Character
The old saw is that character is what you do when nobody's watching.
Well, thanks to the stock option backdating scandal currently roiling some companies, we're finding out exactly what sort of character certain executives have.
Beginning in the 1980's, and taking off in the 90's, executives of public companies started seeing more and more of their compensation take the form of stock options. Options represent the right (but not the obligation) to buy the stock of the company at some future date for a predetermined price (the "strike price"). If the stock is worth more than the strike price, then the options are worth something, and sometimes quite a lot. If the stock is worth less than the strike price, then the option has very little value (it is "underwater").
So, if the stock goes up, then the CEO gets paid very well. If the stock goes down, the CEO just gets his normal salary and bonus.
In theory, and as required by current tax and accounting rules, the strike price is supposed to be set at the market price of the stock on the day the option is granted (this wasn't always the case, by the way). If the company grants stock options which have a strike price below the market price of the stock (that is, they are "in the money"), then the value of those options needs to be treated as an expense and the executive needs to pay taxes.
With me so far? Good.
The problem is that granting stock options isn't like giving someone a puppy. There's a lot of paperwork involved, it takes time to process, and it could be many months before the option grant is disclosed in a company's SEC filings. So unless a company has careful internal controls, it is very easy for someone to, well, fudge a little on the exact date the options were granted.
If you happen to be given stock options on a day when the stock price was lower, then the strike price on the options will be lower, and the options will be worth more. And who's going to notice a few days difference on the paperwork?
The Scandal
A few months ago, the Wall Street Journal ran an article about a fascinating analysis they did on the stock option grants of a number of public companies. And what they found was that top executives at several public companies had the most amazing luck: they happened to be granted stock options on the exact day that would give them the best strike price. Year after year after year. In one particular case (United Health Group), this amazing bit of good fortune increased the value of the stock options by over $200 million over the course of several years.
There are two explanations for this. One is that the CEOs of these companies have the incredible ability to pick the exact bottom of their company's stock price every single time without fail. If this is true, then these men (and they are all men) are probably actually underpaid for their remarkable ability to predict the future, since the odds of choosing the right date every time for all the different companies is something like a quadrillion to one against.
The other explanation is that a lot of public company executives are cheating, consistently and repeatedly.
Of course the executives all deny any wrongdoing, even the ones who have been fired. Some blame clerical errors--and to be fair, there is no evidence that the executives themselves ordered or even knew about the backdating. It is entirely plausible that the dirty deeds were done by overzealous underlings trying to curry favor by quietly lining the boss' pockets.
But whoever actually forged the paperwork to backdate stock options, it is the corporate executives who ultimately benefited, and who are responsible for setting the moral tone of a company. So they need to take the blame.
Who Loses?
Some people might argue that there are no real victims in this scheme, but that's not true. In fact, every dollar in ill-gotten gains from improperly priced options is a dollar straight out of the treasury of the company. That's because when the owner of the stock option exercises the option, he buys the stock directly from the company at the strike price.
If the CEO was given a million stock options priced at $20 per share which should have been $25 per share, then when he exercises the options he will buy the stock for a total of $20 million instead of $25 million. That's $5 million that he has effectively stolen from the company treasury.
Character
If the Wall Street Journal article is correct (and I have no reason to doubt it), then this has been going on for years at some companies. And we're learning the true character of some who have been viewed as corporate "good guys." Competent, hardworking, successful executives who have been quietly transferring money from their corporate treasuries to their personal bank accounts for years. Some of these people I knew personally (though not closely) from my days as a stock analyst.
I met Lou Tomasetta and Gene Hovanec from Vitesse Semiconductor (both now fired) on many occasions, and had nothing but respect for them at the time. They ran a tight ship and managed in the interests of the shareholders. Except for that little paperwork problem that happened to move several million dollars from Vitesse's bank account to theirs.
Kobi Alexander and David Kreinberg of Comverse Technologies are two other executives I personally knew who have been fired for backdating options, though I didn't have quite as much respect for them as I did for Tomasetta and Hovanec. I always thought the Comverse crew were a little too gung-ho about promoting their stock price instead of focusing on running their business as the telecom sector melted down in 2000 and 2001. But still--Alexander in particular was one of the founders of Comverse and was already extremely wealthy. Why did he feel the need to pick the shareholders' pockets for a few million more?
And here in Minnesota, we have our hometown hero William McGuire of United Health Group, who is also embroiled in this fiasco. I don't know him personally, but the man is worth well over a billion dollars and has a squeaky-clean reputation. Plus he's from Minnesota. He, too, has a dark side.
I feel that the best executives are the ones who are acutely aware that they are not working for themselves but for the shareholders. They have a sense of fiduciary duty towards the people who (in theory at least) hired them.
Unfortunately, in most companies there are few strong checks and balances to make sure the CEO is doing his job properly. The CEO serves at the pleasure of the board of directors, and while the board is in theory elected by the shareholders, in practice board members are actually chosen by management and ratified by the shareholders. Very few board members are ever voted out. So there isn't much to stop the CEO from arranging things to work out in his personal favor instead of the company's favor, especially when nobody's watching.