Commentary: A SarbOx Surprise

The new requirements are slowing options tricks

CEOs love to hate the Sarbanes-Oxley Act, complaining that its new requirements are a costly overreaction by Congress to the big accounting frauds.

But a relatively obscure SarbOx provision, one written because of specific crimes by former Enron Corp. CEO Kenneth L. Lay, is proving a key factor in a new scandal: the backdating of stock options.

More than two dozen companies have come under investigation this year, among them UnitedHealth (UNH ), KLA-Tencor (KLAC ), and McAfee (MFE ), on suspicion of fiddling with option grant dates to give millions of dollars of extra pay to executives. While the extent of these potential frauds isn't yet known, the connection between SarbOx and options backdating stands as a vivid illustration of how making information public can thwart bad behavior.

Until early 2002, when it was learned that Lay had concealed sales of Enron shares while saying he was buying more, regulators paid little mind to a loophole in the rules on trading by insiders. Most transactions between executives and their companies didn't have to be reported until 45 days after the end of a company's fiscal year -- possibly as long as 13 months after the fact. Congress clamped down and directed the Securities & Exchange Commission to require reporting of transactions within two business days, effective Aug. 29, 2002. At the time, recalls then-SEC Chairman Harvey L. Pitt, regulators didn't even know companies were backdating options grants.

In academia, meanwhile, professors had been puzzling for years over why time and again stocks went up after companies issued options. Their best guess was that executives knew better than the market that their stocks would rise. But at least two scholars, Erik Lie of the University of Iowa and Randall A. Heron of Indiana University, suspected companies had been using the disclosure leeway to look back and set options to low prices that had preceded runups. The new SarbOx two-day limit, they reasoned, would have made it harder to fudge dates.

The professors checked more recent stock returns. They found that 80% of the mysterious performance around grants disappeared under the new rule. Most of the other 20% came from companies where executives were late with disclosures. The professors showed their work to the SEC. The Wall Street Journal publicized their findings. Now SEC and Justice Dept. investigations are expanding.

``This is an unintended positive consequence of disclosure,'' says Gregory P. Taxin, CEO of Glass, Lewis & Co., a stock research firm. Taxin named Glass, Lewis in a phonetic nod to Louis Brandeis, the U.S. Supreme Court justice who wrote in 1913 that ``sunlight is... the best of disinfectants.'' A century later, effective disclosure laws are as essential as ever.

By David Henry

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