Stock Options Abuse: Jail or Restraining Orders?

Which is a better deterrent to crime: jail sentences, or restraining orders?

We normally apply these sanctions against perpetrators of domestic violence, or robbery. But what about the scandal du jour—endemic stock option abuse?

Which is a better deterrent to stock options abusers: prison sentences, or structural reform around corporate governance?

The latest twist in options backdating? The practice has now been found among directors, not just executives. This is the lesson from a Harvard / Cornell / INSEAD report.

"In the data, we found that directors’ grants are equally susceptible to manipulation," Bebchuk said.

A “lucky” director grant was more likely at companies where executives received lucky grants, the study found. And firms with a higher incidence of lucky option grants were more likely to have governance practices considered unfriendly to shareholders, such as a minority of independent directors on the board.

The firms were also more likely to have "entrenching" bylaws, which make it difficult for shareholders to remove directors.
The study is not the first to raise questions about a possible link between options backdating practices and board governance practices. A study by the Corporate Library of 120 companies implicated in backdating found a high incidence of interlocking directors, or directors who served on more than one company that backdated.

The study suggested that backdating practices may have spread from company to company through these interlocking director relationships.

The disease metaphor is very tempting—practices that may have “spread from company to company through interlocking director relationships.” That sounds like the right answer is quarantine—Chinese walls—house arrest—restraining orders. In other words, reform.

Tempting, but extremely expensive. The US is already an overly litigious society and businesses are creaking under regulatory weight.

Using reform to solve trust issues is like using contraceptives to control the deer population—humane, but very costly, and hard to administer.

Punishment is not the preferred vehicle of reformers. But it may be just the right medicine for trust violations. Selective, highly visible, publicized, strong sanctions, particularly prison.

Many argue that prison is not a deterrent against crimes of passion, and only fosters recidivism. Precisely the opposite can be said about corporate executives and directors. Their crimes are coldly conceived, and prison to them is likely a huge dose of ice water. Jeff Skilling’s conviction and sentencing has already prevented more Jeff Skillings, I suspect.

Trust violations at the board level don’t require Chinese walls, but Chinese prisons. Sanctions are far more efficient, and probably much more effective.