Cover Story : The Backdating Game

Options backdating

 

 

Already a handful of corporate heads have rolled as a result of the options backdating scandal. If regulators and shareholders get more aggressive, that could be just the tip of the iceberg.


cover_story_bigOptions backdating has been the corporate scandal of 2006. Having first appeared back in March, it gathered pace over the summer: By November more than 150 companies had been implicated and scores of directors had been forced to resign. Most observers believe there are almost certainly plenty more skeletons still to come out of the cupboard.

The legal and media hysteria over options backdating—resetting the date on which a share option was awarded to an earlier, more advantageous date (see box, Backdating Basics)—echoes the clamor set off by the massive frauds at Enron and WorldCom. But will the scandal around options backdating have as great an impact on corporate behavior?

Most of the 150 companies implicated in the backdating scandal are not being investigated directly by the Securities and Exchange Commission (SEC) and the Department of Justice (DoJ) because of the huge manpower such an operation would require. Instead, many companies under suspicion have conducted either internal investigations or hired external consultants or lawyers to look into potential problems.

The expectation is that the SEC and DoJ will review this evidence—and the responses of the companies—and decide whether they have acted appropriately. If a company has acted illegally and failed to make amends, criminal charges cannot be ruled out. As Global Finance went to press, only IT infrastructure company Brocade Communications Systems and telecom systems group Comverse Technology had had criminal charges brought against them.

While the SEC and DoJ could take years to conclude their investigations, shareholders have filed 265 class action lawsuits against more than 70 companies, claiming that they have been defrauded as a result of companies misrepresenting earnings. Given that the average shareholder class action takes 38 months to resolve, corporations are likely to find themselves under pressure for some time.

Companies involved in backdating—and their shareholders—have suffered immediate financial consequences as a result of the options backdating scandal. Research by San Francisco-based shareholder consultancy Glass Lewis published at the end of October showed that the companies named in the scandal had effectively been landed with a $10.3 billion bill for the alleged misdemeanors. Of this total, $5.2 billion has been incurred in otherwise unexpected compensation expenses. These costs, as well as additional auditing costs and lawyers’ fees, are expected to rise steeply in the coming months.

Value Destruction
In addition, the study showed that companies implicated in the scandal have suffered a collective $5.1 billion fall in their share prices since they admitted backdating practices. Alternative research concludes that almost $8 billion has been lost from the value of implicated companies when the underperformance of the companies compared to their peers and/or the S&P 500 index is included.

While the immediate financial cost of the options backdating scandal has grabbed the headlines, some observers believe that there could be longer-term cost implications, such as potentially higher costs for directors’ and officers’ liability (D&O) insurance. Companies defending themselves against shareholder claims will inevitably incur substantial costs in the process. “D&O insurance covers costs incurred to defend against allegations of fraudulent behavior and the gaining of profit or advantage, so, to that extent, companies can rest easy,” says Steve Shappell, managing director at Aon Financial Services Group’s legal and claim practice in Denver, Colorado. “However, corporates face other potential costs relating to options backdating.”

Paying the Price
Among these are the potential costs of recompense related to options grants. “D&O insurance does not cover ‘giving back’ costs, if money is required to be returned as a result of options backdating,” explains Shappell. More important, D&O insurance will not cover costs for those individuals found guilty of a crime. In addition, insurers are currently checking that companies have provided accurate information to them in the past. “If corporates have not, their insurance could be subject to rescission by the carrier,” says Shappell.

The longer-term implications on D&O insurance are likely to be limited, according to Shappell. “The situation is likely to resolve itself without significant costs to insurers, and consequently premium costs to companies won’t rise significantly. However, there could be an expectation that companies improve their housekeeping,” he notes.

Changing Corporate Behavior
As well as costing companies money, the options backdating scandal could well result in changes to corporate behavior—either voluntarily or as a result of regulatory compulsion. The SEC issued new rules on executive compensation requirements in July, requiring public companies to provide details of the total yearly compensation for CEOs, CFOs and the next three highest-paid executives.

However, there are unlikely to be new legislative guidelines relating to corporate behavior as a result of options backdating. This is because the alleged incidents of options backdating occurred before the introduction of Sarbanes-Oxley in 2002, which is deemed to have been responsible for a massive improvement in US corporate governance (see box, this page, Back to the Future).

One possible long-term outcome of the options backdating scandal is that companies will become more circumspect in how they award options. Over the past decade, options have increasingly been used because salaries of more than $1 million have not been tax deductible to companies since the introduction of Section 162(m) of the Inland Revenue Code in 1993. Consequently, options have become a salary substitute rather than a reward for performance.

More generally, there could be an increase in the frequency of calls to link pay to performance to a greater extent. A survey by consultancy Watson Wyatt in June showed that a majority of directors and institutional investors strongly favor pay—and equity incentives such as options or shares—based on performance. However, there is no agreement as to whether executives should be rewarded for performing in line with their peers or above their peers.

Another potential outcome of the current scandal could be an acceleration of the trend toward the awarding of shares, rather than options, to executives. In Europe (see box, page 13, A Local Problem?) this move has gathered pace in recent years, and some US-based companies, such as Microsoft and ExxonMobil, have followed suit.

“The options backdating scandal may lead to a rethink about how executives are rewarded and will certainly make it harder for companies to recruit and retain staff,” says Robbert Van Batenburg, the head of global research at Louis Capital Markets in New York. “But the greatest effect of the options backdating scandal could be to strengthen the revolt against corporate greed that has been gaining strength since the beginning of the decade.”

BACKDATING BASICS
What is options backdating? Share options—the ability to purchase shares at a discounted price—are a standard part of executive remuneration. Options backdating means that the date on which the option is granted is changed so that the option appears to have been awarded earlier. For example, rather than an option being based on the stock price when an executive joined the company, it might be based on an earlier—and lower—stock price.

That means that the option is “in the money” from that date of issuance. Such a practice goes against the principal of options as performance-based pay because the executive benefits from share price performance before they could have affected it. Moreover, by being able to look back over stock price performance and pick the most advantageous date to award the option, the concept of backdated options appears unethical.

Why is options backdating a problem? It has the potential to tie companies in knots by causing them to falsely state earnings and taxes. Options backdating is not illegal, but in order for options backdating to work, a company needs to make numerous accounting and tax filing changes. Necessarily, this is a complicated process, and either through error or by design it opens companies to charges of misrepresentation.

Hundreds of companies have failed to accurately report cases of backdating and consequently failed to accurately amend their tax and earning files while many of the individual executives who benefited from options backdating may have similarly failed to declare changes that would affect how much tax they owed.

This behavior not only puts the company and its executives at odds with the Securities and Exchange Commission and the government but means that investors can claim that they have been misled about how a company has performed. Some investors claim that they should be compensated not only for past misstatements but also for the more recent declines in the stock as a result of the scandal.

A LOCAL PROBLEM?
Is options backdating confined to the United States? To date, the options backdating scandal has been confined to the US. “Options have never been as important a part of compensation in the UK and Europe, where the move in recent years has been toward the granting of shares rather than options,” notes Gordon Clark, managing director of executive compensation consultancy Kepler Associates in London. “The difference between receiving shares and receiving options is that the former provides less temptation to manipulate how and when those shares are awarded.”

Clark believes that there is also an important philosophical difference in remuneration practices between Europe and the US. “Since the 1990s, when executive salaries were effectively capped by government at $1 million [under Section 162(m) of the Inland Revenue Code, enacted in 1993], options have increasingly been regarded as a salary substitute, which is vested monthly,” he says. “In Europe, options are more explicitly tied to performance.”

THE SORDID DETAILS
How big a problem is options backdating? More than 150 US companies have been implicated in the options backdating scandal since it began in March—either as a result of internal investigations or following investigations by the Securities and Exchange Commission and Department of Justice, according to San Francisco-based consultancy Glass Lewis. Most observers believe that around 200 companies will be implicated in the scandal by the end of this year. To date, as many as 41 senior executives or directors have left a total of 20 companies as a result of options backdating issues.

Some of the companies involved in options backdating are household names. They include Apple Computer, which has lost two executives, including former CFO Fred Anderson; and Internet jobs website Monster Worldwide, which lost its chairman and CEO Andrew McKelvey twice: He initially resigned from the two posts to take up a chairman emeritus role but then resigned from that post after declining to be interviewed as part of an investigation into stock options grants.

At anti-virus software company McAfee president Kevin Weiss and chairman and CEO George Samenuk both had to go when the company announced it would have to restate 10 years of financial statements. The chairman and CEO of Internet media company CNET, Shelby Bonnie, has also resigned. In mid-October William McGuire, CEO of UnitedHealth Group, a health insurer with a market capitalization of more than $63 billion, resigned as a result of options backdating. Other implicated companies include Foundry Networks, Sycamore Networks, Intuit, Progress Software and Quest Software. Most dramatically, a former CEO of Comverse Technology, David Kreinberg, was arrested in Namibia in September, having reportedly sent $15 million out of the US before fleeing arrest.

Why are many of the companies in trouble in the technology sector? The technology sector has long been an extensive user of stock options, partly because of the entrepreneurial and high-growth nature of the market, which makes options particularly attractive. Although the culture of options-based pay was hit by the dotcom and technology crash of the early part of the decade, options use remains more prevalent in the technology sector than in other sectors.

In addition, the close-knit nature of the technology sector appears to have aided the spread of options backdating as a corporate practice. A study published by corporate governance think-tank The Corporate Library at the end of October noted that of 120 companies analyzed, 51 had directors who were on the boards of other companies implicated in the scandal. The inference is that those directors spread the practice by word of mouth.

BACK TO THE FUTURE
Is backdating still going on? To date, none of the companies under investigation appear to have backdated options after the introduction of Sarbanes-Oxley in 2002. The most obvious reasons for this finding is that Sarbanes-Oxley—introduced to clean up corporate governance following the Enron and WorldCom accounting scandals—changed the requirement for companies to report the granting of options. Before Sarbanes-Oxley, companies had 45 days to report the granting of options; now they have just two days, making backdating more difficult. Similarly, executives who receive options used to have until the end of the financial year to declare their receipt of options but now have just two days.

Could the options backdating scandal uncover other problems? Investigations have already unearthed other potential options-related problems. At the beginning of September a Senate committee on banking, housing and urban affairs met to discuss the backdating problem but also discussed spring-loading options—where an option delivery date is deliberately scheduled to occur just in advance of the announcement of favorable information, such as above-estimate earnings.

As with options backdating, spring loading is not illegal. Indeed, given that options are being awarded at some date in the future, the practice can at least be said to be rewarding the executive appropriately for his efforts. However, spring loading does raise questions about the efficacy of scheduling an award based on privileged information. It is illegal for executives to buy shares in the open market based on insider information, so some observers have asked why obtaining the shares—at an advantageous price—as a result of insider information is legal.


Laurence Neville

 

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