data showed that before 2003, a surprising number of companies seemed to

have had an uncanny ability to choose grant dates that coincided with low stock prices…

“For example, in 2003, the Commission charged Peregrine Systems, Inc. with financial

fraud for failing to record any expense for compensation when it issued incentive stock options.

The SEC's complaint alleged that at each quarterly board meeting, the company's directors would

approve a total number of options for employees. The company would then allocate the options to

the employees during the quarter. But the options wouldn't be priced until the day after the next

quarterly Board meeting. On that day, the company looked back at the market price of its stock

between the two quarterly Board meetings, and picked the lowest price. That turned the options

into in-the-money grants. But even though accounting rules required that they then be recorded as

compensation expense, the company didn't do that. As a result, Peregrine understated its expenses

by approximately $90 million…

“When these stock option practices surfaced, Brocade was required to restate and revise

its financial statements for six fiscal years, from 1999 through 2004. The scheme resulted in the

inflation of Brocade's net income by as much as $1 billion in the year 2000 alone…”9

As can be seen, untold billions of dollars were misreported over the years for companies

who were involved in backdating their stock option grants. It means that the stocks for these

companies may have been overvalued. It means that purchasers of the stock may have had to

purchase at a higher price, much to the elation of cunning executives. This affects employees

who did not know they were being granted backdated options. It affects board members, top

executives, and shareholders, whose companies will now face investigations, and who have

similarly faced a decline in stock value due to the investigations. Some executives have even had

to resign, some have been fined, others convicted. "I'm not an opponent of stock options. They

can be a good incentive tool if used correctly. But they can also be dangerous for companies and

shareholders when they are exploited by executives. I'm not for that,” said Erik Lie, the college

professor whose research has led to this newfound corruption.10

Moreover, this corruption affects the overall economy, as Emerson put it so plainly:

TheStreet.com - http://www.thestreet.com/_tscs/stocks/general/10299710.html and SEC - http://

www.sec.gov/news/testimony/2006/ts090606cc.htm - Testimony Concerning Options Backdating

10 The Salt Lake Tribune - http://www.sltrib.com/search/ci_4387153