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No. of Recommendations: 84
(also posted at: http://watchingtheherd.blogspot.com/2007/01/wsj-new-look-old-blind-spot.html )

Dow Jones updated the look and feel of The Wall Street Journal to make the content easier to read but seems to have done little to make the editorial content easier to stomach.

If you subscribe, you might want to save the January 3, 2007 issue. It could become a collector's item. First, it includes President Bush's call to Congress to help save his presidency with a helpful note at the bottom of the piece reminding the busy executive that Mr. Bush is the President of the United States. Uhhh, THANKS for that reminder.

It also contains the latest installment in a continuing series of columns by Holman Jenkins that wink at stock options backdating as a sign of honest compensation committees competing in a healthy market for executive "talent" so they attract nothing but the best and brightest to loot -- I mean lead -- their companies.

I've written about this before:

http://watchingtheherd.blogspot.com/2006/07/wsj-wrong-wrong-wrong.html
http://watchingtheherd.blogspot.com/2006/07/wsj-still-wrong-on-options.html
http://watchingtheherd.blogspot.com/2006/08/wsj-three-strikes-on-options.html

and will probably have to write about it again when Jenkins writes his next installment on the desperate plight of executives struggling to survive in retirement on $20,091 a day.

In the installment for January 3, 2007, Jenkins provides a bit of an update on the backdating saga at Apple Computer but quickly reverts to his prior arguments that backdating is a ethically harmless way to provide the economic equivalent of a comforting psychological "sippy cup" to executives by ensuring their options are "in the money" during their entire vesting period.

Soooooooo... Lemme get this straight.

We have executives who are supposed to possess the cutting edge financial savvy and nerves of steel required to make decisions about BILLIONS of dollars of revenue streams denominated in dozens of world currencies, choose investment strategies for capital investment across dozens of countries with varying tax rules and depreciation rules, and select hedge fund investments to protect BILLIONS in free cash belonging to stockholders that they've decided to horde in the company treasury.

These are the same executives who need to have options granted "in the money" because they are NOT sophisticated enough deep down in their morally and ethically pure souls to understand the true economic value of an option grant worth a few piddly million dollars?

Seriously.... ARE YOU KIDDING US?

The coup de grace of Jenkins' flawed thinking is his lead paragraph which states that the four dollar jump in Apple's stock price on December 29, 2006 when the Apple board released its report and its vote of confidence in Jobs proved "the market doesn't give a hoot about options backdating."

First, the report from Apple's internal investigation was exactly that -- an internal investigation, not an external legal / criminal investigation. The board report amounted to a puzzling "no one did anything wrong and we'll never do it again" statement that stated

a) Jobs had a hand in setting some of the specific bogus favorable grant dates for grants to some subordinates
b) in many of these cases, the grants were withdrawn so no one really profited from these grants anyway
c) oh yea, in one particular case someone filed documents implying full board approval of a grant when full attendance did not occur (#1)

The admission by the board that documents about board meetings were falsified in the process of operating Apple's option grant program should put the Apple case on a new level of legal concern for authorities and financial concern for investors, yet Jenkins glosses over this for the most part.

Coincidently enough, Jenkins also has the luck to again have his piece published on a day when the news of the day refutes much of his faith in the integrity of Corporate America. In this case, on the same day Jenkins argues that shareholders don't really care about options backdating and larger issues of outsized executive compensation, the board of Home Depot announced the resignation of CEO Robert Nardelli after years of pressure from shareholders about skyrocketing pay coupled and a slumping stock. Nardelli is leaving with $210 million, $20 million of that in cash. (#2) Previously, an August 16, 2006 column coincided with stories of accounting oddities at Dell and Rambus.

Jenkins also makes the mistake of trying to identify a collective motive in the decentralized herd that is the stock market by claiming the $4.00/share jump after the news was due to investors waiving off concerns about the ethical / legal lapses in the management of Apple. An equally likely (more likely?) explanation for the stock price is the following:

1) Apple's stock went from about $75/share 1/1/2006 to a peak of $93.16 during the year, making it a high gainer in the market
2) Investors dumped the stock on 12/27/2006 after hearing news of the board findings (constituting a more likely indication of investor sentiments about the board and Jobs), depressing the stock 6%
3) Mutual funds engaging in their own portfolio "apple polishing" picked up Apple shares on sale on the last day of trading in 2006 to make their portfolios look more sexy to potential investors looking at their next printed prospectus.

Investors, you cannot claim you weren't warned.

Repeatedly.

If you own stock in company A and company A's board collectively issues false information about YOUR company to you the shareholder and you continue to hold the stock without a change in the board, YOU DESERVE TO LOSE EVERY PENNY YOU HAVE. With cheerleaders like Holman Jenkins and the editorial board of The Wall Street Journal egging on Corporate America from the sidelines, you probably will.


WTH

===========================

#1) http://news.yahoo.com/s/nm/20061228/bs_nm/apple_options_dc

#2) http://biz.yahoo.com/ap/070103/home_depot_nardelli.html
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WTH

Please accept one mega rec. My lifetime supply if I live long enough.

Tom
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WatchingTheHerd says

In the installment for January 3, 2007, Jenkins provides a bit of an update on the backdating saga at Apple Computer but quickly reverts to his prior arguments that backdating is a ethically harmless way to provide the economic equivalent of a comforting psychological "sippy cup" to executives by ensuring their options are "in the money" during their entire vesting period.

Soooooooo... Lemme get this straight.

We have executives who are supposed to possess the cutting edge financial savvy and nerves of steel required to make decisions about BILLIONS of dollars of revenue streams denominated in dozens of world currencies, choose investment strategies for capital investment across dozens of countries with varying tax rules and depreciation rules, and select hedge fund investments to protect BILLIONS in free cash belonging to stockholders that they've decided to horde in the company treasury.

These are the same executives who need to have options granted "in the money" because they are NOT sophisticated enough deep down in their morally and ethically pure souls to understand the true economic value of an option grant worth a few piddly million dollars?

Good post overall, WTH. However, Apple is not a strong example. Consider that at the time of the options backdating, the leadership was a bunch of guys who had pulled off a takeover after their company was bought by Apple. They went from a company that was drifting sideways to one that was in serious danger of going down the tubes, and it looks to me like the options contributed to keeping them on board, especially the technical leadership.

Now the bad thing about the backdating shenanigans is supposed to be the dilution of shareholder value. I don't know how to calculate the loss due to dilution by those stock options, but during the subsequent years, AAPL went from the 4 - 6 dollar range to the 60 - 85 dollar range. As a long-term AAPL holder, I am happy enough with the stock performance that I find it impossible to get upset about the dilution.

crassfool
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Now the bad thing about the backdating shenanigans is supposed to be the dilution of shareholder value. I don't know how to calculate the loss due to dilution by those stock options, but during the subsequent years, AAPL went from the 4 - 6 dollar range to the 60 - 85 dollar range. As a long-term AAPL holder, I am happy enough with the stock performance that I find it impossible to get upset about the dilution.

I'd be more concerned about the fact that management appears to have ethical problems and they're acting like its no big deal.

Sure, it might be an isolated incident, but who knows? And they're acting completely unrepentant about it to boot.

Maybe its worth the risk but it would really worry me...
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Now the bad thing about the backdating shenanigans is supposed to be the dilution of shareholder value. I don't know how to calculate the loss due to dilution by those stock options, but during the subsequent years, AAPL went from the 4 - 6 dollar range to the 60 - 85 dollar range. As a long-term AAPL holder, I am happy enough with the stock performance that I find it impossible to get upset about the dilution.

To each there own but backdating as Apple did is illegal and dishonest. So boardmembers/executives enrich themselves illegally and dishonestly? I'd rather put my money elsewhere.

Is backdating of ESO grants illegal?

Backdating of ESO grants is not necessarily illegal if the following conditions hold:

No documents have been forged.

Backdating is clearly communicated to the company's shareholders. After all, it is the shareholders who effectively pay the inflated compensation that typically results from backdating ESOs.

Backdating is properly reflected in earnings. For example, because backdating is used to choose a grant date with a lower price than on the actual decision date, the options are effectively in-the-money on the decision date, and the reported earnings should be reduced for the fiscal year of the grant. (Under APB 25, the accounting rule that was in effect until 2005, firms did not have to expense options at all unless they were in-the-money. However, under the new FAS 123R, the expense is based on the fair market value on the grant date, such that even at-the-money options have to be expensed.) Because backdating is typically not reflected properly in earnings, some companies that have recently admitted to backdating of options have restated earnings for past years.

Backdating is properly reflected in taxes. The exercise price affects the basis that is used for estimating both the company's compensation expense for tax purposes and any capital gain for the option recipient. Thus, an artificially low exercise price might alter the tax payments for both the company and the option recipient. Further, at-the-money options are considered performance-based compensation, and can therefore be deducted for tax purposes even if executives are paid in excess of $1 million (see Section 162(m) of the Internal Revenue Code). However, if the options were effectively in-the-money on the decision date, they might not qualify for such tax deductions.
http://www.biz.uiowa.edu/faculty/elie/backdating.htm
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crassfool writes:

------------------------
However, Apple is not a strong example. Consider that at the time of the options backdating, the leadership was a bunch of guys who had pulled off a takeover after their company was bought by Apple. They went from a company that was drifting sideways to one that was in serious danger of going down the tubes, and it looks to me like the options contributed to keeping them on board, especially the technical leadership.
------------------------

From the books and articles I've read since about 1988, I have my doubts about Jobs. Jobs gets much of the public acclaim as the technical visionary of Apple. However, Apple has been blessed with some AMAZING engineering talent where the rubber meets the road at crucial times in their history (the team of 12-16 core engineers that created the Macintosh being the prime example) who were treated pretty poorly from a financial and cultural standpoint by Apple management. They worked hard because they believed in what they were doing, not because management was dangling financial incentives. I recall stories about the Macintosh effort that said most of the core team probably made maybe $60-70k/year from 1982-1984 but worked 100-120 hours/week the entire time and got NOTHING from Apple in terms of options.

In short, my take on Apple is that its darkest days were typically caused by marketing-focused executives who were able to lead the company during stable periods but lacked the technical expertise and vision to steer the company through the routine technology "lurches" that occur in Apple's industry. Apple didn't survive these downturns by managers like Jobs actively coming in and PULLING the company from under the water, they survived when INCOMPETENT management left and allowed the core of technical expertise to quickly bob back to the surface. It might look the same to the casual observer but the underlying organizational reasons are vastly different.

To the extent options backdating was taking place in Apple to stabilize the firm, I doubt it helped stabilize the talent that wound up producing the iPod or designing the iTunes on-line retail experience or porting the OSX operating system to Wintel in 18 months without a hitch. (Disclaimer: I obviously bring a pretty pro-engineer, dubious-executive slant to the analysis...)

------------------------
Now the bad thing about the backdating shenanigans is supposed to be the dilution of shareholder value. I don't know how to calculate the loss due to dilution by those stock options, but during the subsequent years, AAPL went from the 4 - 6 dollar range to the 60 - 85 dollar range. As a long-term AAPL holder, I am happy enough with the stock performance that I find it impossible to get upset about the dilution.
------------------------

You mention one of two key problems I see with the backdating practice besides the obvious legal / ethical concerns. From a dilution standpoint, part of the danger is the sheer size of American companies is so great that boards and shareholders are losing perspective on things back at the human level.

Since they're in the news, let's take Home Depot as an example. Today's front page article on Home Depot in the WSJ mentioned that besides the ongoing personality battle over their ex-CEO, Home Depot also faced backdating backlash. Per the article, the report issued by its board in December found their 20-year habit of backdating had understated executive compensation by $200 million.

For a stock that has split 9 times in 21 years, $200 million spread over 20 years seems like a small dilution of shareholder equity. If you even try to come up with a sense of the magnitute of the questionable compensation on a per share basis, you might spread $10 million across 2,040,000,000 outstanding shares and you get a "backdating" tax of $0.49 per share per year. A half of a penny per year. Hardly worth worrying about, I guess, right?

Wrong. In my mind anyway. This is the real-life equivalent of the scheme from Office Space, the cult-classic spoof of life in high-tech corporate America, where three software engineers come up with a scheme to steal the "rounding errors" on interest calculations from banks and deposit them in their own account. The perfect crime -- stealing tenths of a penny at a time where the theft is below the precision of the accounting systems adding the numbers up at the end of the day.

The only difference is Office Space was a movie. Boards and CEOs and CFOs who participated in backdating were stealing from shareholders in real life knowing that most investors wouldn't even think about it as long as their own stock was going up. They depended on it. As long as everyone's making money, a few of us stealing some of the money being made wasn't a problem.

The other problem with the options backdating process is, as Home Depot and others are finding out, it resulted in understating the true compensation of the firm's executives. Given that executive pay growth has been closer to exponential than linear, in the case of Home Depot, it's probably safe to assume most of that $200 million in understanded executive pay reflects dollars collected over the past (say) 5-10 years. Well, that overlaps quite well with the tenure of the now-ousted CEO who was tossed because of the combination of HD's stalled stock price and his ever-growing pay. Well, would the board and shareholders become more vocal earlier in the process if they had a more clear picture of how much cash Nardelli was actually draining from the firm's coffers?

THAT'S the real point. At a time when executives claim they are worth huge salaries, board and shareholders may be only looking at the tip of the iceberg when deciding if the exec is doing a "good enough" job to justify $6 million per year when in fact he's costing them $10-12 million. Or $21.6 million like Nardelli collected from Home Depot in January 2006 -- only one year before they decide to toss him overboard.


WTH


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Boards and CEOs and CFOs who participated in backdating were stealing from shareholders in real life knowing that most investors wouldn't even think about it as long as their own stock was going up.

Although most CEOs and top executives do not deserve such mega compensation, in a way option backdating is a "relatively" cheaper way to pay for this largese.

If the board decided to award the CEO $40 million, by back-dating to a date when the strike price was low, they were giving the CEO lesser number of shares.

In a way, back-dating was doing was doing less damage.
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Although most CEOs and top executives do not deserve such mega compensation, in a way option backdating is a "relatively" cheaper way to pay for this largese.

If the board decided to award the CEO $40 million, by back-dating to a date when the strike price was low, they were giving the CEO lesser number of shares.

In a way, back-dating was doing was doing less damage.


======================

I'm not sure I understand / agree with your point.

I think you're assuming that the total quantity of outstanding shares over the life of the grant is small enough so the quantity of options involved with these grants is material in relation to that larger pool. Via backdating, fewer units of shares were required to provide the same dollar value of compensation, thus preventing a large monetary award from altering the voting balance of power of the company as much as it otherwise would have.

For virtually all of these firms involved, the quantity of shares as a percentage of total outstanding votable shares are a blip on the radar (Home Depot for example has two billion+ shares outstanding), and thus the recipient isn't getting a materially diluted voting bloc via backdating versus "fair-dating". They have no real "voting" power per se at all. Of course, they don't need voting power to steer the company. They control the information reaching the board in some cases or reaching shareholders who collectively control the vote or throw it away by allowing the board to vote their proxy.


WTH
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Boards and CEOs and CFOs who participated in backdating were stealing from shareholders in real life knowing that most investors wouldn't even think about it as long as their own stock was going up. They depended on it. As long as everyone's making money, a few of us stealing some of the money being made wasn't a problem.

If people making $20million are willing to lie/steal to make $25million, how can we believe that anything they say & do is not for the sole purpose of making even more money without concern as to employees/customers/stock owners/health/pollution/... ?
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For a stock that has split 9 times in 21 years, $200 million spread over 20 years seems like a small dilution of shareholder equity. If you even try to come up with a sense of the magnitute of the questionable compensation on a per share basis, you might spread $10 million across 2,040,000,000 outstanding shares and you get a "backdating" tax of $0.49 per share per year. A half of a penny per year. Hardly worth worrying about, I guess, right?

===================

I actually did the math correctly, just typed it wrong. $200M / 20 years / 2.04 billion = 0.0049 = $0.0049.


WTH
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WatchingTheHerd says

From the books and articles I've read since about 1988, I have my doubts about Jobs. Jobs gets much of the public acclaim as the technical visionary of Apple. However, Apple has been blessed with some AMAZING engineering talent where the rubber meets the road at crucial times in their history (the team of 12-16 core engineers that created the Macintosh being the prime example) who were treated pretty poorly from a financial and cultural standpoint by Apple management. They worked hard because they believed in what they were doing, not because management was dangling financial incentives. I recall stories about the Macintosh effort that said most of the core team probably made maybe $60-70k/year from 1982-1984 but worked 100-120 hours/week the entire time and got NOTHING from Apple in terms of options.

I was there. All of the Macintosh core team did just fine on options. I wasn't on that team, but I did OK on options too.

Funny story: when I was being hired as a technical writer, I was made an offer that didn't say anything about stock. I said to the hiring manager, "How about some stock options?" She said "Oh, I'll have to ask Steve and Mike." Two days later she was back with a stock option offer which I accepted. A couple of years later, I said to myself Geez, I should have insisted on twice as much stock and they would have given it to me. It was just pre-IPO stock, nobody had any idea what it was worth.

But some time after that, I was apparently the only technical writer who had stock options. This was brought to the attention of Steve Wozniak, and he just gave a bunch of his options to the other writers.

In short, my take on Apple is that its darkest days were typically caused by marketing-focused executives who were able to lead the company during stable periods but lacked the technical expertise and vision to steer the company through the routine technology "lurches" that occur in Apple's industry. Apple didn't survive these downturns by managers like Jobs actively coming in and PULLING the company from under the water, they survived when INCOMPETENT management left and allowed the core of technical expertise to quickly bob back to the surface. It might look the same to the casual observer but the underlying organizational reasons are vastly different.

But those dark days were when Jobs was absent. Believe me when I say that the company was on its way underwater for the last time when Jobs came back and took over, with a team from NeXT.

To the extent options backdating was taking place in Apple to stabilize the firm, I doubt it helped stabilize the talent that wound up producing the iPod or designing the iTunes on-line retail experience or porting the OSX operating system to Wintel in 18 months without a hitch. (Disclaimer: I obviously bring a pretty pro-engineer, dubious-executive slant to the analysis...)

I was an engineer throughout that time, and I will tell you two things: One, the options stuff definitely played a part in keeping the NeXT people on board -- after all they had just commandeered a sinking ship. Two, my emotional bias goes the other way -- like most old Apple employees I despised the NeXT engineering executives who treated us like dirt. But the fact remains that Steve Jobs saved the whole company from going down the tubes. He's not my friend, and his friends are not my friends, but he and his friends made my AAPL stock worthwhile.

Along with the AAPL stock of millions of other grateful investors. That's why Apple is a poor example of the evils of stock-option manipulations.

crassfool
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Interesting. You never know who's typing on the other end of these posts...

I've probably read a lot of the stuff you wrote, like Inside Macintosh (I-VI).

Thanks.


WTH
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WatchingTheHerd says

Interesting. You never know who's typing on the other end of these posts...

I've probably read a lot of the stuff you wrote, like Inside Macintosh (I-VI).

I would love to have been associated with Inside Mac, but I was writing Lisa stuff that nobody remembers. And then I transferred into software engineering.
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Since I believe that all companies managements screw their stockholders and employees, who through 401K and stock purchase plans are also stockholders making them double screwed, in this way, what are you recommending?

Give us your options please. Or if you believe there are morally, you define the term, upright companies please give us your list.

PF
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Jenkins is an Op-Ed writer, not a news reporter. Do you agree with all the Op-Eds in all the papers - The Economist, the FT, the NYT, the WaPo, Crain's, etc?

The News Division of the WSJ has won mulitple Pulitzers, something that won't be changing any time soon.

For really stupid Op-Eds, I refer you to the ones printed in the NYT 15 years ago about how a law passed by Congress limiting tax deductibility of exec salaries to $1mm would solve the 'overpaid executive' problem.

Naj
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