Ethics at Work: Off the balance sheet option

The time has come to study this fascinating case study in corporate chicanery.

November 9, 2006 22:27
4 minute read.

Probably the most widespread business ethics issue this year is options back dating. I've been putting off writing about it because it is always, and therefore never, timely. New examples of this scandal pop up virtually every week, but the time has come to study this fascinating case study in corporate chicanery. For a few decades, it has become popular to motivate employees and executives by giving them stock options. A stock option gives the holder the right to buy the stock at a particular price - if the actual price is above the nominal price, then it pays for the option holder to exercise the option. In this way, employers reasoned, employees would have an incentive to make the company profitable and increase the value of its stock. Most "dot-com" millionaires and billionaires got there through stock options. Regular readers of my column have probably figured out that I have another take on the popularity of this instrument. Giving stock options conforms to what I will henceforth call "Meir's law" - any expense that can be taken off the balance sheet (OTBS) will be taken off the balance sheet. As I wrote on April 7, "One pervasive term plays a role in virtually every major recent economic scandal, microeconomic or macroeconomic. That concept is called 'off the balance sheet.' Enron went under because it created hidden special-purpose entities that kept debt off the balance sheet; social security is underfunded in virtually every country because its obligations are off the balance sheet; pension and health-care obligations are taking companies under because many of them are off-balance sheet." I therefore commented that many seemingly bizarre company obligations to unions, such as guaranteed employment, were popular because they, too, were off the balance sheet. Traditionally, stock options have been off the balance sheet entirely - they have not been considered compensation at all, although they are routinely worth billions of dollars. No wonder they were so popular. But starting in 2006, the US began requiring companies to expense their options, that is, to give them a value and to record their granting as a company expense. At the very time I wrote that column a new scandal was breaking that fit perfectly into my theory: options backdating, a brand new way to get executive compensation OTBS. The detective work began with Eric Lie, a finance professor from the University of Iowa who has studied options grants. In a 2005 paper, Lie observed that a remarkable number of options seemed to have been granted when the stock price was very low, thus giving the recipients huge upside. This could be due to luck, but Lie calculated that the odds against picking the price troughs so consistently was truly astronomical. It could also be due to manipulation of stock prices or to inside information about dips (virtually the same thing), but the patterns were so impressive that even this could not explain Lie's findings. The suspicion, which seemed virtually a certainty, was that companies granted stock options later on but recorded the grant at an earlier date when the stock was selling for far less. Since options are valued based on the day they are supposedly given, the difference between the low, earlier price and the price on the actual day they were granted is - you guessed it - OTBS. The company gave compensation that it did not have to record as an expense. In March this year, the Wall Street Journal published a list of companies whose timing of options grants seemed highly suspicious. The title of this now-legendary article: "The Perfect Payday." The Journal article ignited a firestorm of controversy. At first, many companies claimed that it was all due to chance. Then a few executives started to resign discreetly. Companies claimed that they were "examining" their policies, leading to more resignations and a number of criminal investigations. The list of accused has been getting longer and longer and more than 100 companies are now under investigation in the US. One of the latest casualties is Andrew McKelvey, founder of Monster, who resigned from the company's board just recently. Israel, too, has a prominent representative in this scandal: Kobi Alexander, former CEO of Comverse, who is also accused of backdating. Alexander was a fugitive for a period of months, but recently was arrested in Namibia, where he is free on bail. The remarkable thing about this scandal is that options backdating is not in itself profitable, nor is it illegal. Boards are allowed to give executives exorbitant pay packages, and if they want can do so by giving them stock options at any strike price they agree on. In fact, one Journal columnist, Holman Jenkins, went so far as to call the scandal a "witch hunt." The only thing the companies gained by the backdating fiction is to get the price differential off that annoying balance sheet, as "in the money options" (options given at a strike price below the current selling price) have always been considered compensation. This became a legal problem only because the added compensation was not reported in regulatory filings. Judge Louis Brandeis is famous for stating that "Sunshine is the best disinfectant." I think that overall business does not need a lot of regulation, as long as it acts with transparency. Wherever you find mischief, you generally find that institutions are working hard to hide expenses from stakeholders, and keep whatever expenses they can off the balance sheet. The writer is research director at the Business Ethics Center of Jerusalem (, an independent institute in the Jerusalem College of Technology.

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