Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [21]
The problem with financial products that make cheating easy is that cheats tend to flock to them. The deck is already stacked in favor of stock option holders and against other shareholders. But now the truly greedy pulled cards out of their sleeves. It is not necessarily illegal if everything is fully disclosed, but in every instance, it is sleazy. Moreover, if disclosures are misleading, it can be deemed securities fraud. A March 2006 Wall Street Journal article identified about a dozen companies with suspicious patterns that had become the target of an SEC probe.8
Backdating ensures the most advantageous value possible to employees receiving stock options, no matter how one calculates the value. For example, suppose the rational strike price of a stock option based on business value is $10 at the time a stock option is awarded. But if, three months prior to the options being awarded, the stock had traded at its lowest price for the past year, say at a price of only $3, a backdating executive could set the strike price of the option at only $3 and give himself a much better chance of realizing a future gain.The option is therefore much more valuable.
Backdating is deft theft. Shareholder value is diluted more than any reasonable man expects. Unless the cost of the stock option is expensed, shareholders have a very hard time realizing that executives just took a larger piece of the investment pie than the shareholder might otherwise have been willing to cut for them. Expensing stock options deters cheats.When stock options are immediately expensed, the cost becomes transparent. Had corporate America listened to Warren Buffett, expensing would probably have killed backdating before it started.
Warren’s wisdom is often at odds with “famous names” and the nonsense taught by economists in graduate business schools. In August 2006, venture capitalist Kip Hagopian published a commentary in California Management Review, the scholarly journal of the University of California-Berkley Haas School of Business. He stated that expensing employee stock options was improper accounting and argued stock prices reflect employee stock options liabilities, implying that shareholders know how to efficiently value these stock options.9 He got 29 “famous names” to undersign his article. These included Milton Friedman (who would pass away in November) and Harry Markowitz, both former University of Chicago professors and winners of the Nobel Prize in Economics; George P. Schultz and Paul O’Neill, both former U.S. Treasury secretaries; and Arthur Laffer. Holman W. Jenkins Jr., a member of the Wall Street Journal editorial board, also supported this notion in a separate commentary.10 Even if it were true that shareholders are well equipped to independently value stock options—and it is not—the proper place to account for costs is in the accounting statement. Shareholders shouldn’t have to make a separate correction for material information that has been omitted from financial statements. The “famous names” should have lobbied for more transparency, or better yet, the abolishment of stock options as a compensation scheme. Instead, these Princes of Darkness advocated opacity.
By September 2006, more than 120 U.S. corporations were under investigation by U.S. regulators for backdating employee stock options, followed by many more. By September 2007, companies including Affiliate Computer Services, Apple Inc., Broadcom, United Health, and more had been subjects of the SEC probe, lost senior executives, and reported serious accounting issues related to backdating. In total, 85 U.S. companies made earnings restatements or took charges against earnings due to backdating.
Berkshire Hathaway was not one of them.
If you asked the executives to sell the companies they manage at the same dip in the market price that they had assigned to the strike of their stock options, they would protest that depressed market prices do not reflect the