Is stock option backdating ethically defensible?

Background

Stock options are widely used to supplement the amount of non-performance-based cash compensation for executives and CEOs. Furthermore, Bishara & Schipani state that stock options, “have long been touted as a way to align the interests of the executive with the shareholder…”(2008, p. 13) and thus provide, “greater incentives for executives to improve firm performance.” (Raiborn et al. 2007, p.1) However, due to the transactional nature of options that they can be cashed in there exists motivation for executives or firms to manipulate the price so as to receive the greatest gain. Prior to 2002, a company was not required to, “report the issuance of stock options until after the close of the fiscal year.” (Raiborn et al. 2007 p.3 ) As such many firms decided to retroactively increase the value of their share options, particularly executives options. However, by 2002, the time the control measure, Section 403 of the Sarbanes-Oxley act, was passed, 1 out of every 5 companies were suspected to still utilise the practice. Widespread backdating caused a media stir in 2006, with prominent companies such as Comverse and UnitedHealth being indicted. This caused a ripple through the business community as other organisation came under investigation. In 2006, 173 companies were purported to have retroactively altered the stock options of prominent members of their organisations. Retroactively dating options is defined as follows:

The process of granting an option that is dated prior to the date that the company granted that option. In this way, the exercise price of the granted option can be set at a lower price than that of the company's stock at the granting date. This process makes the granted option in-the-money and of value to the holder. (Investopedia 2013) In simplest form a $90 option in today’s value was granted at $60 as of a previous period, the immediate gain would equate to $30 per share.

Introduction

The media and society has systemically panned backdating as ‘unethical,’ ‘damaging,’ and superficially placed the practice in the same category of the unethical behavior which lead to the collapse of Enron. (Raiborn er al. 2007, p.1) This essay will thus seek to be a sole voice defending the practice utilising various ethical paradigms. The author has sought to provide an extensive coverage of ethics so as to provide a balanced evaluation. Concurrently, backdating will be weighed against egoism, a self-centered ethical paradigm. It will be weighed against cultural relativism. It will be weighed against deontology, or the ‘Duty’ based form of ethics. It will be judged according to the modern business ethics of ‘Shareholder Wealth Maximisation.’ Finally the practice will be weighed against the consequentialist stream of ethics.

Egosim

Egoism, although universally described as an abhorrent trait and as ethically unsound, can be used to describe a situation wherein option backdating is ethically defensible. First introduced by Henry Sedgewick in The Method of Ethics, the egoist viewpoint denotes that individuals act in their self-interest. It creates a business situation where from a personal standpoint each individual is protecting their own interests possibly at the detriment of the long-term business goals. However, egoism can be inserted into stock option backdating as it is protecting the short run interests of the CEO. In the egoistic business culture the instances of executive backdating can result in financial gains even in times of poor performance. Backdating encourages the executive to adopt riskier strategies as the attention is rather on future gain then potential lost remuneration. (Kuratczyk & Etsy 2007, p. 7.) Thereby making it defensible. Furthermore Kuratczyk cites Mastumara & Shin by stating that directors may feel obligated to help executives in times of financial distress and option backdating is one way to shield these executives from option fluctuations. Thus a selfish act becomes one, which can be used as a protective measure. Furthermore, the moral standard of egoism is also fulfilled as backdating similarly improves the company balance sheet and improves incentives for hiring and maintaining executives. Wu reinforces this with findings that show “the act of option manipulation seems to serve the purpose of not only retaining talented executives but also restoring misaligned incentives from a long-term perspective.” (2012, p. 30) Although egoism lies on the negative end of the ethical spectrum can be used to defend backdating by showing increased retention of executives, the alignment of core failures and increasing the incentives for executives to perform, even if in own best interest.

Cultural Relativism

Stock option backdating may be ethically defensible according to cultural relativist theory. Cultural relativism as first coined by Franz Boas, refers to:

“The concept that the importance of a particular cultural idea varies from one society or subgroup to another, the view that ethical and moral standards are relative to what a particular society or culture believes to be good/bad, right/ wrong” (Dictionary 2013).

In this case the companies utilising option backdating were using “themselves or the people around them as the basis for defining ethical standards…”(Kuratczyk & Etsy 2007, p. 8) Friedman et al. furthers this buy stating, “backdating of options is not an aberration according to cultural relativism as there is evidence that at least 29% of public corporations have engaged in the practice (2008) Further estimates by Lie and Herron put at least 25% of all companies between 1996 and 2005 used backdating Heisler 2010, p. 283) At least one hundred and forty companies have been investigated by the United States Securities and Exchange Commission for this ambiguous practice. By having this overt majority utilizing the practice, “the practice may be seen by executives, directors and other stakeholders as a common norm and thus morally acceptable on this basis.”(Adam & Shwartz 2009, p. 232). Cultural relativism provides some defense for the practice of backdating as in the business culture at that time most businesses used the practice.

Deontology

The deontological stream of ethics may make backdating defensible. Deontology proposes that human beings have certain rights to pursue their own self-interests, however, the rights of others must also be respected. (Ryan et al. 2008, p. 14) Furthermore, deontologists focus on the rightness of acts and not of their outcome. The rightness is contingent on the individual’s duty to others. Options backdating does not pass these initial standards. As most companies discreetly and non-transparently issue backdated stock options as part of a under the table deal to executives it cannot be justified according to rightness and thus duty. However, If the compensation committee were to overtly disclose the backdated stock options to the stakeholders in line with a performance based package it be sound and in line with the duty to report to shareholders. In most cases, especially those prominent in current media, executives have changed the dating on their own options packages thereby increasing personal wealth but not shareholders and thus failing to live up to ethical and legal requirements. Conversely, in some cases individuals have felt as if they were acting according to rightness dictated by industry standards and guidelines thus making the practice defensible. This is echoed by William McGuire UnitedHealth Group CEO when he stated, “…To my knowledge, every member of management believes…at the time… we…followed appropriate practices for those option grants which affected all employees and not simply executives…and that such activities were within guidelines and consistent with stated…objectives…” (Jennings 2009, p.362). However, the feeling of acting according to rightness does not counteract the sense of injustice felt by shareholders. The shareholders do have a legal and ethical right to receive accurate, reliable and transparent information on executive remuneration. (Raiborn et al. 2007, p.12) The individual’s perspective of rightness thus does not counteract the duty to report this financial information. In this way, backdating does not pass deontological standards and is not ethically defensible. (Bishara & Schipani 2008, p.14.)

Shareholder Wealth Maximisation

A common limitation to the argument of defensible backdating is that ethically the act of backdating is not maximising shareholder wealth as it costs corporations. The Shareholder Wealth Maximisation principle states:

“The immediate goal and ultimate purpose of the public corporation is and should be to maximise return on equity capital.”(Windsor 2009, p.1)

This is a universal assumption in business ethics and economics. A common thread through the arguments of those against stock option backdating is the perceived negative effect on the share price of the purported offenders. Authors regularly quote such figures, as “the market value decline in those companies since the investigations into the practice began has been about $500 million, or more then $10 per share on average.” (Raiborn et al. 2007, p.4) As well as lofty estimates as, “a recent estimate puts the total cost of the options backdating scandal alone, including costs of financial statements, legal fees and penalties at more then $10 billion. (Adam & Schwartz 2009, p.231) The practice of backdating has been inextricably linked with the same unethical practices, which brought about the collapse of Enron. These are in fact flawed and misdirected assumptions. There are a handful of problems with such a proposition. Firstly, stock option backdating was used as a form of compensation that incentivised CEOs to increase the wealth of shareholders, as outlined previously. Concurrently, it has been shown that although the practice has dwindled, boards have sought other mechanisms to renumerate CEOs in lieu of restrictions on backdating. (Mack 2008, p.17-18) These other mechanisms are designed to do the same thing to increase shareholder wealth maximisation through retaining and incentivising CEOs. It has only been through the public reaction, the investigations that have only highlighted the act and only minimally prosecuted, that brought about a decrease in shareholder wealth. The act itself in concert with many other questionable CEO compensation practices has in been linked to increased share value pre- scandal of corporations. Take for example the Apple backdating scandal. Steve Jobs in fact only took a $1 per annum salary, whilst most benefits received were from options and some backdated from the period of 2001 to 2006. One only has to look at the performance of Apple in recent years to see that backdating has had no perceivable impact on the firm’s value. (Worstall 2011) This is in line with Wu’s findings that in an analysis of over 6,386 option backdating grants using the top 1500 businesses in the S & P rating, there was no “relationship between option manipulation and operating performance immediately afterward and there seems to be no significant long-term market low performance either.” (2006, p.1) Backdating thus has no direct effect on SWM. It’s only through negative public reaction that caused a decrease in share value. Backdating can be ethically defensible if it is used to create value through attracting, retaining and motivating executives.

Consequentialism/Utilitarianism

Options backdating may be ethically defensible when justified according to consequentialist criterion. Consequentialism most simply means:

“Whether an action is morally right or wrong depends entirely on its consequences. It is concerned with “consequences, as well as the greatest good for the greatest number of people.”(Kuratczyk & Etsy 2007, p.9)

According to Bishara & Schipani, consequentialist analysis purports that backdating options only benefits the executives and not the business and thus is unethical. (2008, p.14) That is shown that to be untrue (Wu 2006, p.1) They further cite the inherent damage to the average value of the shareholdings, dropping by $389 million. (Kuratczyk & Etsy 2007, p.10) Through Wu we have found no long-term damage to the companies (2006, p. 12). This thus leaves room for other analysis. If the damage to the value of the brand and shareholding was superficial does then the net benefit of utilising back dated options to increase business performance outweigh damage by negative media attention. Heron et al. purports that the actual damage to individual brands is indeed ‘non-trivial.’ They state in reference to the Mercury Capital case of 2005, “Although the legal expenses incurred by Mercury Capital are higher then those for the average company, the costs… are clearly material for most companies…” Furthermore, Collins et al. have drawn a link to those investigated for backdated options and positive operating performance. They found that companies that had previous used, “backdated executive stock option grants are positively related to future firm operating performance…” (2008, p.20) It should then be of no surprise that most businesses in the S & P 500 best performers utilised the practice. Although the correlation is difficult to assert, the practice can be ethical if it is used to create net benefit. The action of backdating is simply outweighed by the increase in performance.