Wednesday, October 11, 2006 - The Progress & Freedom Foundation Blog

Backdating Ethics

Every day we learn of another company that had executives backdating stock options, and in many of those cases the CEO or board members have resigned as a result. This practice seems most prevalent in the tech industry, not surprising as that is where the culture of compensation through options is most pervasive. The tech industry fought a losing battle against FASB standards that required expensing of stock options; maybe part of their resistance was the fear that more transparency would lead sharp eyes to the backdating?

Warren Buffett has been sufficiently moved by the growing scandal that he issued one of his rare edicts to the leaders of his Berkshire Hathaway companies. From Forbes:

In a memorandum to his top managers, known as his "All Stars," the plain-talking billionaire urged resistance against the lure of such questionable if sometimes widespread practices as stock-options backdating. "The five most dangerous words in business may be 'Everybody else is doing it,'" the memo published by a British newspaper said.

With the images of the CEOs of WorldCom, Enron and others still fresh in our minds, what will be the fallout from this latest black eye to business?

The fallout, I fear, will be a further erosion of consumer trust.

This is very important, because markets can't function without trading within it, and in a global economy companies are essential for performing that trade (the Dutch taught us that hundreds of years ago when trying to leverage the cost of shipping ventures to the East Indies). Here at PFF, we like to call ourselves a free-market think tank. We don't call ourselves a pro-business think tank, preferring to leave that moniker to, say, a chamber of commerce. Why the distinction? Because markets are amoral; they produce outputs based on inputs. Actions by companies, however, can vary in their morality.

Companies shouldn't try to be saintly; I would never recommend a company adopt a motto of doing no evil, because it will be only too easy for critics to shout "hypocrite" every time the company pursues the financial interests of its stakeholders. But it's not unreasonable to expect a certain amount of ethical behavior among executives.

It's important to note that these backdating practices have been limited to executives. Today it has been reported that CNET co-founder and CEO Shelby Bonnie is stepping down as a result of a backdating controversy, although for some odd reason he's remaining a director (CNET was wise enough not to report on the resignation itself, instead posting a Reuters story). The period in question for CNET runs from 1996 through 2003, or most of the company's existence. I was an employee of Bonnie's CNET from 2000 to 2001. I was never able to exercise any of my stock options, because they were always "under water," or valued at a price higher than the stock's present market value, the entire time I possessed them. It appears that may not have been a problem for CNET executives.

There are too many people in this world who want to divide. Rich vs. poor. Corporations vs. the people. A scandal like this, where it seems pretty clear that some people who were doing very well got greedy and decided to do better, provides fuel for those seeking to divide both of the above camps.

In a business class I'm taking right now, the professor has spent some time talking about the scandals that led to Sarbanes-Oxley. All evidence, including a recent speech from the former head of the Federal Reserve, shows that it was a typical Capitol Hill overreaction. The bad guys are going to jail on laws written before SOX, and now companies that were playing by the rules all along have to spend tons of money just to prove that (ex ante vs. ex post approach yet again). The only SOX winner is the new SOX-compliance industry. Yet most of my classmates, still furious over the scandals of a few years ago, think SOX didn't go far enough and would support further regulation. I'm sure the stock expense scandal isn't helping perceptions.

In this modern era of instant news and incredible Wall Street and government scrutiny, if you are a business leader you need to realize that if you don't follow Buffett's advice and do what you know is right rather than what others seem to be doing, you'll eventually get caught. You should also know that the fallout won't just affect you, but confidence in the market as well, even though the market itself is neutral and bears no culpability for your greed.

posted by Patrick Ross @ 11:20 AM | Generic Rant