Option Backdating and Its Implications

I. IntroductionEvidence has emerged that several thousand publicly traded firms used hindsight to secretly backdate stock option grants to both executives and nonexecutive employees, boosting the options' value.1 Many of these firms, it turns out, also allowed executives to covertly backdate the exercises of their options, further inflating their option pay.2 Because both types of secret hindsight backdating are illegal,3 over a hundred companies have become the targets of federal investigation, and dozens of managers have been forced to resign.4This Article begins by examining the implications of option backdating for the debate over how managerial pay in publicly traded firms is determined. Under the dominant "arm's length" view, executive compensation packages are largely shaped by market forces: Boards bargain at arm's length with executives to secure arrangements that serve shareholders' interests.5 According to the alternative "managerial power" approach, executives have power over their boards and use their influence to obtain pay that is both excessive and overly decoupled from performance.6 Under this view, the main limit on executives' ability to obtain excessively favorable pay arrangements is fear of shareholder outrage.7 The desire to minimize shareholder outrage, in turn, causes firms to "camouflage" - hide or obscure - both the amount and performance-insensitivity of executive compensation.The Article describes and analyzes three types of secret backdating: (l)the backdating of executives' option grants; (2) the backdating of nonexecutive employees' option grants; and (3) the backdating of executives' option exercises. It shows that each type of covert backdating is unlikely to reflect arm's length contracting. However, all have the effect of inflating and camouflaging managerial pay. Thus, secret backdating is better explained by - and provides further support for - the managerial power approach to executive compensation.8The Article then considers the implications of secret option backdating for a second, related debate: Whether the Sarbanes-Oxley Act (SOX) and accompanying stock exchange reforms obviate the need for further corporate governance improvements. Lucian Bebchuk and I have shown that these reforms, while a step in the right direction, still leave managers with considerable power over their boards.9 Managerial power should be reduced, we have suggested, by making it easier for shareholders to replace directors who fail to serve their interests.10 Our critics have argued that SOX and recent reforms have adequately addressed U.S. corporate governance problems, making further reforms unnecessary.11The phenomenon of secret option backdating, I explain, suggests that these critics were mistaken. Among other things, SOX put in place new option transaction disclosure requirements that, if followed, should have put an end to secret backdating.12 In particular, firms were required to disclose each executive option transaction within two business days. This two-day disclosure requirement made it impossible for complying firms to backdate these transactions more than two days.However, thousands of firms continued to secretly backdate options by weeks or months after SOX, even though it entailed - in addition to other legal violations - a blatant disregard of the Act's two-day reporting requirement. The fact that secret backdating persisted after SOX provides evidence that, as Lucian Bebchuk and I have argued, managers indeed continue to have excessive power over their boards. Further reforms aimed at increasing shareholder power may thus be needed.The remainder of the Article proceeds as follows. Part II describes the first form of secret backdating: The practice of covertly backdating executives' option grants. It begins by explaining that most stock options have been granted to executives at-the-money (with a strike price set to the grant-date market price) rather than in-the-money (with a strike price set below the grantdate market price). …