Editor's Note: In the middle of the last decade, two business professors and a handful of
Wall Street Journal reporters called attention to widespread backdating of employee stock options, launching a flurry of prosecutions that cost numerous executives their jobs and a few their freedom. Roger Donway ’s monograph Rich-Hunt tells the story of Greg Reyes, CEO of Brocade Communications Systems, who was convicted and sentenced to 18 months in prison and a $15 million fine—a miscarriage of justice wrought by ambitious prosecutors and their cheerleaders in the media. At The Atlas Society’s 2012 summer conference, where Greg Reyes spoke of his ordeal, Roger Donway explained why the backdated-options frenzy was an anti-business persecution generated out of the flimsiest excuses. What follows is an edited version of Donway’s talk.

My monograph Rich-Hunt is subtitled “The Backdated Options Frenzy and the Ordeal of Greg Reyes.”  But if you have not read the monograph, and if you missed the whole frenzy of 2005–2011, you may well wonder: What is a backdated option? Indeed, you may not even be quite sure about what an option is and how it works. So, let me start there.
An option is a type of security that gives a person the right to buy a share of a company’s stock at a specified price. For example, an option might give you the right to buy a share of Google at $5. That would be a very valuable option. Or an option might give you the right to buy a share of Google at $5,000. That would not be so valuable.
Typically, when a company gives options to its employees as a form of compensation, the employees are allowed to buy shares in the company (which is called “exercising the options”), and the price at which they may buy the stock is called the option’s “exercise price,” or “strike price.” Typically, however, they can exercise their options only after a defined span of time (called “the vesting period”) and before a certain date (called “the expiration date”).
So, the value of such option grants rests entirely on the possibility that the stock will be selling above the strike price during the period of time that the employee is permitted to use the option to buy a share. If the stock price is higher than the exercise price, the employee can reap a profit by purchasing a share of stock at the exercise price and then immediately selling that share on the stock market. Of course, if the stock price does not rise above the strike price between the time that the options vest and the time that they expire, then the options are forever worthless.
Typically, when an employee exercises an option, the corporation creates a new share of stock to sell to the option holder, thus expanding by one share the total number of shares outstanding and so diluting by some amount the worth of each previously outstanding share.
Typically, too, the unvested options of an employee who leaves a company expire immediately.
OK. Step two. Options can be described as in-the-money, at-the-money, or out-of-the-money. If an option’s exercise price is below the current stock price, it is said to be “in the money.” If an option’s exercise price is exactly equal to the current stock price, it is said to be “at the money.” And if an option’s exercise price is above the current stock price, it is said to be “out of the money.” But these are descriptions that really make sense only if the option is in the period when it can be exercised.
If you keep in mind what I said a moment ago, you can see that these three descriptions may be deeply misleading when the option cannot yet be exercised. If an option is “in the money” but will not vest for another five years, what sense does it make to call it “in the money”? A horse that finishes “in the money” has finished the race and has definitely won something for those who bet on him. But an option that is “in the money” may prove worthless in the end.
To see the problem, imagine an option to buy Google stock that has an exercise price is $5. That option is deeply in the money. Last time I checked, it is approximately $560 in the money. But remember: Options typically have a vesting period and an expiration date. So, suppose the Google option does not vest until July 1, 2112, and it expires on July 2, 2112. Obviously, the worth of the option is highly uncertain. In fact, it would probably be worth nothing. Because who knows whether Google will even exist a hundred years from now?
So, the phrase “in the money,” when taken out of all context, tells you almost nothing about an option.
Of course, if options are going to be used as a method of compensation by companies, they cannot be as dubious as the Google option I just described. After all, when options are used as a method of compensation, the prospective employee is going to be thinking about getting the options and working for a smaller cash salary than he otherwise would. In negotiations, therefore, he is going to ask: How much is this grant of options likely to be worth to me in the end? How many options am I getting, how long is their vesting period, when is the expiration date, and how much am I likely to make on each option?
He may make nothing, obviously. Even if he negotiates what he thinks is an extremely good deal, it is still a gamble on his part. He has to weigh the quantity of options he is getting and the exercise price, against the current price of the company’s stock and its likely future price—as he sees it. If the company offered him a million options, vesting immediately—but their exercise price was 1000 dollars over the current stock price— he would say, “Forget it. I’ll take the cash.” So, it’s a gamble: quantity, exercise price, current stock price.
At the same time, the company that wants to hire the employee is also juggling quantity, exercise price, and current stock price. The company wants the prospective employee to accept more options and less cash. But it wants to hold down the quantity of options, because it does not want the shareholders’ equity to be too greatly diluted. One solution is to give the prospective employee a relatively small number of options, but make each option more likely to bring the employee some money after they vest. And the company can do that by keeping the exercise price of the options low. Assuming the company is doing well, over the long term, the employee can then be fairly confident that he will make some money from the options, although obviously he does not know how much.
Indeed, what companies found was: Potential employees whose options are a little below the current stock price are likely to settle for far fewer options even though they may not be able to exercise those options for months or years to come. Psychologically, just having options that are even a little in-the-money gives potential employees a lot more confidence and thus a lot greater willingness to accept options in place of cash. And of course that optimistic psychology allows the company to offer fewer options, and dilute shareholder equity less.

APB 25

So, it makes sense for companies to offer prospective employees an options package that is slightly in the money. With such an options package in hand, employees are willing to accept fewer options for the cash they give up, and the shareholders gain because their equity will be less diluted if the option holder ever does get to exercise his options. This is another point that you would never have gleaned from the frenzy that journalists created about backdated options: offering to prospective employees options that are in the money is a positive thing for shareholders, not a negative thing; and the more “in the money” the options are, the more positive.
Leave it to government to screw up a solution that’s a winner all around.
The SEC, as you probably know, requires publicly traded companies to certify that their annual reports and quarterly reports are prepared in accordance with generally accepted accounting principles, colloquially known as GAAP. And these accounting principles are determined by a private organization set up by the accounting profession. Up until 1973, this organization was the Accounting Principles Board; beginning in 1973, it was the Financial Accounting Standards Board.
Now, in 1972, just before its expiration, the Accounting Principles Board issued one of the most idiotic opinions ever put forth in the entire history of accounting. As this was the 25th opinion of the Accounting Principles Board, it is known by the deceptively bland name of APB 25.
APB 25 resolved the highly controversial question of how compensation options should be treated in corporate reports. And what APB 25 said was: In-the-money options must be treated as a noncash expense.

That idiocy was the entire basis of the backdated-options frenzy.
 So here are a couple of examples. A company gives an employee one million options with an exercise price of $10, on July 1, when the stock price stands at $10. Those options, under APB 25, represent absolutely no expense at all to the company and its shareholders. They don’t cost them anything. And this is true even if the options vest immediately, the stock price on July 2 is $11, the happy recipient walks away with $1 million in profits on July 2, and the shareholders have their equity diluted by the addition of a million shares. All of that is absolutely no expense at all to the company.
But suppose the company issues 100 options to an employee on July 2, with exactly the same exercise price of $10. That does represent an expense to the company according to APB 25. Why? Because the stock price is $11 on July 2. And those 100 options represent an expense to the company even if the options’ vesting date is years in the future; and even if the stock price falls on July 3, never to break $10 again, and thus the options are never exercised and the shareholders’ equity is never diluted in the least.
Now, if that makes sense to you, then you may have a job with the SEC or the Justice Department or the Wall Street Journal. Because that is the idiocy of APB 25, and that idiocy was the entire basis of the backdated-options frenzy.

Backdated Options

At the time APB 25 was issued, unfortunately, businessmen did not fight back against its idiocy. For one reason, options were not as significant a method of compensation in 1972 as they would be later, during the Internet boom.
Businessmen also did not fight back because these absurd noncash expenditures were not something that real investors worried about. Yes, the deduction from earnings might look bad superficially, and unsophisticated business journalists might take them seriously. But a genuine investor would ignore these so-called expenses—generated of, by, and for the sake of GAAP.
And then, too, there seemed to be many ways by which companies could avoid APB 25’s nonsense without actually violating the regulation.
Which is where we move into the subject of backdating options.
If a company’s stock is fluctuating around a more or less fixed point, it might well be possible for an astute executive to offer prospective employees their option package at a time when the executive fairly well knows that the stock is at a low point. In fact, the executive might know that the company is about to announce some good news that will send the stock higher. Stock options issued when the stock was known to be low would not constitute an expense under the absurdity of APB 25, but such options would nonetheless very soon be in-the-money.
But there was another way that many CFOs and general counsels thought that companies could get around the idiocy of APB 25, and that was the legal doctrine of nunc pro tunc, or “now for then.” Corporate boards occasionally put corporate actions into effect retroactively. They do this either at a board meeting or by means of a Unanimous Written Consent.

These retroactive actions are perhaps most familiar in conjunction with Unanimous Written Consents, because in those cases the company wants an action to go into effect immediately, without waiting for all the consent forms to be faxed out to directors and faxed back. So, the consent forms say that the action goes into effect sometime prior to the form’s being signed.
So here was another way to get around the idiocy of APB 25. If the stock is up at the moment when you want to offer some options to prospective employees, in place of cash salary, look back to see if there was a day when the stock was somewhat down. Date the options on the day the stock was down, and then have the compensation committee put through the paperwork to make the grant retroactive.
That might seem fishy. But as the judge in the Greg Reyes trial noted, it is not. He said: “My guess is if you ask the American people, the public, and you say, ‘Do you think it’s all right to backdate a document,’ 90 percent will say, no, it’s not. But, by the way, they will be wrong because in some circumstances it’s perfectly right to backdate.” Unfortunately, he said that in a private meeting with the lawyers and not to the jury.

The Internet Boom

So much for the theoretical background on options. Let me move on to the history of the frenzy.
In the early 1990s, three things happened to increase greatly the use of options as a form of compensation.
In 1993, the Omnibus Budget Reconciliation Act included a highly egalitarian feature generated by a storm of outrage from the anti-capitalist culture: a $1 million cap on the amount of pay to top executives that a company could deduct as a business expense, unless it was performance based. Symbolically, it was a direct slap at wealth creators. Practically, it meant that the best chief executives would have to be compensated by some other means than cash. Stock and stock options were the most obvious method of linking pay to performance.
Not coincidentally, perhaps, the Financial Accounting Standards Board decided in 1993 that options would definitely have to be expensed from now on, using an equation—the Black-Scholes equation—that the FASB seemed to think could predict the value of options even in the absence of a market. This time, business did fight back, and the FASB allowed companies to go on using (and avoiding) APB 25, so long as they put the Black-Scholes information in footnotes.
Lastly, in the same year, 1993, the Mosaic web browser was released, and the Internet boom got under way. High-tech start-ups sprouted like mushrooms. They were short on cash but long on promise, and bright young men were willing to trade current salary for a piece of the action, in the form of options.
 Greg Reyes, former CEO of Brocade
Computer geeks became a mudslide, pouring down the California hills and into the new high-tech companies faster than the personnel departments could handle them. Brocade Communications Systems, Greg Reyes ’s company, was hiring hundreds of people a month.
And this raised a fundamental issue of fairness. The stock was rising rapidly. If 100 people doing similar jobs were hired across the span of one month, and were given equal quantities of options, with exercise prices set on the day their hiring, then people hired mere days apart, for similar jobs, would be receiving very different remuneration.
Here is a real example. A person hired by Brocade on May 25, 1999, who received 100,000 options with an exercise price set at that day’s close would have an exercise price of 45. A person hired three days later, on May 28, 1999, who received 100,000 options with an exercise price set at that day’s close, would have an exercise price of 65. So the first fellow, hired a mere three days before his colleague, has a package of options that is $20 in-the-money. He could not get at the 20 dollars, as I’ve said, because of the vesting period. Still, he was sitting on paper wealth of $2 million, before he had even set up his desk. Meanwhile the second person, coming in just three days later to do the same work, had no paper profit. And of course he had to wonder if the stock would keep rising at such a rapid rate. No tree grows to the sky, as stock investors say.

The purpose of backdating options was to reward wealth producers in a fair manner.
  Coincidentally, in just that month, May 1999, Brocade hired a new chief financial officer, Mike Byrd, who came up with a solution. Byrd had previously been CFO at Maxim Integrated, another Silicon Valley company, where they had had a system of backdating options. Byrd instituted the same system at Brocade, allowing new hires the freedom to pick the date on which they wanted their options priced. Eventually, however, the practice arose of having all the new hires within a fiscal quarter be given the same exercise price, and specifically, the stock’s low price for the quarter. That seemed to make the process as fair as it could be made.
Once the quarter’s whole contingent of new hires was completed, all of the paperwork needed to make the grants retroactive would then be drawn up by the Human Resources department.
Even so, the torrent of employees all getting option grants at the end of the quarter meant that the process of authorizing them needed to be made faster. It was not practical to have a bunch of directors take up their valuable time signing off on the compensation packages for hundreds of non-executive employees. So while the board retained the sole authority to grant options to directors and executives, Greg Reyes was made a committee of one for the purpose of granting non-executive options. As a result, after the Human Resources department had drawn up the retroactive paperwork, in accordance with Mike Byrd’s plan, Reyes would be brought a whole stack of option grants with little “Sign Here” stickers, and he would work through them as fast as he could, sometimes even while he was on the phone or in meetings.
So, in sum, the purpose of backdating options was to reward wealth producers in a fair manner. The procedure was necessary in order to avoid one of the most idiotic accounting rules ever set forth. And most people were convinced, in all good faith, that the ability of boards to take action retroactively made backdating legally permissible.

The Frenzy

Now, you may have noticed that the story I told focuses on the 1990s and the Internet boom. So it’s striking that the backdated-options frenzy did not erupt until late 2005, half a decade after the bubble had burst.
On November 3, 2005, the Wall Street Journal published a story that seemed to have no special import, buried as it was on page A7: the headline read: “Mercury Interactive Executives Quit: CEO, Finance Chief, Counsel Resign as Probe of Options Uncovers Improper Pricing.” The reporters were Rebecca Buckman, Mark Maremont, and Karen Richardson.
The cause of the exodus was said to be “disclosures about improper pricing of employee stock options.” The Journal story also said that Mercury had found several dozen cases in which “the reported date of a Mercury stock option grant differed from the date on which the option appears to have been actually granted.” But the story did not say why that might be important. It merely said: “The price of Mercury shares on the reported option grant date was lower than the share on the actual day the options were issued.” But why that might be important, the story never explained.
In its final two paragraphs, however, the article mentioned two other companies that had run into trouble with the SEC owing to option-related matters. One was Nyfix, which had announced back in March that it was restating financial results as the result of an SEC inquiry into its stock option grants. The other was Brocade Communications Systems.
What the reporters at the Journal did not know at the time was that the SEC had been tipped to the possibility of “backdated” options by two academics whose statistical analyses suggested the following: Suppose that stock option grants were awarded strictly at random. In that case, the degree to which stock option grants have managed to avoid immediate stock-price falls, and to profit from immediate stock-price rises, would be highly improbable—in the range of hundreds-of-millions to one.Erik Lie
The academic paper that first gave rise to the SEC tip was called “On the Timing of CEO Stock Option Awards.” It had been written by Professor Erik Lie of the University of Iowa’s College of Business and submitted to Management Science in February 2004. It said: “This study documents that the abnormal stock returns are negative before unscheduled executive option awards and positive afterward … Unless executives possess an extraordinary ability to forecast the future marketwide movements that drive these predicted returns, the results suggest that at least some of the awards are timed retroactively.”The article was published in the journal’s May 2005 issue.
Immediately, Lie began to work on a new paper, this time with Randall A. Heron, an associate professor of accounting at Indiana University, and a friend of Lie’s ever since the two had shared an office during graduate school at Purdue. This paper was called, “Does backdating explain the stock price pattern around executive option grants?” The authors took Lie’s backdating hypothesis from the earlier paper and tested it by comparing executive options that could have been backdated and executive options that could not have been backdated because SEC regulations that had grown out of Sarbanes-Oxley made such backdating essentially impossible.The abnormal stock returns that Lie had found in his first paper disappeared when the possibility of backdating was eliminated. The Heron/Lie paper would not be published until February 2007 (in the Journal of Financial Economics), but well before that, the authors tipped off the SEC to their findings.
Randall A. HeronBy the time the news about Mercury Interactive broke in November 2005, it appears, Randall Heron had become dissatisfied with the SEC’s response to his tip. Greg Reyes was out at Brocade, and the SEC was launching an investigation of the company. Some sort of restatement was happening at Nyfix, and now CEO Amnon Landan (Forbes’s 2003 “Entrepreneur of the Year”) was out at Mercury Interactive. But Heron apparently lusted for much, much more. At the end of the Journal’s Mercury Interactive story were the email addresses of the three reporters, and Heron sent them each a letter calling attention to his findings and attaching a copy of the working paper that he and Lie had underway.
Quickly, Mark Maremont wrote a story that gave the backdated-options frenzy a trial run. Within one week of the Mercury Interactive story and Heron’s email, Maremont had prepared for the Journal a story that pulled together the cases of backdated options so far revealed, plus some pro forma information on the SEC investigation, some ideas from the academic paper that Heron had sent him, and some conversations with Erik Lie. This time, the article ran on page A1; it was 1,600 words long, and it carried only Maremont’s byline.
The headline on the story was rather restrained, reflecting its tentative allegations. “Authorities Probe Improper Backdating of Options—Practice Allows Executives to Bolster Their Stock Gains; A Highly Beneficial Pattern.” The lead declared only: “Federal regulators and academics, scrutinizing a broad pattern of well-timed stock-option grants, are exploring the extent to which companies improperly backdated grants to provide insiders an extra pay windfall.” Note the term “improperly.” There is nothing improper about backdating options. The question was how companies applied APB 25 if they did backdate options. But by putting the emphasis on the word "backdating,” journalists like Maremont were able to suggest a fundamentally deceptive practice and avoid any discussion of APB 25’s inherent idiocy.
 Mark Maremont, senior editor, Wall St. Journal
Then, in his fourth paragraph, Maremont began the rich-hunt by emphasizing the theme of “greed,” which would dominate the Journal’s yearlong frenzy over backdated options. During the 1990s Internet boom, he wrote, option grants “attracted controversy, in part because some executives made huge fortunes off them as their stock prices soared. Backdating—which is not necessary illegal—bolsters the gains [from options]. . . . By tying strike prices to earlier, more favorable dates, executives granted options can instantly lock in a paper gain—and, if a stock goes up, increase their real gain when they exercise them.” Maremont quoted Professor Lie as saying that “the practice could have resulted in a total of ‘billions of dollars’ in extra pay going to insiders at those companies [where backdating occurred].”
Note: extra—as opposed to what? If companies had eschewed backdated in-the-money options in favor of at-the-money options, then the companies presumably would have had to give larger quantities of options, so that the pay would have come out to be approximately the same, albeit with greater dilution of shareholder equity.
Note, too, the near-total emphasis on executive option grants, which continued throughout the frenzy. Why should that be? If the sin of backdating lay in the paperwork and bookkeeping error of failing to follow APB 25 correctly, then the innumerable grants to low-level programmers made for the sake of fair treatment should have been denounced as no less egregious than grants to CEOs. But of course they were not. Because the paperwork was never the issue.
Over the next nine months, the Journal would continue to stir up the backdated options frenzy. Initially, the Journal reporters stirred up the frenzy through the use of those stratospheric odds, such as three hundred billion to one and twenty million to one. But while this clearly refuted the possibility that the options had been awarded by sheer chance, it did not say what was wrong with consciously backdating options. Occasionally, to secure their credibility, the reporters would admit that backdating options was not illegal, although they preferred to say that backdating options was “not necessarily illegal.”
No matter. The reporters’ solution was to skip quickly over legalities and launch a rich-hunt by alleging the twin sins of greed and unfairness. This, they did repeatedly. In “The Perfect Payday,” Journal reporters Charles Forelle and James Bandler wrote: “A key purpose of stock options is to give recipients an incentive to improve their employer’s performance, including its stock price. No stock gain, no profit on the options. Backdating them so they carry a lower price would run counter to this goal, by giving the recipient a paper gain right from the start.” So: unfairness in the service of greed.
In their next big story, Forelle and Bandler wrote: “Backdating is deliberately moving the grant date earlier, to a more beneficial time when the price was lower. In effect, it gives the executive an instant paper profit, undermining the incentive purpose of options.”On May 31, they repeated the argument: “Backdating an option grant to yield a better strike price vitiates the incentive purpose of the grant, effectively letting an executive profit after the fact from stock movements—a luxury of hindsight no regular investor could ever possess.”
As is typical in journalism’s antibusiness frenzies, the reporters’ characterizations were utterly misleading.

Occasionally, to secure their credibility, the reporters would admit that backdating options was not illegal.
 For example, the authors put forth the idea that stock options are meant to give employees the incentive to work harder and thus increase their company’s stock price but backdated, in-the-money options that provide an immediate paper profit run counter to that goal. Now, no employee, with the possible exception of the CEO, can be expected to move a company’s stock price by his own efforts. So, in fact, stock options and the potential for eventual profits are not meant to drive employee behavior like food pellets given to white mice. They are instead meant to make employees satisfied team members and fans of a company. Setting the exercise price in-the-money may well make an employee a better, harder-working team player than would out-of-the money options, just as fans of baseball teams that are close to winning the pennant are likely to be more enthusiastic than the fans of a club that is further away from winning the pennant.

An even more absurd idea is that in-the-money options provide an “immediate profit.” The Wall Street Journal reporters were careful to refer to “paper profits,” but others, such as the New York Times’s Eric Dash, were less careful. Dash wrote about “the use of discounted options at dozens of companies, where a spike in the stock price was not required for executives to reap big rewards. A profit was already baked in.”This is simply a gross misstatement of the facts. And it must have been darkly humorous to the thousands of high-tech employees who reaped nothing from their backdated options when the Internet bubble burst. Nevertheless, throughout the whole backdated-options frenzy, little attempt was made to let the public know that an option may be “in the money” and yet ultimately worthless. Indeed, the misleading nature of the phrase “in the money” was deployed to maximum advantage by the rich-hunters.

"The corporate crime lottery was never cranked up more than it was in the backdating cases.”

--Larry Ribstein
To round out my story of the backdated-options frenzy, I would add just two facts. When Erik Lie and Randall Heron began investigating backdated options, a leading Silicon Valley lawyer told them that he would be surprised if there was a single company in the Valley that was not backdating options. And that is probably pretty close to true. In 2006, Lie and Heron studied 7,700 publicly traded companies—from all around the country: West, East; high-tech, low-tech—and what they found was that nearly 30 percent of them (2200) had backdated options. If we take those two thousand companies, we can probably multiply the number of people involved by at least five to ten: directors, CEOs, CFOs, Human Resource VPs, controllers, and so on. That means the potential number of victims of the backdated-options rich-hunt could have been 10,000 or 20,000.
But I would tell you, lastly, that only a dozen scapegoats were ever prosecuted criminally in the backdating frenzy, and only five people were ever sentenced to prison, the most egregious instance being the imprisonment of Greg Reyes, who never backdated his own options at all. This is what the late Larry Ribstein, a professor of business law at the University of Illinois, used to call “the corporate crime lottery,” because there is absolutely no fairness—nor even any attempt at fairness—in the prosecution of so-called white-collar crimes like backdated options. The Justice Department is not going throw 10,000 to 20,000 American executives into prison for what was—at most—a bookkeeping violation of the most idiotic rule in the history of accounting. Nevertheless, 5 of those 10,000 to 20,000 executives, no different from the others, were sent to prison. And as Larry Ribstein wrote: “The corporate crime lottery was never cranked up more than it was in the backdating cases.”

> Buy Rich-Hunt: The Backdated Options Frenzy and the Ordeal of Greg Reyes , by Roger Donway

Rich-Hunt is the most comprehensive study yet of the interaction of business, law, and journalism in the backdated options episode. It is a case study of prosecutorial misconduct and the media’s tendency to be an echo chamber for accusations against businesses. But it is primarily the story of a man who excelled in business achievement. Greg Reyes became CEO of Brocade at 36 and increased its revenues twenty-fold within three years—only to be felled by a miscarriage of justice. In this deeply researched work, Donway shows how Reyes became the victim first of a board made fearful by the power of regulators; then of a frenzied media attack on backdated options; and, finally, of prosecutors who charged him with fraud. Despite the prosecutors’ failure to establish that someone was misled, the central point required for a charge of fraud, Reyes was convicted and sentenced to 18 months in prison.

Rich-Hunt includes an introduction by Greg Reyes and a foreword by David Kelley.

This eBook is downloadable here as an epub document.

Note: Rich-Hunt can also be purchased in paperback from LuLu, or as an ebook for Kindle from Amazon .



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