How to Clean Up a Scandal

ACS and several other companies caught in the options backdating scandal are firing executives and winning back investor confidence

On Nov. 27, Affiliated Computer Services (ACS) reported the results of an internal probe into the backdating of option grants at the Dallas technology services company. That, in and of itself, isn't so unusual. More than 200 companies have been touched by the scandal, including Apple Computer (AAPL), Barnes & Noble (BKS), and Gap (GPS). What was surprising is that ACS's stock surged 6% on the news, to $53.60, before retreating to close at $50.25 as the whole stock market plunged on Nov. 27 (see, 11/27/06, "ACS Shares Higher after Execs Resign").

What got investors' attention was the extent of the company's housecleaning. ACS provided loads of detail on its internal investigation, which was conducted by the law firm Bracewell & Giuliani and included interviews with 40 current and former directors and employees. More dramatically, the company replaced Mark King, its chief executive officer, and Warren Edwards, the chief financial officer, saying that they "violated the company's code of ethics for senior financial officers." Both men have denied any wrongdoing through their attorneys.

Experts say ACS's actions sent a clear and much-needed signal to investors: that the board was serious about cleaning up the backdating mess. "I think firing people is necessary in some cases," says Erik Lie, an associate professor of finance at the University of Iowa who conducted the original research that uncovered widespread options backdating. "You want shareholders to see that you're addressing the issues."

Not All Backdating Is the Same

The backdating scandal involves companies that issued stock option grants to executives at favorable prices. Typically, the companies picked a date in the past when their shares were trading at a particularly low price, so the price at which executives could exercise, or acquire, shares was lower than the current market price.

Of course, the situations at the companies involved in the backdating scandal are all different and the circumstances don't always require the firing of top executives. The backdating may have been accidental or it may have been handled by a limited number of people.

Still, ACS is one of several companies that are now demonstrating how executives and boards caught up in the scandal can rebuild their reputations with customers, employees, and investors. Others include KB Home (KBH), Shaw Group (SGR), and Mercury Interactive, which has been acquired by Hewlett-Packard (HPQ). Launching an internal probe is a necessary first step, if there's any suspicion of wrongdoing. "You want to do that before the [Securities & Exchange Commission] begins an inquiry," says Paul Hodgson, a senior research associate at the Corporate Library, which does research on governance and compensation issues.

If any problems are uncovered, it's important to address them with the utmost speed. "You want to restate your financials quickly," says Lie. "You want to pay any additional taxes quickly."

Showing Executives the Door

Initially, ACS moved slowly in its probe. In May, the company made a filing with the SEC that said, "ACS does not believe that any director or officer of the company has engaged in the intentional backdating of stock option grants in order to achieve a more advantageous exercise price."

It was only six months later that ACS took the step of pushing out two of its top executives. Such a move can be difficult, especially if it's an executive who has been integral to the company's success. But it may be necessary to reassure outsiders. "The blueprint that we're seeing is, first and foremost, if someone broke the law and knew they broke they law, they have to go," says Patrick McGurn, executive vice-president at Institutional Shareholder Services, which advises institutional shareholders on governance and proxy issues.

A growing number of chief executives have lost their jobs as fallout from the scandal spreads. Among those affected have been the CEOs at UnitedHealth (UNH), McAfee (MFE), CNET (CNET), Comverse Technology (CMVT), Vitesse Semiconductor (VTSS), and (MNST) (see, 10/12/06, "CEOs Feel the Heat"). Homebuilder KB Home said on Nov. 12 that its longtime CEO Bruce Karatz was stepping down from his post (see, 11/13/06, "KB Home Cleans House"). The company's stock rose 4% the next trading day, to $44, and has since increased to more than $48. Mercury Interactive was one of the first companies to see its CEO leave under the cloud of an options investigation, back in 2005 (see, 7/29/06, "Mercury's Star Rises").

Standardizing Options Grants

McGurn of ISS says there are important steps that companies can take, even after removing executives involved in backdating and restating financials. Companies can attempt to reclaim for their shareholders financial gains that top executives reaped from backdating options or move to reprice options that have been issued.

McGurn adds that companies can also institutionalize certain practices to make sure backdating doesn't happen again. For example, all options can be granted at the same time every year or every quarter.

Lie cautions that companies can go too far, however. He points to UnitedHealth, which after coming under intense scrutiny over its options awards moved to eliminate the use of options for its chief executive and president. "I think maybe that's going further than you have to go," says Lie. "Options can be very useful as a motivational tool."

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