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Anyone who owns stocks knows the feeling. After the price jumps, you wish you could travel back in time and buy more at lower prices.
For top executives at dozens of companies, this fantasy appears to have been a pleasant and profitable reality, thanks to a boondoggle known as options backdating. For some, the practice may have added tens of millions of dollars to their compensation.
It's been going on for more than a decade, but in recent months the practice has come under the scrutiny of the Securities and Exchange Commission. And now it's taking a toll on stocks. Already, companies such as UnitedHealth Group (UNH, news, msgs), KLA-Tencor (KLAC, news, msgs) and Trident Microsystems (TRID, news, msgs) have seen their share prices fall by 10% to 20% as investors worry that these companies may need to restate years of financial results.
More companies are sure to join the list. Analysts believe options-backdating time bombs are still ticking inside dozens of companies that have yet to be publicly implicated.
"This is fundamentally cheating and stealing," says former SEC chairman Harvey Pitt, who now leads consulting firm Kalorama Partners, which advises companies on good corporate governance practices. "When people are paid so well, you really have to wonder what is going on in their minds to try to cheat and get a little more."
The scandal is in its early days, and it's bound to gain steam. Here's a primer on what's really going on and how you may actually be able to profit from it as an investor.
How backdating works
Lots of companies, of course, hand out stock options to CEOs and other employees. The idea is that executives will work harder, make better decisions, etc., if they are rewarded by a rising stock price. Options give execs the right to buy company stock at an "exercise price," also known as the "strike price." Typically the strike price is the value of the stock at the end of trading on the date the options were granted. At many companies, options are granted only at predetermined dates throughout the year.At some companies, however, the options-grant dates were more flexible. Some top managers -- including UnitedHealth Group Chairman and CEO William McGuire -- were given the ability to choose their own option-grant dates. It appears that some executives, in cooperation with members of the companies' boards, cherry-picked dates when their stock prices were lowest.
Why it's unfair
What's wrong with that? Suppose a CEO gets 100,000 options near the end of the year on a day when the stock trades at $20. Exercising the options a year later when the stock goes to $30 gives the CEO a profit of $10 times 100,000, or $1 million. But if the options are backdated to a point when the stock traded for only $10, the exec earns an extra $1 million in the deal.Stock-market researchers began suspecting a few years ago that this was going on. Studies showed too many executives were getting the best exercise prices for the year for their option grants.
All six of the stock-option grants for Affiliated Computer Services (ACS, news, msgs) CEO Jeffrey Rich from 1995 to 2002 were dated just before a rise in the stock price, often at the bottom of a steep decline, The Wall Street Journal reported. The odds of that happening by chance are around one in 300 billion, according to the Journal. Rich called his good timing "blind luck."
Most of this funny business happened during the 1990s, and it didn't really slow down until 2002, when the Sarbanes-Oxley Act forced companies to report options within two days of being granted. Before that, they didn't have to report options until 45 days after the end of the fiscal year, which gave them far more freedom to look back pick and the best prices.
Companies are allowed to grant options at a price below the current market value, but unless they disclose this to shareholders, it is a form of fraud. Executives involved in options backdating face potential civil and criminal charges.
Who did it?
So far, about two dozen companies are suspect. In many cases, top executives have resigned after suggestions of scandal, and authorities have announced investigations.But the experts think there is still a lot more to come. "I suspect we are very early in the game," says University of Iowa associate professor of finance Erik Lie, who did much of the ground-breaking research that got the ball rolling on options backdating. His research suggests many of the companies currently under suspicion are actually innocent, caught up in a growing witch hunt. But his research also suggests the practice happened at around 40 more companies that haven't been accused publicly. Lie doesn't think Sarbanes-Oxley stopped the practice in 2002, either, and notes that as many as 20% of companies now miss by several weeks the two-day deadline to report options.
Companies suspected of backdating options are typically in the technology and health-care sectors, where big option grants are common. It also happens most often at smaller companies with a market cap of less than $1 billion. Lie speculates this is because it's "easer to pull a scheme like this when there are fewer people involved."
Here are the companies under investigation by the SEC, other regulators or grand juries, as reported by the companies themselves:
UnitedHealth Group (UNH, news, msgs)
Brooks Automation (BRKS, news, msgs)
F5 Networks (FFIV, news, msgs)
Openwave Systems (OPWV, news, msgs)
Sycamore Networks (SCMR, news, msgs)
RSA Security (RSAS, news, msgs)
Comverse Technology (CMVT, news, msgs)
Juniper Networks (JNPR, news, msgs)
Vitesse Semiconductor (VTSS, news, msgs)
UnitedHealth has acknowledged problems with the way it administered stock-options grants and warned that it might have to restate results. Sycamore said it had previously completed an independent investigation into options backdating and subsequently restated financial results. In May, Vitesse terminated its CEO and finance chief because of concerns about the way its stock-option program was administered. Brooks Automation, Comverse Technology and Juniper said they are conducting internal reviews of their options-grant programs.
Several other companies have announced they are conducting internal reviews, including Altera (ALTR, news, msgs), CNET Networks (CNET, news, msgs), Quest Software (QSFT, news, msgs) and Trident Microsystems.
Is there another explanation?
Wait a minute. Is it really so odd that executives would get options grants at times when their stocks are cheap? After all, studies show that insiders like top execs and directors have consistently good timing with open market purchases of stock.Lie, the University of Iowa professor, isn't buying it. The reason: Insiders don't do nearly as well with open-market stock purchases as they did with the options grants he's studied. "It is uncanny how good they were at predicting stock prices," says Lie. "You don't see the same pattern with insider purchases."
Should you sell?
One thing is sure; investors are shooting first and asking questions later. Stocks have been falling anywhere from 10% to 20% on news of suspected options backdating. You can expect more fireworks as more revelations of options backdating surface.Investors have good reason to worry. Here are the chief concerns that backdating raises:
- Heads will roll. "If CEOs falsified stock-grant documents, that is a very serious problem, and I think it would be very hard for those CEOs to command moral authority," says Pitt. In short, they have to go. "Given the high reliance on key management team members by many small technology and biotechnology companies, the loss of any of these executives could be extremely negative," says Goldman Sachs (GS, news, msgs) analyst Michael Moran.
- Even when executives do get the boot, suspicions still linger that other funny business may have been going on because the practice suggests a culture of poor internal controls, says Leland Bettis, at Equity Incentive Analytics, a division of Gradient Analytics.
- Earnings may take a hit. Options backdating that creates an artificially low exercise price is essentially a gift to executives. Companies that granted those options will have to account for them as expenses. Companies may also have to forgo tax benefits they claimed for the cost of stock options, which can normally be deducted because they are considered incentive-based pay. When stock options are granted at artificially low prices, the giveaway can't be considered incentive pay. So companies lose the tax benefit they had claimed, and they may have to pay fines and penalties as well. UnitedHealth has warned it might have to take charges that could reduce the past three years' net earnings by $286 million. There will be more nasty surprises like these.
- Companies will be sued. Plaintiffs' attorneys don't pass up opportunities like this one.
Buying opportunity
Some value-oriented investors think the market has been too harsh on several companies caught up in the options backdating issue.George Putnam of The Turnaround Letter -- consistently one of the top-ranked investing newsletters according to Hulbert Financial Digest -- thinks Vitesse Semiconductor is now a good buy for the long term, because of the current weakness.
John Buckingham, who manages the Al Frank Fund (VALUX, news, msgs) and edits another top-ranked investing newsletter called The Prudent Speculator, has recently been buying shares of UnitedHealth Group, KLA-Tencor and SafeNet in the weakness caused by concerns of options backdating. "I certainly understand the 'where there is smoke there is fire' fears, but I believe that the share prices have already been overly singed," says Buckingham. "The valuations are very compelling."
At the time of publication, Michael Brush did not own or control shares of companies mentioned in this column.
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