SEC Chairman Cox on Options Backdating

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The following is excerpted from a speech given by SEC Chairman Christopher Cox to the New York Financial Writers Association on June 8. The full text can be found at www.sec.gov/news/speech/2006/spch060806cc.htm. Cox was speaking about executive compensation when he turned to the issue of backdating stock options.

Let me tell you about another important part of our pending executive compensation rule that might see further refinements in the days ahead.

Our final rule will very likely address the issue of back-dated options, which is currently so much in the news. As you know, this refers to the practice of selecting a grant date for an option award that's earlier than when the award is actually made.

While I can't comment on the SEC's ongoing investigations of specific companies, I can tell you what the Commission's position is. Back-dating must be fully disclosed. And the granting of back-dated options must be properly accounted for.

Our rulemaking and enforcement interest in back-dating reflects our firm conviction that stock options can be a vital tool for both public and private companies of all sizes. The proper use of options in compensation can make a very positive contribution to our economy by offering significant future rewards to those individuals who create value for a company and its shareholders. Options can be an extremely useful way for a company to establish positive incentives for its executives and employees.

A major purpose of stock options is to give employees the incentive to work harder to increase the value of the company's stock. And in fact, it's entirely reasonable to expect employees with a vested interest in the business to work harder. Another reason that companies issue stock options is to decrease the amount of money they have to spend on salaries. Yet another purpose of options is to create an incentive for executives and employees alike to stay with a company. That's especially true when options vest over time.

In each case, what makes the option work as a powerful motivational tool is that unlike a bonus, it isn't so much a reward for prior performance as it is an incentive for future performance.

That's why the undisclosed back-dating of options is such a serious potential problem.

By giving the recipient of options an undisclosed paper gain right from the start, it cuts the direct connection to future performance. And in the process, what investors might otherwise view as a shareholder-friendly way to align their interests with those of the company's executives becomes instead a more expensive way for the firm to structure its compensation program.

When a company decides to back-date options, it usually does so because the stock price was lower at the earlier date. But if the effect of the back-dating is to hide compensation from the shareholders, by overstating the extent of the risk-based element, there can be serious accounting, tax, and securities law issues.

When a company fails to disclose to shareholders that it paid additional compensation through back-dating in violation of the terms of the company's stock option plan - or when it fraudulently misrepresents that it granted options at an earlier date than they actually were granted - this interferes directly with the shareholders' right to know both the level and the form of executive compensation. And that is clearly wrong.

As one means of dealing with this problem, our proposed executive compensation rule will provide better and more useful disclosure of the backdating of options. It would require that a company clearly identify the portion of compensation that results from "in-the-money" option awards resulting from backdating.

The proposed rule will require the disclosure of the full value of an option based on the date the award was actually made. That means the added value from an option's being in-the-money at the time of grant would be clearly disclosed. It would specifically require a comparison of the exercise price of the option to the grant date market price of the option, whenever the exercise price is lower than market price. That way, investors could see the additional compensation that was immediately conferred on executives when the option was granted.

Just as important as these dates and numbers will be the plain English disclosure of just how the company determined when to make its option awards.

The Commission is even now considering further adjustments to our executive compensation proposal to deal with the issue of backdating options. Our staff in the Division of Corporation Finance are collating all of those thousands of comments and will make a recommendation to the Commission at an open meeting soon.

As part of that review process, we will consider the need not only for any changes to the rule, but also for additional guidance to address further the backdating of stock options. So stay tuned. We want this matter settled in time for next year's proxy season, and I have every reason to expect that it will be.

So what will come of our imminent decision to require more and better disclosure of options and every other aspect of executive pay? How will people use the information? How will it affect overall compensation levels in public companies? What will be the net result?

Well, for starters, disclosure is likely to intensify the debate over CEO compensation. After all, even in the current environment of somewhat confusing disclosure, the moment companies release their pay figures each proxy season, journalists like you tote up the numbers and publish them widely. In the new environment under our proposed rule, the immediate result will be that all of you will find it far easier to tabulate a CEO's total compensation.

You'll also have more details about what that compensation consists of, including the perks, and never-before-disclosed information about what executives might be paid when they leave. We know from experience what happens next, with disclosure of the egregious cases.

The $20,000 oriental carpet, the $8,000 horse, the free company jet in retirement, or the half-million dollar consulting deal that keeps paying your heirs even after you die - those cases will attract a lot of attention, and they'll give shareholder activists new opportunities to call for better discipline.

And the closely watched ratio of average worker-to-boss compensation will be calculated anew, this time with far greater accuracy.

Now you've occasionally heard it said that because aggrieved investors can't automatically convert their distaste for excessive compensation into action - because as shareholders they have no way to directly force change - this new information won't add anything.

But surely, that misses a main point. The SEC requires the disclosure not only of executive compensation, but also hundreds of other significant items that shareholders have a right to know. In every case - and in this respect executive compensation is no different - the fact that the shareholders' interests must be vindicated by their representatives on the board of directors doesn't obviate the need and the value of making the information public.

Improved access to information is in fact a form of public participation in decision-making. It directly enhances the quality of economic decisions. Access to information contributes to public awareness of reform issues. It gives the public the opportunity to express its concerns - and enables not only corporate managers, but also government officials to take into account those concerns.

This article was originally published on 2006-06-15
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