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Stock Option Evil Doers

5/19/06

The ranks of an obscure criminal class have swollen in the last few months: those who backdate options contracts. Where did all these evil-doers come from?

As of today, ten public company executives and directors have resigned over the matter, and the SEC is “probing” about 20 hapless firms. All this before some ambitious state attorney general or the tort bar gets hold of it. The flap has all the markings of another corporate America scandale.

We suspect a chunk of these backdaters were inspired to undertake their actions when FASB (or the Financial Accounting Standards Board, the CPA’s governing body) announced in 2004 a set of insanely complicated new rules effective mid-2005 that require companies to expense the costs of stock options against their bottom line. If you're thinking of playing options games, or even if you're on the fence, better to do it before falling under FASB’s microscope.

We’re not saying that backdating for the simple reason of instantly creating in-the-money options isn't criminal. It is, and the courts ought to nail the perps. What bothers us are the reverberations and implications of FASB’s pronouncement.

First, some context: FASB’s argument is that shareholders have the right to understand how executives cashing in their options will increase the number of shares outstanding, thereby diluting earnings per share. This, in turn and all things being equal, should reduce each share’s market value. Therefore the public gets screwed.

Well, yes, the public has a right to know about potential dilution, especially in high-tech microcaps. But the public has always had access to SEC filings on insider stock options granted, so they can calculate prospective dilution effects on their own.

The problem is that FASB demands to know what an option costs. This exercise launches the intrepid traveler into one of finance’s most theoretic and exotic realms, one where you can sight the Black-Scholes and Lattice Model rara avis. To calculate option cost, you first have to forecast when the option would be cashed. That, in turn, requires you to predict the stock’s value at various times in the future. (If you could do that, you should be making millions in the market, not fussing around with this arcana.) Then you have to roll back these moments of theoretical dilution to the present day by looking at the cost of capital to discount the timing variances. Now you've got "cost".

Sounds like a job for a market seer cum finance professor cum psychologist (since not all executives will cash in their options simply because their contracts are in the money). For a tour of the mind-boggling complexity of such calculations see The CPA Jounal’s “Accounting for Stock Options”. We'd like to see an historical analysis of how such cost estimates compare to reality.

In the never-ending search for financial certainty and security, there are some things that are simply unknowable beyond back-of-the-envelope intuition. FASB accountants, government watchdogs and class action lawyers apparently never encounter such circumstances. For them, a next logical step would be to demand that public companies guarantee their future stock prices.


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