Backdated Options, Future Rules?David Henry
After the greed and accounting saga of the late 1990s, the stock-options backdating scandal now pounding nearly two dozen companies might seem a little like a footnote. After all, most of the backdating seems to have happened 5 to 10 years ago, long before the practice was largely thwarted in August, 2002, by new rules mandated by the Sarbanes-Oxley Act.
But the story isn't over yet: The latest investigations could have serious cash consequences. And they could build new support for the kind of regulations that businesses claim are too burdensome. The probes have already diverted executives' attention from running the companies involved. Ten executives or directors at four companies are already out of their jobs.
IRS IN THE ACT?
Shareholders have already seen upward of $35 billion of stock market value evaporate at companies that have acknowledged investigations by the Securities & Exchange Commission, the U.S. Justice Dept., or their own special committees. And stocks of another dozen or so companies have also been flagged as vulnerable to investigations by Wall Street analysts in a wave of new research reports.
"This is still going to have implications for these companies," says Erik Lie, the associate professor of finance at the University of Iowa who discovered evidence two years ago pointing to widespread backdating. Some companies may turn out to owe back taxes, Lie notes. They may even be subject to penalties and fines from the U.S. Internal Revenue Service, Michael A. Moran, an accounting analyst at Goldman, Sachs & Co. said in a research note Monday.
Many of the options in question are still outstanding, raising the possibility that companies will have to buy back stock and offset the dilution they cause. "It is sort of like continuous bleeding," says Lie. Some investors are already trying to stop that bleeding by having the options rescinded. On Tuesday, pension funds for Ohio state employees and teachers sued UnitedHealth Group (UNH) to take back options it contends were favorably timed for Chief Executive William McGuire. But even that remedy could trigger expensive legal wrangling.
There's also reputational damage. Backdating is seen as a symptom of poor financial controls, as some companies have acknowledged, and possible poor governance by directors. UnitedHealth Group, for example, has acknowledged in public filings that it had a "significant deficiency" in the administration, accounting, and disclosure of its stock options. Its success in administering health-benefit plans and making acquisitions depends on its reputation. Its image won't be helped by the admission that it may have to restate earnings to reflect nearly $300 million in additional expenses.
At the heart of the investigations is the fact that tax rules and accounting standards turn on whether an option was "out of the money" when it was granted. If an option gives the holder the right to buy shares at the same cost as the market price or at a higher price on the day of the grant, it is considered out of money. That makes the option incentive compensation and thus a deductible expense for tax purposes.
Out-of-the-money option grants did not have to be counted as an expense by corporations when figuring their earnings until this past year. The suspicion in these cases is that the options' recorded grant dates were set back to when the market price was lower than it was when they were actually awarded. If that happened, it means the executives received options that were "in the money" -- and wouldn't have qualified as tax deductions.
Lie, of the University of Iowa, found overwhelming signs of exactly that happening. Looking at 1,668 option awards granted at irregular intervals from 1992 through 2002, Lie found that the stocks involved tended to go down before the date reported for the grant and then up afterward. On average, the stocks' returns in 30 days after were about five percentage points better than the market returns. Lie says the practice was apparently widespread. He believes that someone at every fifth company, if not more, was looking back to pick days that would set a lower "strike" price when an option can be exercised.
Lie's research started having immediate consequences to investors after it was picked up by the Securities & Exchange Commission last year and then publicized in March by The Wall Street Journal. The Journal added to the suspicion by figuring the long odds (as much as 300 billion to one) of executives repeatedly getting options set at exceptionally low exercise prices. Since then stocks of companies named as being under investigation by the SEC, the Justice Dept., and special board committees have been hammered.
Last week, the Center for Financial Research & Analysis (CFRA), an accounting research firm that red-flags stocks for institutional investors, said in a report it had looked at 100 companies that issued a lot of options and found 17 companies that on at least three occasions had awarded options at, or close to, 40-day lows in stock prices. CFRA said that while the 17 have the "highest risk of having backdated options," it has not confirmed any backdating.
The 17 companies were American Tower (AMT), Broadcom (BRCM), Brocade Communications (BRCD), CNET Networks (CNET), Delta Petroleum (DPTR), F5 Networks (FFIV), Juniper Networks (JNPR), McAfee (MFE), Medarex (MEDX), Mercury Interactive (MERQ.PK), Microstrategy (MSTR), Openwave Systems (OPWV), Rambus (RMBS), RSA Security (RSAS), Semtech (SMTC), Sepracor (SEPR), and Zoran (ZRAN).
Monday, Joe Osha, an semiconductor industry analyst at Merrill Lynch, reported in a note to clients that the stock prices of six companies in the Philadelphia Semiconductor Index had surged by an average of at least 14% in the 20 days following options grants in 1997 through 2002.
The six were KLA-Tencor (KLAC), Marvell Technology (MRVL), Novellus Systems (NVLS), Linear Technology (LLTC), Broadcom (BRCM), and Maxim Integrated Products (MXIM).
None of the companies or individuals named in the reports has been proven to have done anything illegal. Nor does Lie claim to have proof of backdating. But the suspicion is measurable. For example, shares of KLA-Tencor plunged 10% Monday after being named in another Journal story, being listed by Merrill Lynch's Osha and acknowledging at an investor conference that the Justice Dept. is investigating. Shares of UnitedHealth are down 25% since the beginning of March.
When people are suspected of cheating at public companies the consequences go beyond those directly involved. Investors become wary, and that undermines the market, which this month has come off its year-to-date highs. Regulators worry about wrongdoing on their watch, become more distrustful, and tighten rules. That's how the oft-lamented Sarbanes-Oxley rules came about in the first place. The more this scandal grows, the more those regulations look necessary.