Now that the scandal, media frenzy, investigations (internal and external), prosecutions, and shareholder litigation seems to be winding down, a recently published academic study suggests that backdated options may not have done much harm to shareholders after all.

Is Backdating Executive Stock Options Always Harmful to Shareholders?
The study, “Is Backdating Executive Stock Options Always Harmful to Shareholders” authored by a team of five academics, posits that backdating isn’t the problem it was perceived to be because:

1. The real cost of stock options to shareholders is dilution, which is disclosed via diluted EPS. This calculation takes into account the strike price of the option, whether backdated or not, therefore, shareholders were aware of the potential dilution caused by backdating.
2. The reduced exercise price is more valuable to employees than the company’s cost for the discount. Thus, companies that granted backdated options may have been able to grant smaller options that were less dilutive than the options they would have granted if the options had been at-the-money at grant.

A Case for Discounted Stock Options

I was excited to see the paper, not because I think backdating is okay, but because I am a fan of discounted options. Under ASC 718, discounting an option doesn’t necessarily result in a dollar-for-dollar increase in the fair value of the grant. This makes discounted options a bargain from a compensation standpoint: the expense for the discount is less than the value delivered to employees (for this same reason, I’m not a fan of premium-priced options). The paper does conclude that there are situations where discounted stock options can be beneficial to both the company and employees.

Unfortunately, the very real obstacle of Section 409A still stands in the way of actually granting discounted options and, from a tax-revenue perspective, there are some valid reasons to discourage discounting (see my blog entry “Discounted Stock Options: Inherently Evil or Smart Strategy?,” March 16, 2010), so I don’t see this changing any time soon, study or not.

Flaws in the Study

There are also a number of flaws in the study. First, the study assumes that the company never realizes a tax deduction for ISOs and that ISOs have to be subject to vesting requirements–any Level I CEP candidate knows that both of these premises are false. In addition, the study assumes that stock options never qualify as performance-based compensation under Section 162(m). The authors in general seem to be very confused as to the operation of this area of the tax code.

Word of the Day

I did learn a new word when reading this study: “Pareto-improving,” which refers to something which harms no one and benefits at least one person. The authors conclude that, at least in some situations, backdated options can be Pareto-improving. I still haven’t figured out what sunspot equilibria are, though.

Only a Few Days Left for NASPP Conference Early-Bird Rate
The 19th Annual NASPP Conference early-bird rate expires this Friday, June 24.  This deadline will not be extended–register for the Conference today, so you don’t miss out.

NASPP “To Do” List
We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog. 

• Register for 19th Annual NASPP Conference (November 1-4 in San Francisco).  Don’t wait; the new early-bird rate is only available until this Friday, June 24.
• Check out the NASPP’s Facebook and Twitter pages.
• Register for the NASPP’s newest online course, “Financial Reporting for Equity Compensation.” 
• Complete the Compliance-O-Meter quiz on Reconciling Broker Transactions.
• Take the “Question of the Week” challenge.
• Renew your NASPP membership for 2011 (if you aren’t an NASPP member, join today).
• If you are in the Altanta area, attend the Atlanta NASPP chapter meeting on June 24. 
• Attend the Silicon Valley NASPP Chapter All-Day Conference this Thursday, June 23.  As I blogged about last week, I’ll be presenting on one of my favorite topics: Pumping Up Purchase Plans: Re-Thinking the ESPP.  I hope to see you there!

– Barbara