It has not typically been my practice at "Adam Smith, Esq." to decry the emergence of lucrative new practice specialties, but we now have a candidate:  The explosion of stock option "backdating" investigations swamping 87, 112, or over 2,200 companies (depending on who's doing the counting).   I know of at least one AmLaw 25 firm that has nearly 100 options backdating matters open.  What is most disturbing to me as a writer and publisher is that the legal press has been no more immune to the socially correct hyperventilating surrounding this "story" than has been the mainstream and popular press.

Just within the past 48 hours we've had Justin Scheck of The Recorder (here, on law.com) write under the headline, "Prominent Corporate Lawyers Didn't Stop Shady Options Deals," and again (here, on law.com), with Petra Pasternak, "[Larry] Sonsini on Board[s] of Several Companies With Dubious Stock Awards."   The bill of particulars is now familiar:

• In 1998, Amylin Pharmaceuticals awarded options five times; three of those five dates represented 90-day lows.
• The odds of this happening "are roughly one in 22,000," according to the suddenly acknowledged expert on these matters, Erik Lie, professor at the University of Iowa Business School.
• We are then told, the writer clearly evincing a heavy heart, that these "louche pay practices at Valley startups...also raise difficult questions about what name-brand Valley lawyers...knew -- or should have known -- in their roles as directors."  (Singled out by name are Larry Sonsini of WSG&R, Bob Gunderson of Gunderson-Dettmer, Mario Rosati of WSG&R, and James Gaither of Cooley.)

Then, the other shoe drops, at least momentarily, and the usual caveats about "it's too early to tell" are issued:  The last word, however, goes to Bill Lerach, who virtually advertises his services for hire:

"They're allowed to delegate responsibility to committees, but that's only an interim delegation. It's not an abdication," he said. "If a board wants to close their eyes and rubber-stamp what a committee does, then they'll have to pay the consequences. Of course, in the real world, that's what usually happens."

In the second story, we see LSI Logic, Echelon Corp., and Lattice Semiconductor—at each of which Sonsini was a board member—granting options at "unusual" times of year, or where they were "oddly timed," or "at exceptionally low [stock price] levels." We are also edified to learn that "like so many other tech firms, Echelon -- at least in hindsight -- was much overvalued in 2000," and that (I quote in full for a reason):

"The planned distribution to [Echelon] directors in 2000 also fell on what turned out to be a fortuitous day. The annual meeting in 2000 was April 27, when the stock was trading at $31.44, near its low.

"Had executives received their options in late June of 2000 -- as they had the previous two years -- they would have received them when the stock was trading at $62, near its high.

"But later that year, the company reported to the SEC that it had chosen to award the executive grants on April 27 -- the same day as the board had met -- allowing the executives to purchase shares at the lower level.

"In no other year did the board line up the award date for executives with the date for board members."

So, as long as we're talking about Echelon, a computer peripheral manufacturer (NASDAQ symbol: ELON), let's look at how the specifically cited grant (April 27, 2000) fared.  The grant was for 100,000 shares at a strike price of $30.25, with the first 25% vesting on April 27, 2001, and 1/48th of the remainder vesting at the end of each full month thereafter.  How great a deal was this?

 

As you can see, the stock never even recovered to $30.25 by the time the options vested, and the entire award was -- "with hindsight" -- utterly worthless.

This brings us to the fresh breath of sanity visited upon this sorry non-scandal by Holman Jenkins of the WSJ, who writes today about the accounting fiction at the heart of all this.  Here's the nut of it:  Kip Hagopian, a venture capitalist who has gotten notables such as Milton Friedman, Harry Markowitz, Paul O'Neill, and George Schultz (with 26 others) to sign a call for ending the expensing of stock options, published in the current issue of Berkeley's Haas Business School California Management Review.  Again, bear with me because it stands quoting the abstract in full:

Point of View: Expensing Employee Stock Options Is Improper Accounting

Kip Hagopian

In December 2004, the Financial Accounting Standards Board (FASB) adopted a new standard of accounting for employee stock options (ESOs). This standard, entitled, Statement of Financial Accounting Standards 123R, requires that ESOs be valued at the date of grant and expensed over the vesting period of the options. The signatories to this position paper strongly oppose this revision to GAAP because they believe that the expensing of ESOs is improper accounting that will result in the serious impairment of the financial statements of companies that are users of broad-based option plans. The case against expensing ESOs can be summed up in six simple statements: an ESO is a “gain-sharing instrument” in which shareholders agree to share their gains (stock appreciation), if any, with employees; a gain-sharing instrument, by its nature, has no accounting cost unless and until there is a gain to be shared; the cost of a gain-sharing instrument must be located on the books of the party that reaps the gain; in the case of an ESO, the gain is reaped by shareholders and not by the enterprise; the cost of the ESO, therefore, is borne by the shareholders; this cost to shareholders (which, not coincidentally, exactly equals the employee’s post-tax profit) is already properly accounted for under the treasury stock method of accounting (described in FAS 128, entitled, “Earnings per Share”) as a transfer of value from shareholders to employee option holders; and neither the grant nor the vesting of an ESO meets the standard accounting definition of an expense. These six statements lead to the conclusion that an ESO, while it may have an economic cost to shareholders, is not an expense of the entity that grants it.

For those of you remaining in the audience, the bottom line is that granting options is a transfer outside the operating business itself (whose performance should be reflected in the P&L), from the owners of the business to the employees. No asset passes through the business.

Why, then, are we now learning that so many prominent lawyers were involved?  They were "involved" in the same sense accountants and managers and even printers were involved:  They were simply there.  Faced with an impenetrable, nonsensical rule—that options must be expensed if priced in the money but not expensed if priced at the market as of the grant date—hundreds and hundreds of companies chose to ignore the nonsense and instead do this:

"Why companies might wish to issue "in the money" options rather than take potluck on the stock price on whatever day the complicated paperwork happened to be finished is not hard to fathom. It is, after all, the irreducible role of management to seek to control things, including the value of inducements dangled before employees."

A little bit more reality, a little less hysteria, and lot less judging of the historical behavior of seminal figures by the ever-so-superior standards of today, which we are blessed by our superior intellect at last to be privy to.