Thursday, October 12, 2006

The biggest corporate scandal you never heard of...

Front paged at Booman Tribune, My Left Wing and ePluribus Media. Recommended at Daily Kos. Linked at Google Finance

And the lid is about to blow off.

At least two dozen high level directors or officers forced to resign. Well over 100 companies under investigation. Potential fraud. "Accounting irregularities". SEC investigations. Big name companies like Apple, Bed, Bath and Beyond, Home Depot, McAfee and Monster Worldwide. And yet, barely a reference in the news about the latest scandal to take over corporate America, other than a few articles, including one in today's Wall Street Journal.

The scandal - backdating of stock options for executives and directors, and it is being called "a fundamental breach of trust to your investors" by Charles Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware. Oh, and it is analogous to stock price manipulation after the fact.

I'll explain a bit of the background, why this is such a huge deal, as well as what is being done to (hopefully) start to close this egregious practice.


Just a bit of information on stock options, since it isn't the sexiest of areas (unless you are getting them). When you receive a stock option, it is essentially an "option" to purchase stock at a specified price. That price is (or should be) determined as of the date the option is granted. For example, if you are granted a stock option today, it should be based on TODAY's stock price.

When you receive the stock option, there is no income that you would report or derive, since you haven't yet bought the stock, and the stock price may ultimately fall below the price you have the option to buy it for. Additionally, there is generally a specified period that you must hold the option for before "exercising" it.

When you "exercise" the option, there is income to the individual who exercises the option. This income is also subject to payroll taxes and income tax withholding. This income is based on the difference between the price of the option when it was granted and the price the stock is on the day you exercise it. You don't have to sell the stock to have the income, although many people do exercise and sell the stock at the same time.

Example: You receive a stock option in January when the price of the stock is $5. You exercise it in October when the stock price is $15. You have income of $10 on that stock option, regardless of when you sell it.

If you sell the stock at a later date, then the income you have from the "exercise date" to the "sell date" is only subject to the capital gains tax, and we all know how Bush and Congress just reduced that tax rate. Following the example above, if you sell the stock in December when the price is $20, then there is the original $10 subject to income tax (at a higher rate) and the $5 (from the $15 to the $20) is income which is taxed at a LOWER capital gains rate.

Why Backdating is an Issue

What had been happening is that companies were artificially changing the dates on which the stock option was granted to a date where the stock price was lower than on the date when the stock option was actually granted. What this means is that if a CEO was granted a stock option in April when the stock price was $10, the company, and sometimes even the officers themselves, changed the date of the grant to an earlier date when the stock price is lower.

So, if the CEO got the option when the stock price was really $10, but then changed the date to an earlier date when the stock price was $4, then the CEO just got $6 more in income.

From WSJ:

Backdating amounts to pretending that an option was granted earlier than it actually was, at a beneficial time when the share was trading at a low price. Since options entitle their recipients to profit from a rise in price, claiming the grant occurred at a time of low prices could give the recipient a running start to extra profit.

At a minimum, backdating generally involves accounting and disclosure violations. It can also constitute fraud. U.S. attorneys in more than a half-dozen jurisdictions are probing at least 50 companies. Five former executives of two companies are facing federal criminal charges for their alleged participation in backdating schemes.

Pretty scummy, eh?

The WSJ article (may be behind a firewall but I will give some snippets below) talks about what is going on now, some of the more egregious offenders, and even has a scorecard which lists around 115 companies that are targets of SEC or Justice Department investigations, as well as those whose officers have resigned or who will have to restate their earnings as a result of this fraudulent behavior.

Which brings us to today. More than a few companies have already dismissed senior officers, and one CEO is facing extradition charges as a result of this:

Five senior officers at two well-known Silicon Valley companies became the latest corporate casualties of the stock-options backdating scandal, adding to a toll that is likely to continue to rise as companies wrap up probes of their internal practices.

In the latest actions, Shelby Bonnie, founder and chief executive officer of Web publisher CNET Networks Inc., and George Samenuk, chairman and CEO of computer-security vendor McAfee Inc., stepped down following internal probes that found use of options backdating. So far, some two dozen executives or directors have been fired or suspended or have resigned amid options probes. Among them are top officials of Apple Computer Inc., Web-site operator Monster Worldwide Inc. and software maker Comverse Technology Inc., whose former CEO is facing extradition proceedings in Namibia.

Experts said more departures are likely. More than 100 companies are under investigation for options backdating, and scores of them are still conducting internal probes.

Not only that, but there are requirements that companies must meet with respect to securities filings, which could lead to investor lawsuits, and the possibility of being delisted from a stock exchange.

What is Being Done?

Well, besides SEC and Justice Department investigations, as well as firing of people involved in this fraudulent behavior, there are stricter internal reviews that are going on where these practices are being identified. Additionally, there is the ability to determine if there were large grants of stock options on dates where the stock price was at or near a low, so that can help identify problems.

Of course, we all know what can happen when there is "self regulating", like in the instance of Bed, Bath and Beyond:

Bed Bath & Beyond Inc., the specialty retailer, said Tuesday that its review had found rampant backdating, concluding that "almost all annual grant dates" for several years were likely selected "with some hindsight." At a time when many corporate disclosures about backdating are opaquely written, the company's statement was frank and detailed, laying out how many grants the company believed were backdated and giving a sketch of how the process worked.

What's more, Bed Bath & Beyond said, the co-chairmen and chief executive had responsibility for picking the dates; the men themselves benefited from the low prices. But the board committee probing the options offenses concluded that no one had "engaged in willful misconduct." No top executives have departed Bed Bath & Beyond because of options misdeeds.

So, it remains to be seen how this will all play out. But it is interesting that this scandal, which would further destroy confidence in a company's motives for "looking out for its investors" or certainly for the greater good of its employees, is not generating a peep.

And yet, we are talking about at least hundreds of millions of dollars that officers, directors and corporate boards all bilked and cheated to benefit highly from.

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