The Malum Insanum That Created Backdated Options

Last week, I wrote about my concept of malum insanum , behavior that is illegal only because some idiot in authority has issued an edict that makes it illegal. One of the most vivid examples of a mala insana has to be APBO No. 25, the edict that gave rise to the “crime” of failing to treat backdated options as a compensation expense. It is the “crime” for which Brocade’s former CEO, Greg Reyes, now faces prison.

An option, of course, is the right to buy a share of stock at a certain price (called the “exercise price” or “striking price”). And corporations often give such options to new employees as part of a pay package. In the case of start-ups, options are a particularly attractive form of pay, because they do not drain away the scant cash that the company needs to fuel its growth.

Clearly, options have a value in the mind of the person who accepts them in lieu of salary. If they did not, he would hardly forgo the cash that his work would ordinarily bring him. But how great is an option’s value? The answer is necessarily personal, both for the employee and the employer. For the employee, the value will depend upon what he believes is likely to happen to the stock price during the years he must wait to exercise the option and on how much he values the chance of making future gains as opposed to receiving current cash. For the company, the option’s value depends upon what it believes will happen to its stock price, what difference it expects the employee will make to that stock price, how much it wants to avoid spending cash on employee compensation, how much it wishes to avoid expanding the number of its shares (as it must when an employee exercises his options), and many other considerations.

But here is the malum insanum that was laid down in 1972 by the Accounting Principles Board’s Opinion No. 25 (APBO No. 25): If the exercise price of an option being given to an employee is equal to the current market price of the stock, then the company should treat the option as having no value at all. But if the exercise price of the option is below the current market price, then the company must consider that difference to be the exact value of the option—regardless of how far in the future the option will be exercised or what the outlook for the stock price may be. And it must treat that “intrinsic value” as a compensation expense. This, as professor of accounting Paul Pacter said: “is really ‘nonaccounting’ that ignores economic reality."

What happened following the issuance of APBO No. 25, predictably enough, is that thousands and thousands of America’s most innovative and productive executives looked at the rule and said, “You must be crazy.” In order to act rationally, executives at approximate one-third of all American corporations chose to violate APBO 25’s malum insanum via the process that became known as “backdating.” (Just how that worked is a matter for another day.) When anti-business journalists discovered the infraction and began publicizing it, in late 2005, the executives were denounced as criminals, fired from the firms that they had built, and fined tens of milions of dollars. An unlucky few, approximately 10, were chosen to be tried as criminals and sentenced to prison. Of these, the greatest is surely Greg Reyes, who is scheduled to begin a serving eighteen months in prison beginning this Friday. Insane.

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