San Francisco Chronicle - June 18, 2006
Backdating Scandle Expands
Tougher regulations expected to restrict how stock options fit within executive compensation
By Carolyn Said, Chronicle Staff Writer
Is it Enron all over again?
The stock-options backdating scandal continues to metastasize. Almost every day, reports come to light of yet another company under scrutiny for possible rigging of stock-option awards to executives.
About four dozen companies, including 17 in the Bay Area, are now under investigation to determine whether they retroactively changed option award dates to a time when the stock price was low, thereby padding the value of the options.
An option gives a person the right to buy stock in the future at a fixed price -- usually the price on the date the option is granted. The more the stock rises, the more the option is worth.
By selecting award dates when company stock prices were at or near their lowest, backdated options come with built-in profits for recipients. That undercuts the main intent of stock options: to motivate executives to increase the company's stock price.
The good news is that, just as Enron and other accounting scandals of the late 1990s prompted the tough Sarbanes-Oxley rules for corporations, the stock-options scandal is helping spur strict regulations on executive compensation. Companies will have to disclose in plain English exactly how much they pay their executives -- everything from golden parachutes to free rides on corporate jets to cushy consulting gigs to stock options.
"No shareholder should need a machete and a pith helmet to go hunting for what the CEO makes," said Christopher Cox, chairman of the Securities and Exchange Commission, in a speech last week to the New York Financial Writers Association.
In January, the SEC proposed stricter compensation disclosure rules and received an avalanche of comments -- some 20,000 and counting. Now with the stock-options scandal spreading, Cox said the rules will specifically address reporting of stock options.
"Backdating must be fully disclosed," Cox said in the speech. "And the granting of backdated options must be properly accounted for."
The new rules are likely to be in place by late summer or early fall -- in time for clear descriptions of executive compensation to be included in 2006 annual reports.
Compensation experts said companies should easily be able to comply with the new rules.
"These rules should not result in a significant amount of additional internal expense," said David Broman, chief executive officer of Syzygy Consulting Group, a Lafayette compensation-consulting firm. "Most of this stuff is done now internally, at least for companies that are well run. It's just a matter of math and having your compensation consultants or accountants run the numbers for you."
One loophole shrinks
Sarbanes-Oxley has already tightened the loophole that allowed backdating to flourish. Companies used to have a month to report stock-options grants. Under Sarbanes-Oxley, that window is down to two days -- which means any backdating could happen only within 48 hours.
"This latest scandal is the death knell for the argument many have made that Sarbanes-Oxley is too burdensome, particularly on smaller public companies," said Peter Blume, head of the business practices group at Thorp Reed & Armstrong in Pittsburgh. "All these backdating cases occurred prior to summer 2002, when Sarbanes-Oxley became effective."
Experts say the scandal shows that boards of directors were lax.
"It demonstrates that many boards had a lack of control or understanding of the details of options plans," said Amy Borrus, deputy director at the Council of Institutional Investors, a Washington, D.C., association representing union and corporate pension funds. "Now, boards will feel impelled to seize control back from management, to get rid of the wiggle room as far as issuing options."
The council is sending a letter to the 1,500 largest public companies asking them to disclose their policies on options grants, whether their boards are reviewing their policies and whether the companies are being investigated by any outside agencies.
"We want to put companies on notice that they should have policies and practices in place to guard against this kind of manipulation," Borrus said. "The council policy is that long-term incentive awards should be granted at the same time each year except in the case of extraordinary circumstances. It won't guarantee no monkey business, but it will minimize the opportunity."
Another enabling factor for the alleged backdating was the investing climate around the turn of the millennium.
"During the boom years up until 2000, anybody getting a stock option was going to get a gain," Broman said. "As the stock market crashed and went into a period of extreme volatility, there was no guarantee an option would give you a gain. What appears is that a lot of these executives were intentionally backdating to guarantee a gain. It was a pure motivation of greed."
Bruce Vanyo, co-chair of the securities litigation practice at Katten Muchin Rosenman in Los Angeles, said he thinks some cases will turn out to be executives who were acting within the rules.
"I do know in a number of instances it was nothing more than a matter of (executives) looking at lows in the stock price and saying, 'Now's a good time to grant me those options I'm entitled to under the plan,' " he said. "As long as there's proper disclosure, it's not a problem. I don't think we should pass judgment on what actually happened because we don't know."
The SEC and the Department of Justice are the main agencies probing the companies; their investigations could take upward of 18 months, experts said. The Internal Revenue Service and many companies are also combing through records for improper options grants.
Many companies under the microscope are already paying an immediate penalty in the form of drops in their stock prices.
"It has hurt the credibility, at least in the short run, of some tech bellwethers," said Terry Connelly, dean of the Ageno School of Business at Golden Gate University in San Francisco. "By and large, the shares of companies that have disclosed an informal SEC inquiry or worse have suffered more than others."
Conversely, when Sunnyvale chipmaker Zoran Corp. last month said an internal inquiry showed that its options granted had been properly awarded, its stock jumped almost 5 percent.
Some companies are restating earnings and even firing executives. Security software company McAfee of Santa Clara, for instance, terminated its general counsel after discovering an improper stock-option grant to him. Howard Earhart, chairman of Power Integrations, a San Jose chipmaker, resigned last month and the company said it will need to restate almost seven years of financial results.
Some shareholders sue
At the same time, shareholders have filed lawsuits against many of the companies and their officers. Such suits are likely to take a couple of years to wend their way through the legal system.
Once investigations are complete, the companies and their executives are likely to face more consequences, ranging from SEC civil fines and sanctions to criminal prosecution by the Justice Department.
"I think companies and some of the executives should have a real concern about the possibility of criminal charges if it can be shown there was an intent to deceive the boards of the companies or their shareholders regarding the terms of these options," Blume said. "I think that's why federal prosecutors have gotten involved now in reviewing the facts of these cases."
Moreover, companies face potentially substantial tax consequences, he said.
Ultimately the changes that are likely to result from the options scandal should wind up benefiting shareholders by providing them with more and better information, experts said.
"The positive that could come out of this is the idea of there being a level playing field -- everybody does compensation the same way, everybody does options the same way," said Daniel Tyukody, who heads the securities practice at Orrick Herrington and Sutcliffe. The Los Angeles law firm has several clients embroiled in the scandal.
"It will benefit shareholders because they can understand things better," Tyukody said. "It will benefit companies because there (will be) more transparency."
E-mail Carolyn Said at csaid@sfchronicle.com.
Bay Area companies involved in options probes
These Bay Area firms have disclosed inquiries from the SEC or the Justice Department about their options programs, or have started internal investigations. At McAfee, Mercury Interactive and Power Integrations, senior officials have left after disclosures of possible improprieties.
- Altera
San Jose - Applied Micro Circuits
Sunnyvale - Asyst Technologies
Fremont - Cnet Networks
San Francisco - Equinix
Foster City - Intuit
Mountain View
- Maxim Integrated Products
Sunnyvale - McAfee
Santa Clara - Mercury Interactive
Mountain View - Juniper Networks
Sunnyvale - KLA-Tencor
San Jose - Macrovision
Santa Clara
- Openwave Systems
Redwood City - Power Integrations
San Jose - Rambus
Los Altos - Sanmina-SCI
San Jose - Trident Microsystems
Sunnyvale
Source: Chronicle research
