Commentary: How The Options Mess Got So Ugly—And Expensive

As grants soared in the 1990s, so did the temptation to cheat when issuing them

Sir Walter Scott had it right when he wrote "Oh, what a tangled web we weave, when first we practice to deceive!" More than 121 companies are undergoing investigations to untangle right from wrong in the mess left by widespread grants of stock options to employees in the late 1990s. It seems to get only more complicated by the day. And it all could have been prevented 12 years ago.

A flood of option grants, and apparent backdating, grew out of companies' misleading arguments in 1994 that options are not a cost. Corporate chiefs persuaded Congress to go along with that pretense and force the Financial Accounting Standards Board, or FASB, to retreat from its plan to make them count options as expenses. Over the next 11 years companies in the Standard & Poor's 500-stock index dismissed $246 billion in options compensation, overstating earnings by 7%, according to The Analyst's Accounting Observer.

Now the consequences of the free-money facade have gone beyond earnings exaggerations to fraud investigations. The Securities & Exchange Commission has launched 74 inquiries into possibly fraudulent backdating of grants, says researcher Glass, Lewis & Co. Prosecutors have started 49 criminal probes. "It is unprecedented to have so many major corporations under investigation at one time," says Matthew J. Jacobs, a former federal prosecutor now heading a white-collar defense team in Silicon Valley at McDermott Will & Emery. Apple Computer (AAPL ), Home Depot (HD ), and Caremark Rx (CMX ), each of which opposed expensing in '94, are under investigation.

Some probes will likely find no crimes, just sloppy books. But all are costly. Companies must pay accountants and lawyers to study documents and see if options carried true dates. "On these types of investigations, I don't think you can blow your nose for less than $1 million," says Lynn E. Turner, managing director of research at Glass Lewis. Software provider Mercury Interactive Corp. has spent at least $70 million.

The year 1994 triggered the disaster. Congress, by agreeing to stop FASB, essentially blessed the practice of paying employees with options. Grants soared, doubling by 2001 for S&P 500 companies overall. Many tech outfits cranked up their printing presses even faster, paying executives and enticing new recruits with options instead of with earnings-reducing cash. As the grants increased, so did temptation, since the gain from cheating went up with each additional option, says Fabrizio Ferri, an assistant professor at Harvard Business School.

Winning in Washington also sent a message to company directors, controllers, and auditors that they needn't monitor options the way they do cash. "It put the gatekeepers in the mindset of not challenging anyone," says Turner, a former SEC chief accountant. With little incentive to make sure grant dates were correct, it's no wonder many investigations seem to be taking forever.

Although FASB now requires expensing, resistance endures. Last month the University of California at Berkeley's Haas School of Business published a paper arguing for repeal of expensing. It was signed by 30 experts, including three Nobel prizewinners in economics. It contends that options are instruments for sharing stockholder gains, not company expenses. Whatever the merits of the argument, it won't undo the damage from the abuse of options. Says Jack T. Ciesielski, publisher of The Analyst's Accounting Observer: "They ought to just give it a rest. With these things, people can't seem to keep their worst impulses in check."

By David Henry

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