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April 15, 2007
David Warsh, Proprietor


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And Besides, the Wench is Dead

When the Pulitzer Board this week awarded its gold medal for public service to The Wall Street Journal for its “creative and comprehensive probe” into backdated stock options, it recognized one of the most remarkable newspaper stories of recent years. 

But the citation, when it noted that the inquiry “triggered investigations, the ouster of top officials, and widespread change in corporate America,” understated the novelty of what had been achieved. (It was simply repeating the boilerplate criteria for which the public service prize is given every year.)

It’s not that the backdating scandal was so great. Compared to the grandiloquent fraud of the various famous cases of the tech boom — Enron, WorldCom, HealthSouth, Tyco, etc. — it wasn’t epic. This year’s student loan scandal, with university officials around the country accepting kickbacks from various banks, has its own piquant style. Rather, the self-serving dishonesty at the heart of the backdating business was so banal, the WSJ‘s ingenuity at determining its extent so great, and the defense of the practice so surprising, that the exposé ranks as one of the most illuminating explorations of everyday morality in decades.

In fact, as the WSJ reported, the story itself began with an alarm raised by a finance professor, the government already had begun its investigation before the newspaper wrote its first word, and the nature of the changes in corporate America is far from clear.

Instead, with nearly two dozen major stories over 18 months, the series accomplished something more subtle and far-reaching than getting a bunch of executives charged and/or fired.  It amounted to nothing less than an audit of a key US business practice (and its apologetics) in a time of war. Facilitating its inquiry, and making it uniquely powerful, was a tool altogether new to newspaper investigation — a statistical technique designed to measure the improbability of coincidence, in this case, the issue of an option to buy company shares on the best of all possible dates. Yet underpinning the story was the oldest of newspaperly virtues — a confident and well-informed recognition of a breach of trust.

Thus did the series shed new light on some of the most controversial issues of the present day — not the least by calling forth scorn from the WSJ‘s own editorial page, and, especially from one of its star columnists, Holman W. Jenkins, Jr., who, as the story unfolded on the front pages of the paper, routinely derided it as a “molehill” and a “witch-hunt.”

Here is the bare-bones background necessary to understand what will happen next, in this highly revealing internecine clash.

The first back-dating story in the WSJ, the one that set the stage for all the rest, appeared on November 11, 2005. It carried the byline of Mark Maremont, a veteran investigative reporter who made his reputation in Texas during the savings and loan crisis of the late 1980s: “Authorities Probe Improper Backdating of Options/ Practice Allows Executives to Bolster Their Stock Gains/ A Highly Beneficial Pattern.”

“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,” began Maremont.

It was in 2004 that the SEC began investigating the practice of backdating, he reported, taking pains to explain the circumstances in which the technique first attracted attention:

Options to buy shares at a pre-set “strike” price — a point at which recipients can convert them to shares — became a widespread form of compensation during the 1990s boom, especially at technology firms.  Along the way they attracted controversy, in part because some executives made huge fortunes off them as their stock prices soared.

Backdating — which is not necessarily illegal — bolsters the gains. Typically strike prices are set at the market price of the underlying stock on the day the option is granted.  Recipients often must hold options for a set period before they can exercise them. — meaning they could gain in value if the stock price rises, or become worthless if it falls.

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 then described how Erik Lie, a professor of finance at the University of Iowa’s business school, had found, in an extensive study of the stock market boom, a pattern of stocks falling sharply just before the dates on which options were granted, then rising sharply afterwards, even after overall market gains were taken into effect. 

In a second study, this one joint with the University of Indiana’s Randall Herron, Iowa’s Lie found that the effect all but disappeared after August 2002, after the Sarbanes-Oxley corporate-reform statute required corporations to report their options grants within two days of making them, rather than within the weeks or even months that had previously been allowed, thereby eliminating the possibility of backdating grants and offering up one of those “natural experiments” for which economics researchers live.

Some academic experts doubted that the practice of backdating could have been very widespread, Maremont reported.  He quoted David Aboody, of UCLA’s business school, saying that he would be “shocked” if the practice turned out to be a common one.

To produce the large aggregate effects that Iowa’s Lie had found, Aboody said, hundreds of companies would have to be engaged in what amounted to “criminal activity.” That would require “systematic stupidity in the corporate world, which I find hard to believe.”  “I’m assuming they have lawyers,” he said.

Maremont’s story was scrupulously clear, but, had his scoop been the end of it, the matter would have been quickly forgotten. What came next was an act of considerable moral imagination on the part of the WSJ’s editors and their reporters, calling into play all the forensic powers at their disposal to establish what had been happening. The statistical findings of finance professors were an indication of corruption. Successful prosecutions were plenty concrete, but they were anything but statistical in their approach to the problem. (Maremont had reported the first of these, of Mercury Interactive Corp., in his initial story.)

Could the broad facts of the back-dating matter be established by newspaper methods? That is, could they be set out sufficiently forcefully before the general public, with clear explanations, sharp measurements and striking examples of particular companies, so that their significance could be fully assessed? That is what the editors decided to find out.

Maremont, 48, headed a small investigative team based in Boston; he and reporter James Bandler, 40, set out on an investigation parallel and, in certain ways, complementary to that of the federal authorities, designed to uncover the historical facts of the matter. As often happens with such borderland explorations, the reporters immediately found themselves in need of an intermediary language. Before long, they brought in Charles Forelle, a 27-year-old WSJ reporter with a degree from Yale in applied math, to oversee the preparation by consultants of a special algorithm with which to gauge the likelihood that particular grants were simply the result of good timing.  They were joined, too, by reporter Steve Stecklow, 53, who in due course would contribute a pair of memorable stories to the series.

Thus, after four months of hard work, Bandler and Forelle published “The Perfect Payday,” on March 18, 2006. The sub-head stated: “Some CEOs reap millions by landing options when they are most valuable.  Luck — or something else?” The story itself related the saga of several companies in which boards of directors granted top executives their options on remarkably propitious dates. The odds of one such favorable grant were found to be 300 billion to one, compared to 146 million to one that a particular $1 ticket might win the Powerball lottery. The effect, at least on the various communities that took corporate governance seriously — the legal, accounting and regulatory professions — was electric.

There followed many more stories, built out in something of the fashion of trench warfare. In May, Forelle and Bandler identified five more companies that seemed to have engaged in back-dating, and, in another story, reported that the practice seemed to have been employed in compensating ex-CEO Richard Scrushy of HealthSouth Corp., who remained under legal siege on various fronts despite his acquittal on criminal charges last year. In June, Forelle and Maremont implicated Monster Worldwide Inc. in the practice, and Forelle and Bandler explained that Microsoft had routinely set option prices at monthly lows throughout the ’90s.

In July, in “The 9/11 Factor,” Forelle, Bandler and Maremont reported that corporate boards of 186 companies — including 91 firms that didn’t regularly grant options — had handed out more than twice as many options in the waning days of September 2001 as in any comparable period in the two years before — taking advantage of the 14 percent drop in the market in the days after 9/11 in order to insure that the awards would be especially valuable.  And so on, and on, until by the end of the year the WSJ had run 17 highly variegated stories about the backdating scandal.  (The stories themselves and a video interview with their authors can be found here.)   

All the while, criticism of the story mounted, too, mainly in the person of Holman W. Jenkins, Jr., a famously contrary columnist on the WSJ editorial page. For example, he wrote in June, “Another business scandal, this one over options ‘back-dating,’ reveals that some CEOs are ‘in it’ for the money. Tsk Tsk.” Concerns with tax, disclosure and accounting treatments of the suspect options — that is, with representing the truth — he dismissed in July as “goody-goody.”

Throughout, Jenkins sought to turn the story into a seminar on options theory, attacking news accounts for charges that the reporters didn’t really intend to make, bringing to bear the considerable ingenuity of the options community to justify paying executives whatever the traffic would bear, citing the rival New York Times as providing “refreshing correctives” to “presumptions that continue to linger in certain media accounts….” “Why such canards persist in the coverage is itself a bit of a mystery,” he wrote last month, “but editors have their reasons.”

An editorial in October, “Backdating to the Future,” summed up the rump view of the story this way: “The practice has now been suspected or detected at so many companies — 115 at last count — that its alleged perfidy is being diluted by its ubiquity.  Are all the CEOs, CFOs and general counsels at all of these companies greedy and corrupt?  Seems unlikely.” Instead it was rapidly changing government regulation that was to blame. “While there’s no excuse for false reporting to shareholders, the worst reaction to this mini-scandal would be for Congress to overreact.” Already, the law had been changed by the Sarbanes-Oxley statute. “…[B]efore the dudgeon gets too high, let’s bear in mind that this problem is already in the past.”

This is, of course, the argument for expedience and immateriality that was immortalized by Christopher Marlowe in the following exchange in his 1591 play, The Jew of Malta:

Friar Barnadine: “Thou hast committed–”

Barabas: “Fornication– but that was in another country;
          And besides, the wench is dead.”

The Barabas defense is as hollow today as it was when Marlowe made fun of it more than four hundred years ago. The basic problem with backdating is fabrication, not fornication. It has to do, not with fleecing shareholders, but with misleading them. Deceptive practice is the issue, not some purely economic crime. When Jenkins wrote, “embroiled are not just a few bad apples… but Apple, Pixar, Microsoft [and] Juniper Network” — he was missing the point altogether. Companies that backdate options without acknowledging it are bad apples in the context of the story.

(It should be said that it is not unexpected that good newspapers should harbor such strong differences of opinion within their ranks. And Jenkins is right nearly as often as he is wrong, often within the space of the same column. You have to marvel at a paper with the courage to routinely permit publication of views as fundamentally conflicting as these, in the expectation that the truth eventually will out.) 

The good news is that the habit of casual deception apparently hadn’t become all that widespread in corporate America.  With the scandal apparently having pretty well run its course, the 150 companies caught up in it so far represent less than a tenth of the 1,800 “leading companies” in the Standard & Poor ExecuComp data-base to which the WSJ turned for its survey of post-9/11 practices. It is far less than the 29 percent of all listed companies that finance professor Lie estimated must be backdating in order to account for his data. The bad news is that among those that engaged in the practice were a handful of highly respected companies, lawyers and accounting firms, many of whom, like the editorial page of The Wall Street Journal,  apparently still don’t think they did anything wrong.

In the end, WSJ managing editor Paul Steiger put it this way: “I believe one of our highest callings as a news organization is to unearth the ills of business so that society can fix them. The exposure of the pernicious disease of options backdating was a particularly dramatic example of just that.” So what exactly is it that you can expect to happen next? You can expect the editorial page sooner or later to attack the prize, the first ever won by the Journal in the Pulitzer’s pre-eminent public-service category.

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