Options Backdating: Will Your Stocks Pay the Price?

When it comes to accounting, you reap what you sow--and the seeds of the current options-backdating flap were planted years ago when stock options weren't a mandatory expense. For years, the tech industry and various fellow travelers fought tooth and nail the notion that stock options should be expensed on the income statement. And for years, they had their way--until scandals like WorldCom and Enron changed the political climate enough to strengthen the hand of the pro-expensing crowd. (Never mind there was little--if any--connection between expensing options and the corporate scandals of the past several years.)

What else should we have expected? After all, when the accounting rules say that the transfer of economic value from shareholders to employees need only be recorded in a footnote--and not deducted from reported income--the rules are essentially saying that options are free money. And that's exactly how many companies treated them.

It's no coincidence that just about every company which has so far been caught up in potential backdating was an egregious abuser of stock options back when they didn't need to be expensed. After all, if giving away 4% or 5% of the company every year was kosher in the eyes of a particular management team, it wasn't a much bigger step to issue options retrospectively at a guaranteed-profitable strike price.

This is why options-issuance (and expensing) was never just an accounting issue. It was (and is) a capital-allocation issue. Management teams that take their role as a steward of shareholders' capital seriously don't give away options willy-nilly, because they're aware that options have an economic value no matter what the accounting standards say. By contrast, management teams who view shareholders' capital as play money tried to have it both ways--options were so valuable that they were vital to attracting talented employees, but they weren't valuable enough to be recorded as an offsetting expense to net income.

Now What?
So, what do you do if one of the companies you own--or would like to own--gets swept up in the backdating imbroglio? Knee-jerk selling is unlikely to be your best option, especially if you wait for news of a subpoena. What our analysts are doing is separating the issue into two parts--valuation and corporate stewardship--and looking at each independently.

In my opinion, backdating has a much bigger impact on stewardship than on valuation, and I'd expect to see more of an impact on our Stewardship Grades than on our fair value estimates. That said, most of the companies allegedly involved in backdating already have poor Stewardship Grades from us, since we've always taken a dim view of lavish stock options, and we've always taken the position that options are a real cost and should be expensed.

Valuation
The effect of backdating options on a company's valuation is real, though it's murky and unlikely to sink larger and more-stable firms. The critical issue here is separating out restatements from the likely cash impact to a firm. The cash impact will likely come from six areas:

Shareholder lawsuits: This is the one that generates the most headlines, of course, and could wind up costing companies real money. I think most companies will settle pretty quickly, though, since putting charts of stock prices and options grants in front of a jury is about all that the plaintiff will need to do. Unlike most accounting scandals, options backdating has a visual aid.

Regulatory penalties: Generally, these don't amount to all that much in terms of actual dollars. In any case, why fine the company and thus soak shareholders twice--once for the options backdating and again for the fine? Better to go after the guilty parties personally.

Disgorgement of tax benefits: The IRS will want its pound of flesh, of course, and companies that claimed tax deductions for stock options (compensation is deductible) may very well need to return that money to the IRS--with penalties and interest. Since most companies break out the tax benefit from options on their cash flow statements, this one should be a bit easier to estimate.

Cash fees paid to service providers: This one's not getting much attention, but my guess is that it'll be big. Lawyers and accountants will need to be paid for offering counsel and aiding in the restatement process. Odds are good that internal controls at many companies will need to be recertified as well, and this will be no small task, since we're looking at a long time period (10-plus years), and potentially millions of supporting documents for companies that were heavy option issuers. Note, however, that companies may try to overstate these costs and throw normal Sarbanes-Oxley costs in with costs related to options issues. One firm has thrown around a $100 million figure that seems way too high.

Forgone cash generation: If you're a senior executive at a firm that's been swept up in this debacle, odds are that you're thinking a lot about whether you'll go to jail--not about pressing operational issues at the company. This will vary greatly by company, of course, but could be a real impact in the short run until either things get resolved or there's some turnover in the executive suite.

Potential client losses: This is a wild card, and will almost certainly be limited to companies with large public clients like unions or public pension funds that might face pressure to sever their business relationships with an implicated company.

All in all, I'd say that the larger the firm, the less the proportional valuation impact is likely to be. The big ones will generate the most headlines, but they're also the companies with the most resources to deal with the problem, and the strongest businesses. At smaller and shakier companies, however, the cash impact could very well cause a material impairment to intrinsic value.

The key point here is that the headline impact of options backdating may cause some companies to trade at very large discounts to their intrinsic value even after factoring in likely cash costs. Some of these discounts may even wind up being large enough for the stocks to be attractive purchase candidates. These are the proverbial dollar bills that can be bought for $0.50--the bill may be dirty, torn, and unlovely, but it's still a dollar bill.

Corporate Stewardship
Personally, I think the backdating issue is less about valuation and more about the character of the folks running the companies that are involved. This is something that matters a lot to some investors, and relatively little to others. The first step here is to look into the continuity of the board and executive team from the time the alleged backdating took place until today. In some cases, you may find that there's been near-wholesale turnover in the executive suite, and if that's the case, you may be looking at a stock that's selling off unnecessarily. Don't forget the board, though--if the same board members are still in place, they should be held accountable. (And if any board members received backdated options as a part of their annual grants, they should be publicly flogged.)

So, if the same folks are still running the company, what do you do? In my opinion, backdating options ranks up there with the most blatant accounting frauds by misleading investors on a variety of fronts. It deliberately severs the link between pay and performance while presenting the veneer of a performance-based compensation plan, and it causes overstated cash flow by claiming a tax deduction for a potentially nondeductible expense.

However, all of these issues pale in comparison to one simple point: Executives who engaged in backdating were not putting shareholders first. They were not acting as owner-partners seeking to maximize the value of the firm, but rather as grasping hired hands seeking to maximize their own wealth at the expense of others. At the end of the day, that's all you really need to know.

A version of this article originally ran on May 31, 2006.