Sympathy For Stock Option Backdaters?

Some are calling it a witch hunt. Some are calling it the latest and
greatest scandal in the relatively short history of high tech.


Whatever you want to call the chowder pot of stock option backdating cases,
it still boils down to sketchy accounting.


Granting options below market value is legal if it’s fully disclosed to the
public and properly accounted for.

But stock option backdating is the practice of granting shares at prices
below the market price on the day of the grant, virtually ensuring the
recipient a better price for their shares down the line.


For example, say an executive is given stock at an exercise price of $5 per
share, when the company’s real stock price on the grant date is $15 per
share.


That’s a potential $10 profit for the exec, whereas a shareholder who bought
the stock in the market on the same day would have had to pay $15 per share.


Now, that’s not much of a difference when we’re talking about one share of
stock. But try multiplying it by hundreds, thousands or millions.

We’re talking about a multi-million-dollar payday here.


In a nutshell, the executive gets an unfair advantage over investors who are
gambling that the stock will perform well.


When the Securities and Exchange Commission finds something askew in the
numbers, it can be a royal headache for the companies.


It could mean millions of dollars in financial restatements if the SEC comes
asking for the real numbers for the years in
which option dating was fudged.


Just ask Mercury Interactive, which recently claimed
that the backdating practices of three directors could cost the company $70
million in financial restatements and legal fees.


If that kind of toil and trouble doesn’t induce a debilitating migraine, how
about having execs shipped off to jail?


Just ask companies like Brocade Communications Systems, who just watched a
former CEO and vice president get slapped
with multiple charges related to backdating.


Ask three former Comverse Technology executives, who are facing
criminal and civil charges for fraudulently backdating millions of stock
options.


Sometimes clerical mistakes happen.


But for the companies who did intentionally alter option grant dates to
generate profits, shame on you for getting overtaken by hubris and greed.


While other accounting scandals exploded, your backdated option grants
simmered and boiled over after the SEC and other regulators had already
fired off various compliance laws to force greater accountability from
companies.


I asked Jill Fisch, securities professor at Fordham Law School and former
trial attorney with the Justice Department, how this backdating situation
could have gotten so out of control.


Fisch told me the late ’90s were a great time to backdate stock options
because the market was volatile, there was a lot of money to be made in
stock options, and basically, no one was paying attention.


Fisch explained that before the dot-com implosion, people thought it was
fine for the executives and the high-level employees to get paid a lot of
money.


But when the markets began to sour in late 2000, 2001, the public
became more skeptical of options and began to see that options don’t really
pay CEOs and other high-level execs for performance.


“We didn’t have the same kind of disclosure of options-based compensation we
do now, so it was harder to figure out what was going on then,” Fisch said.


Okay, fair enough. There is greater accountability for options-based
compensation now, and some folks are afraid of leaving something out of the
mix that could affect earnings per share.


But why do we see it in high tech so much compared to other lines of
businesses? Fisch said high-tech vendors traditionally feel further a field
from typical business.


“[They thought] it’s so modern and new. ‘The [accounting] for these
standard, nuts-and-bolts companies doesn’t really apply to us in the same
way'” Fisch said.


So perhaps some high-tech vendors felt their work is a little different than
the rest of the business world, and therefore they could get a little leeway
with the SEC.


Somehow, I don’t think the SEC is biting; the slew of investigations bears
that out.


But here’s what really blows my mind. Apparently, there are some whispers
afoot that the SEC is merely out to get companies.


Business Week recently published a telling Q&A with Network Appliance CEO
Dan Warmenhoven, who essentially downplayed the backdating issue.


In it, the CEO said he felt the SEC was on a “witch hunt” to get
companies.


“I think it’s become a witch hunt. I think the government is looking to find
some egregious examples [of wrongdoing] and to publicly hang people for
them. That’s fine. But where does it stop?”


Mr. Warmenhoven, the purpose of hammering these execs now is to send a
message that shifty accounting won’t be tolerated. It stops when the
corruption is quashed.


“They’re penalizing today’s shareholders for events that occurred five years
ago. But who is this protecting, exactly? With Enron, every shareholder in
the company lost money. The same with Qwest, and with MCI-Worldcom. But I
don’t know who the injured party is here.”


I have answers, Mr. Warmenhoven.


1) The “penalizing” of the shareholders, who may suffer from some stock
drops, is a small price to pay for cleaning up an accounting mess that could
have been avoided and shouldn’t have happened in the first place.


2) The companies these execs lead are what the SEC is trying to protect.
Forking over millions of dollars in fees for legal help, audit committees
and financial restatements can adversely affect a company, becoming a
distraction to its leaders.


3) Execs may not be directly stealing from the shareholders in these
backdating fraud cases. But they still lied to stockholders, who assumed
employees weren’t getting unfair stock price boosts. Lying is fraud.


“Investors are hurt because the company’s financial statements are wrong and
because execs are getting paid more,” Fisch said. “And rather than providing incentives for execs to increase stock price, the options are paying off for execs even when they don’t do that.”


Fisch also had strong feelings about Warmenhoven’s attitude.


“Calling this a witch hunt seems to be really disingenuous,” Fisch said.

“This is really flagrant abuse. The whole idea of option-based compensation
is that executives were supposed to be paid according to the market and bear
the risk that their stock price wouldn’t perform.”


Warmenhoven’s questioning of how investors are hurt reminds me of the scam
depicted in the 1999 comedy film “Office Space.”

The main characters write a
computer program that pinches fractions of pennies from all of the accounts
it comes in to contact with, presumably without the victim realizing it.


When the main character’s girlfriend tells him that it’s stealing, he
demurs, comparing it to the “take a penny leave a penny” jar in convenience
stores. His logic is that the dollar amount is so small that no one gets hurt.


The movie mocked the moral flexibility of a few young men; backdating
skewers the compensation accounting practice, enabling executives to help
themselves to the company’s money well without earning it through
exceptional performance.


Mr. Warmenhoven, with all due respect, you ask an investor if they mind if
you treat yourself to a better strike price. But don’t be surprised when
they slap you silly.


As to the witch hunt theory, we don’t know enough about the individual
backdating cases to say whether the dozens of company executives are
guilty of outright fraud.


Again, there could be some honest mistakes.

But for those who blatantly
finagled stock option dates, I have no sympathy for what the SEC, FBI or
state attorneys general do to them.


If a bunch of executives have to go the Salem route for illegally profiting,
let them burn in the legal system. That’s what it’s there for.

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