Boalt Expert: Executives Backdated Options to Inflate Their Compensation, Not Just to Benefit Their Firms
The recent conviction of former Brocade CEO Greg Reyes on all 10 counts of securities fraud brought against him has sent a sobering message to the corporate community. The San Francisco jury's verdict on August 7 will likely strengthen the government's ongoing probe of stock option practices, forcing corporate officials to closely review their backdating procedures.
Although some observers question whether Reyes personally benefited from the backdated options, Boalt Hall's Professor Jesse M. Fried, an expert on executive compensation, corporate law and insider trading, argues that backdating creates windfalls not just for companies but their top officials as well. "The view that options were backdated solely to benefit the firm and not to enrich executives," Fried writes in an August 23 San Jose Mercury News op-ed piece, "is absurd."
Stock options let employees buy company stock at a future date by paying market price on the date the options are granted. Fried explains that until recently, these options "did not have to be recorded as an expense against the firm's reported earnings," while options priced lower than the grant-date price did have to be expensed. By backdating (choosing a date when the stock price was low and retroactively assigning that date to the options), Brocade, a San Jose-based software company, inflated its reported earnings by disguising lower-priced options as non-expensed options.
Although Fried says that civil liability may be more appropriate than criminal prosecution in backdating cases, he disputes the claim that CEOs manipulate option grant dates simply to lure talented employees: "Had firms wished to openly award lower-price options to their employees, they were free to do so. To be sure, these options … would have to be expensed, but that would not have prevented firms from attracting high-quality workers."
Reyes backdated an enormous personal stock options grant in 2001, causing analysts to undervalue the grant by nearly $15 million. In doing so, says Fried, "Reyes reduced the likelihood that shareholders would find his pay excessive and pressure the board to reduce it." Even if CEOs do not personally receive backdated options, Fried notes that they still profit by backdating other employee options, because overstated earnings lead to higher executive bonus pay: "CEOs backdated options to directly and indirectly inflate their own pay, not to benefit their firms."
Fried has taught courses on law and economics, corporations, and corporate finance and bankruptcy reorganization. He is also a faculty co-director of Boalt Hall's Berkeley Center for Law, Business and the Economy.