Cash Bonuses for Backdated Options

According to a January 20, 2007 Wall Street Journal article entitled “Executives Get Bonuses As Firms Reprice Options” (here, subscription required), some of the companies ensnared in the options backdating scandal are paying cash bonuses to executives whose options are being repriced, as the option exercise price is shifted to the actual grant date from the backdated date. According to the article, these bonuses are going to executives who weren’t involved in options wrongdoing, and who would otherwise see the overall value of their paid compensation shrink as a result of the repricing.

Although the repricing is designed to make the executives’ compensation whole, some executives could wind up better off as a result of the cash bonuses, because they are “swapping unrealized, potential profit” (since the share price could decline) for cash. In the examples cited in the article, the cash bonuses involve payments of hundreds of thousands of dollars.

Some companies are going even further and paying the 20% excise tax payable under IRS Section 409A on “discount” options whose exercise price is below the level of the stock on the day the option is granted.

The article does point out that there are a number of companies that have concluded that the problem “should be fixed without taking more out of shareholders’ pockets” and have accordingly declined to pay additional amounts to affected executives.

What are we to make of all this? On the one hand, as Professor Larry Ribstein points out on his Ideoblog (here), the executives receiving the cash bonuses weren’t involved in the backdating: “If they didn’t do anything wrong, why punish them by taking away some of their agreed compensation?”

While I see Professor Ribstein’s point, it is a struggle for me to see that the right thing for companies to do here is make a cash payment to the executives. The point of options compensation is to align corporate managers' interests with those of shareholders by providing that managers only do well if shareholders do well. By converting that investment risk into fixed cash, the element of shared interest is eliminated. To the contrary, it converts the shared interest into exclusive service of executives’ interests at shareholders’ expense.

The reality of shareholders expense leads to another concern. The executives receiving the cash bonus may have been cleared of wrongdoing, but for the backdating to have taken place there had to have been some missing internal controls. Even if the executives were uninvolved in the wrongdoing, they were present when the errors occurred. As between the executives and investors, who ought to absorb the compensaion consequences involved with cleaning up the mess? Shareholders already are absorbing all of the costs of accountants’ and attorneys’ services required to clear up accounts. Why should shareholders also have to absorb additional costs for cash compensation to senior executives who were “on the bridge” when the malfunctions occurred?

There are also a couple of very serious atmospheric problems with the cash payments at this particular point in time. First, by communicating that the incremental additional value of the backdating options represents compensation to which the executives were entitled, the companies are inferentially suggesting that the backdating was an intended part of their compensation scheme. (This is a conclusion that Professor Ribstein overtly draws.) Whatever the theoretical debate might be about the propriety of backdating, now is a particularly poor time for companies to suggest that backdating was a calculated part of their intended compensation scheme.

Finally, with all of the scrutiny on executive compensation in general right now, providing executives with immediate cash payment for flawed variable compensation sends a very provocative message – particularly as at least some of the companies involved, according to the Journal article, have not yet determined how they will treat backdated options by nonexecutive employees.

These and other concerns are obviously the reason why many other companies are declining to reimburse executives for repriced options. The fact that many companies have declined to make these cash payments certainly puts the companies that are making the payments in a conspicuous spot – the front page of the Wall Street Journal, for starters.

H-P CEO Claims He Was Not “Bullet Dodging”: On January 19, 2007, the House Committee on Energy and Commerce forwarded to the SEC a letter that H-P CEO Mark Hurd sent to the Committee in response to the Committee’s questions about his exercising of H-P options shortly before the H-P pretexting scandal broke last fall. A copy of the Committee’s letter, to which Hurd’s letter is attached, can be found here. In his letter, Hurd defended the stock transactions, which took place two weeks before the pretexting scandal broke, and the same day as he was questioned by H-P’s outside counsel in connection with the internal investigation surrounding the abrupt resignation of former H-P board member Tom Perkins.

Hurd specifically wrote that “My August trade was not a case of bullet dodging.” Hurd stated that the trade was part of his regularly scheduled trading plan, established on the advice of his financial planner and broker, and consistent with the legal opinion he received from H-P’s counsel in advance of the trades. He also states that he began the process to execute the trades before anyone had asked to interview him. He also pointed out that the options exercised were granted, and the exercise price was set, long before the exercise date.

While the letter is interesting and its release has generated press attention (for example, this January 20, 2007 San Jose Mercury News article, here) this may all be much ado about nothing. As the While Collar Crime Prof blog points out (here), “while the timing is suspicious … the company’s stock price increased after Hurd’s sale,” so that rather than dodging a bullet, “he may actually have taken one instead.”

Oh, Behave: Some great quotes about behaving comme il faut (or not), here.