Saturday, August 26, 2006

Chicago Tribune Editorial - Cashing in on the calendar

Chicago Tribune Editorial - Cashing in on the calendar
Copyright © 2006, Chicago Tribune
Published August 26, 2006

More than 80 companies have come under scrutiny in federal investigations of possible stock option fraud, and you can't help but wonder if we're on the verge of Enron/WorldCom/Tyco revisited.

So far, news of the investigations hasn't roiled the markets the way a spate of corporate scandals did a few years ago. But this does have the potential to shake the confidence of investors.

An option is the right to buy a share of a company's stock in the future at the price of the share on the day the option is granted. So, if 1,000 options are valued at $25 a share, and the stock goes up to $35, the holder can buy and sell and make a quick $10,000 profit. (Or buy and hold the shares.)

The practice under scrutiny is called "backdating." The option might have been issued on a day when the stock was worth $25. But if the option is later changed so it's pegged to a date when the stock sold for, say, $20, the holder can make a larger profit.

Backdating may be legal if a company's board of directors approves it and investors are alerted that it's being done. But it's illegal if it's done in secret. That practice doesn't allow investors to accurately judge the potential cost of a company's option grants.

The Securities and Exchange Commission is investigating this practice, as are federal prosecutors in San Francisco. Some companies have been forced to restate their earnings or delay issuing quarterly results. Apple Computer this month said it will have to restate earnings going back years. The company said its financial statements could "no longer be relied on" because of "irregularities" in its handling of option grants.

Two former executives of Brocade Communications Systems have been indicted by a federal grand jury on conspiracy and securities fraud charges. The former CEO of Comverse Technology is believed to have fled the U.S. after federal prosecutors charged him and two other Comverse executives with securities, mail and wire fraud related to backdating stock options.

Other firms have publicly revealed that they are part of the ongoing investigations.

Stock options have been particularly popular in the high-tech field because they provide a way for some start-up companies to reward executives with the prospect of future riches in lieu of big paychecks. So it comes as no surprise that many of the 80 companies under investigation in the backdating scandal are high-tech companies.

But the practice may be far more common. More than 2,000 U.S. firms have engaged in the practice, according to an analysis by two professors, the University of Iowa's Erik Lie and Indiana University's Randall Heron. They examined nearly 40,000 stock option grants to executives at more than 7,700 companies between 1996 and 2005. Their analysis revealed that 29 percent of the companies manipulated at least some option grants. The practice fell off four years ago after the SEC required companies to report option grants within two days, but it didn't disappear. Some companies apparently ignored the new rules.

"Backdating goes to the heart of investor confidence," SEC Chairman Christopher Cox said last month. The SEC is writing new rules that will require companies to spell out when, how and why they backdate options. More information for investors is good. Armed with that, they can make up their own minds about a company. As for executives thinking they can get away with illegal backdating, the best deterrent is likely to be the one that has been so effective with other corporate scandals: arrest and conviction.


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