Backdated share options put R10m in Clicks boss’s pocket
THE RECENTLY appointed finance director of Clicks, Michael Fleming, effectively bagged a “signing on” fee of around R10 million last year when the company allocated him 551 832 share options at R25.37 an option. This was the prevailing price on September 1, 2010, and compares with the price of just under R40 when Fleming joined the company last April. Yesterday the shares topped R44.
A note in the group’s 2011 financial report states the “allocation was made retrospectively as part of an appointment package”. Allocating shares at a price that prevailed on an earlier date is referred to as backdating and is discouraged by the King 3 code on corporate governance. The Public Investment Corporation, which is the single largest share- holder in Clicks, voted in support of the group’s remuneration policy but “highlighted the issue of the backdated share options” with the company.
In 2007 dozens of executives and directors of US companies were forced to resign following a high-profile investigation into the backdating of share option awards. The results of the investigation, which caused widespread shock among the investing public, indicated that backdating was a common practice and that it generated substantial risk-free profits for executives at the cost of the shareholders.
In layman’s terms backdating is equivalent to betting on a horse after the race has finished. For the lucky insiders it is an easy way to bag substan- tial sums of money. Until recently it had the additional huge benefit of not being visible to the shareholders who were funding the exercise.
There is considerable incentive for executives to manipulate the granting of options.
Although South African practices in relation to executive remuneration tend to mimic those of the US, no regulator has ever investigated the occurrence of backdating options by listed companies. In the absence of such an investigation the public has rather blithely assumed there was no backdating. However, recently available research reveals that backdating of options was commonplace among listed companies in South Africa.
The research focused on the share price movements of the top 40 Jse-listed companies between 2001 and 2006 and describes a number of strategies that appear to have been used by corporate executives to enhance the value of their share options at the expense of shareholders. Eight of the top 40 companies, including Telkom, Kumba and Pretoria Portland Cement, had to be excluded because they provided insufficient information from which to draw conclusions.
The research was conducted by Glen Holman, Joanne Shev and F Zheng of UCT’S department of accounting and was the subject of an article published in the SA Journal of Accounting Research in late 2010.
The crux of the issue is: “Executive share options are typically granted with an exercise price equivalent to the share price on the day the option is granted. Executives prefer to be granted options when the share price is at its lowest, due to a lower exercise price leading to a higher option value.
“This motivates executives to backdate the granting of share options to dates with lower share prices, thereby reducing the exercise price and inflating the value of the options to the executives. As a result executives benefit on exercising their options at the expense of the company, its shareholders and other stakeholders.”
The importance of share options to the value of executive remuneration at the time is highlighted by a study referred to by the authors. The 2006 study noted that the average salary of the top 10 chief executives was R32 794 a day. When exercised share options are included this figure increases to R91 972 a day. “This suggests that share options play a significant role in the remuneration of chief executives.”
Furthermore there is considerable incentive for executives to manipulate the granting of options. By studying the movements in the share prices and the dates when options were granted to executives of the top 40 companies, the authors were able to identify evidence that suggested executives had been doing exactly the same as their US counterparts. They had opportunistically timed the awarding of options to occur before an expected increase in the share price or had opportunistically timed the release of information around the time that options were granted.
With typical academic understatement the authors note that the findings “would suggest that some opportunistic behaviour might have occurred around the executive options grants, including backdating”.
The authors conclude that their study “contributes to the literature on the backdating of share options in South Africa by providing evidence of executives manipulating the timing of share options grants. It is also relevant, in that it suggests that executives utilise performance-related incentives to manage their own compensation to their personal advantage”.
The good news is that since 2006, the more vigorous International Financial Reporting Standards (IFRS) have significantly reduced the ability and the incentive for “opportunistic pricing” of share options.
The expensing of options and the much greater disclosure demanded by IFRS ensures that any company that wants to hand over a generous payment must reveal everything to shareholders.
A vigorous approach by tax authorities, reducing the scope to classify benefits as capital gains rather than income, has also contributed to curbing the use and abuse of share options.