Options Backdating Must Be Seen in Corporate Governance Context

With issues on stock options backdating roiling the regulators and the markets, it is time to remind ourselves that the issue of stock option compensation is inextricably intertwined with corporate governance. This was the lesson taught by corporate governance guru Ira Millstein in testimony before the Senate Banking Committee on Feb. 27, 2002. (I am providing a link, but caution that it may not survive introduction of the new Sen. Dodd committee page). And it is a lesson for the ages.

The Weil Gotshal senior partner said that an effective system of corporate governance must strive to channel the self-interest of managers and directors into alignment with the corporate, shareholder and public interest. Yes, we are back to the age-old conundrum of corporate governance and modern corporations first identified by Berle and Means, which is, in an age when management of the company is divorced from ownership, how do we align the interest of the shareholders with management. Mr. Millstein urges stock compensation as a method of aligning the interests of management with shareholder interests. Citing Berle and Means, the senior partner emphasizes that the key issue of corporate governance throughout the history of the stock company has been what he calls ``the agency problem,’’ in which corporate management may not always subordinate their interests to those on whose behalf they are acting.

He reaches back beyond Professor Berle and praises Oliver Wendell Holmes for recognizing that humans can not be expected to act moderately, prudently, morally and ethically at all times. Justice Holmes noted that regulation must address the prospect that self-interest may cause persons to act badly by providing countervailing incentives and disincentives. In Mr. Millstein’s view, this Holmesian principle applies to corporate governance regulation as well. He posits that the self-interest described by the eminent Justice can interfere with the moral, ethical and legal obligations of directors and managers to protect and enhance the assets of the corporation that are committed to their care by, and for the benefit of, others.

It is in this context that stock option grants must be viewed. I believe that the use of options to align the interests of company management and the shareholders is legitimate. But the interests of the two groups must be completely congruent, that is, both groups must face the same risks. The practice of backdating options, and for that matter repricing options, favors the managers over the shareholders and destroys the true alignment of interests.