A Discussion About Options Backdating

Fortune Magazine has a couple of blog columns. One is called Legal Pad, by Roger Parloff, Fortune’s Senior Editor for Legal Affairs.

An experienced and educated journalist who writes well in what is normally an informative blog, Mr. Parloff recently posted what I take to be a temporary moral faux pas or blind spot. You decide. The posting is titled Backdating: A Little Less Than Meets the Eye.

Parloff says:

In a recent conversation about options backdating that I had with Stanford law professor Joseph Grundfest, who heads its Rock Center on Corporate Governance, he kept having to use the phrase [“I’m not defending it”] as he explained an interesting point I hadn’t really appreciated until then. Now I’ll need to make liberal use of that phrase too.

Though recipients of backdated options received unfair gains, and shareholders were deceived—and I’m not defending either injustice—in each case the extent of the harm may be a little less than some of us are assuming….

…Of course, a lot of quarters can mount up to real money, so I’m not defending this practice…

…there is a snowball effect that, in some cases, may be disproportionate to the crime.

But I’m not defending it.

Roger, if you’re not defending it, just what is your point?

Chris Cox—Chairman of the SEC— stated clearly in testimony before Congress just what is at stake in these cases:

The purpose of disguising an in-the-money option through backdating is to allow the person who gets the option grant to realize larger potential gains-without the company having to show it as compensation on the financial statements.
Rather obviously, this fact pattern results in a violation of the SEC’s disclosure rules, a violation of accounting rules, and also a violation of the tax laws.

Morally Bankrupt: Options Backdating

Are you suggesting, Roger, that there is some dollar amount below which you would recommend SEC disclosure rules, accounting rules and tax laws be ignored? That these kinds of violations, committed by CEOs and CFOs, should be judged based not on principles but on how much they stole?

That’s what your readers seem to think you meant. Four of the five comments to your posting say the options backdating scandal is “a public opinion-generated frenzy,” that “no harm was done,” that a market cap shouldn’t be punished by 25% when unjust compensation added up to only a few million, and that damages are less than funny accounting might indicate. If you thought you were being subtle or sardonic, the point appears to have been lost.

Come on, Roger—can we have just a little moral outrage here, please?

Business Scandal

At the heart of all business scandals are a few common themes: lying, intentional breaking of laws, and rampant selfishness. Add them up and, for lack of a better term, let’s call it ethics violations.

Now, there’s nothing wrong with assessing the economic impact of law-breaking; in fact, it’d be great to hear some numbers from Parloff or others.

But if you’re going to do that, then factor in the cost of trust destroyed. When dozens of corporate leaders intentionally violate the law behind closed doors for the sake of personal self-aggrandizement, what is the cost of employee cynicism, social skepticism and moral rot that you create? I’m guessing it far exceeds the ill-gotten gains of several dozen CLOs (Chief Lying Officers).

Economic Cost of Low Trust

That’s not just rhetoric. The economic cost of low trust is massive; for one thoughtful approach to the subject, see “Collaboration Rules,” by Philip Evans and Bob Wolf, Harvard Business Review, July 1, 2005.

The options backdating scandal is fundamentally about integrity and honesty, not about the dollar amount scammed. For a national magazine’s senior editor to headline his comment as “Backdating: a Little Less than Meets the Eye” is to miss the point and—as evidenced by his responses—to influence others to miss the point as well. It should have been "Backdating: More than Meets the Eye," and Perloff should be reminding the Stanford professor and the rest of us about the cost of trust abused.

We should expect better from Fortune.

Update: This article has been featured in the Carnival of Capitalists