When Backdating Goes Bad!

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Yesterday's executive compensation bonus pool filing by Bear Stearns provides a good opportunity to discuss the pseudo-scandal of backdating. And, if you've been following our scandal-skeptical coverage of backdating, you'll probably want to read this because we're going to take you along a quite different road here.
Let's back-up for a moment and look at yesterday's filing. What Bear Stearns has done is cap the total bonuses of its top five executives at $39.5 million, which is thirty percent of $165 million. That cap applies regardless of whether the bonus is awarded in cash, restricted stock or stock options. So what does this have to do with backdating?
Well, keep in mind that current rules prevent most backdating by requiring companies to disclose stock options grants to top executives almost contemporaneously with the date they are made. You can't really backdate a stock options grant by more than several days.
But let's imagine those rules went away, so that we're operating back under the old, pre-Sarbanes-Oxley accounting regime under which most of the backdating occurred. Now the Bear Stearns filing is an extreme example of something that a lot of corporate governance gurus have long called for—disclosure of the total bonus or compensation available to top executives. This sort of thing has its definite pluses—better information to the shareholders and markets, and less opportunity for directors to claim afterwards that they didn't understand the total compensation package. So you won't get any more Dick Grasso-NYSE type fights with a Bear Stearns type disclosure.
But it also demonstrates an opportunity where backdating a stock could be used to effectively inflate executive compensation.
After the jump, we explain why, in some cases, backdating might be a serious corporate scandal.

Let's use an imaginary time line. Suppose the low point of Bear Stearns stock price in 2007 is August 14, 2007, but the stock option bonus grant is actually made on November 14th. Imagine that between those dates the stock price increases 10%. Now a grant of 1000 stock options backdated to August 14th will look like it was worth less than it would if it were dated on November 14th. This means that a compensation board approving a backdated grant in November could avoid the bonus cap by backdating.
So we see how a highly favored corporate governance scheme—capping executive compensation—can create a perverse incentive to cheat. And clearly this kind of cheating is wrong not just because it fudges the accounting rules but because it violates a publicly made pledge to shareholders that executive compensation would be capped.
And even without the prior promise of a compensation cap this kind of backdating can work in nefarious ways. Since it reduces the disclosed amount of executive compensation, it can be used to mislead the markets about total compensation after the fact. Company filings revealing total compensation to executives would understate the actual compensation since they would cost of the grant at the lower, backdated share price rather than the higher share price at the date of the actual grant.
So regulators, accountants and shareholders would be right to call shenanigans on this kind of backdating. But is this criminal? That requires a few extra assumptions. First, we would have to know whether the difference between the disclosed compensation and the actual compensation is material. Would an ordinary, reasonable shareholder care about the difference between the disclosed and actual compensation levels? Second, we'd have to know something about the mindset of the people dating the grants. Were they trying to secretly smuggle more money to the executives without telling shareholders or were they backdating the options for more innocent reasons?
Are there innocent reasons for backdating? Well, the fact that backdating seems to have been so widespread provides one innocent reason. If it was the standard industry practice, it's easy to imagine that a compensation committee would assume it was acceptable. What's more, a company's financial position is not actually changed by the fact that it made the grant on November 14th rather than August 14th. Stock options actually granted on August 14th appear to be worth exactly the same as stock options fictionally granted on that date. And anyone with a pen and paper could figure out that an executive granted options dated on August 14th would by November 14th be in possession of stock options worth more than the disclosed amount.
To put it slightly differently, the fact that the disclosed compensation is less than the actual compensation is really an accounting fiction. At the end of the year, a stock options grant dated August 14th would be worth more. The fact that the compensation cap would not be exceeded would only be due to the fact that the company prices the grant on the date of the grant. This would be true whether or not the grant was actually made on August 14th or backdated to that date. The executive still pockets more paper gains at the end of the year than the accounting reveals.
But this brings us to a real problem with backdating. A combination of accounting rules, corporate governance fads and perceived public outcry against executive compensation, may have created an atmosphere where a companies felt pressured to reduce the apparent size of compensation package below the actual level of compensation they believed were required to hire and retain top level executives. But if companies were under the impression that disclosing actual levels of compensation would upset shareholders, well then it seems they at least believed that they were making a materially false disclosure to the markets. And that, of course, makes backdating a serious legal issue.
That's quite a lot of words to explain why something being treated as a major corporate scandal by most of the business press might actually be scandalous. But we've spilled enough digital ink explaining why backdating might not be as bad as everyone thinks. So it seemed only right to describe the cases where backdating could be a serious matter.