A More Rational Reason for Backdating

Previous installments of this column have reported on the backdating scandal, in which many companies are being scrutinized for grants of stock options that were either recorded as being granted at a prior date when the stock price was especially low ("backdating") or granted just before favorable news that would result in a higher stock price ("spring loading"). The effect in either case is to increase the option holder's profit by picking a day with an especially low stock price so that the option, being granted at that low stock price, will have a larger "spread" between the price the option holder pays and the market price at which he or she can sell the shares.

Microsoft is one of a number of companies that have said they had policies to price their options at the lowest price during a 30-day period. The company said it did so to prevent unfairness to its thousands of optionees, some of whom might be fortunate to get a grant at a low price and others who get their grants on nearby dates at much higher ones. Micosoft discontinued the practice in 1999 and restated its financials. Like other companies, Microsoft said it believed that the practice did not require an accounting charge. Micrel, another company following the practice, said its auditor, Deloitte & Touche, first told it that the practice did not require a charge but years later changed its mind. Micrel is being investigated for its practices (Microsoft is not because it disclosed it in 1999 and restated its financials) and is suing Deloitte.

The practice raises an important issue with options as a broad-based ownership plan. The most important element in valuing options is volatility. Companies with very volatile stock prices are rewarding employees, in large part, simply by letting them exercise an award at the highs while ignoring the lows. Employees could profit considerably from options even if the company's price underperforms the market. Volatility also introduces a lottery effect into incentive compensation for the very reasons that concerned companies like Micrel and Microsoft. In others words, to some extent, employees are being rewarded not for anything they have collectively done but for an entirely extraneous series of events.