(cross-posted at Deny My Freedom and Daily Kos)
The collapse of the so-called New Economy came furiously and quickly at the end of the 1990s. While its demise was largely characterized by the demise of the dot-bomb startups, it was the ugly accounting scandals of large companies like Enron, Worldcom, Tyco, and many other firms that truly underpinned the ‘irrational exuberance’ of the economy during the Clinton years. It led to the Sarbanes-Oxley Act, a law that required more stringent oversight of the accounting done within each firm.
At this juncture, most people would like to believe that enough regulation is in place. Firms regularly complain about how Sarbanes-Oxley is unnecessary and that it is extremely costly to implement, particularly for smaller firms that do not necessarily have the working capital to pay for such measures. However, there is the rise of another accounting scandal on the way – and it is going to get uglier before all the dirty laundry is aired. This time, it’s about backdating stock options.
The list of companies being investigated in the stock-options saga grows longer by the day and could easily climb much higher, according to the professor whose research brought the issue to light.
More than 50 companies are being investigated by the Securities and Exchange Commission and federal prosecutors over whether they “backdated” or otherwise manipulated the dates they granted stock options to employees to make the options more lucrative, according to Reuters.
Why is this a big deal? To begin with, I’ll begin with a review of what exactly stock options are and how they are used in compensating executives.
There are two basic types of stock options: there are calls and puts. Calls give the owner of the call the right to buy a stock at a pre-determined price, also called the strike price. Therefore, the owner of a call would like the price of the stock to appreciate – if it goes above the strike price, the person can make a profit by exercising the option, buying the stock at the lower price and selling it at the higher market price. Puts give the owner the right to sell a stock at the given strike price. Owners of puts want the stock price to depreciate; therefore, they can make a profit by selling the stock at the strike price and re-buying the stock at the lower market price. Whenever you see stock options in the frame of executive compensation, they are always talking about call options – the firm and the executives will benefit if the stock price goes up, which is why corporate executives are brought on to begin with.
In the 1990s, there was a move away from paying corporate executives in cash to paying them in the form of equity – whether it be stock, or, as has become more prevalent in the last decade, in stock options. The theory behind this move is that corporate executives are supposed to maximize shareholder value (another debate in and of itself); therefore, it would be better to compensate them in a form that aligns the motives of the executive (to make a higher salary) with that of the shareholders (to make money on their investment). Most of the time, options are priced ‘out of the money’ – that is to say that on the day that stock options are granted, the market price of the stock is below the strike price. This provides further incentive for executives to do a better job, thus making the stock price rise above the strike price and making the option ‘in the money’.
This brings us to the current scandal of backdating stock options. In the recent months, it’s been uncovered that several firms have apparently granted executives stock options on days when the stock price of their firms was at a periodic low. Let’s take Broadcom, a semiconductor and communications company, as an example.
As you can see, the options in question were granted at a quarterly low. Essentially, this means that there was a much larger upside potential for the executives to make a profit once the stock price inevitably rebounded. As the term implies, backdating means that the options granted to these corporate executives were not actually given to them on that date; instead, they were granted at a later date but were booked as having been granted at the earlier date. By stating that these options were granted at a time when the stock price was lower, this also means that there is a larger difference between the strike price and the market price of the stock, lowering the intrinsic value of the options (options traded in the market are usually valued with a formula known as Black-Scholes. However, as jwb points out, incentive options such as these have no real value, as they cannot be freely traded). Because the value of these options is lower, a lower stock-based compensation expense has to be listed in the financial statements of the firm – and this is where the accounting link is. The end result is that a company’s income is higher than it should be, and corporate executives get richer by manipulating the date at which the stock options were granted.
To imagine what the effects of such a restatement might be, let us return to the Wall Street Journal’s article on Broadcom:
Broadcom yesterday said its stock option accounting problems primarily relate to a grant of 8.5 million shares awarded May 26, 2000. At the end of that day, shares were trading at $78.917, a quarterly low. Over that summer, the stock would top $180. The company said that, although the option pool was “set aside” on May 26, “allocations to individual recipients were not completed until the summer of 2000.”
The company said none of those shares has ever been exercised and that “substantially less than 1% of those options remain outstanding.” The company said that it has identified “a few additional instances” of timing issues related to grants made in 2000 to 2002. Though it said the magnitude is expected to be less, “the adjustments could be substantial.” The company said it is expected to restate for the years 2000 through 2005 and the first quarter of 2006.
The $750 million hit to Broadcom’s bottom line is a blow to a firm with 2005 revenue of $2.7 billion. From 2000 through 2005, its annual bottom line has ranged from net income of $412 million last year to a net loss of $2.7 billion in 2001. The company said the charges were noncash and wouldn’t affect its financial condition, shareholders’ equity or previously reported revenues.
Consider that the Enron’s share price collapsed in large part due to a $1.2 billion writedown due to the illegal partnerships the company was involved in. $750 million is nothing to sneeze at. Furthermore, this is not just an isolated problem. Apple has found ‘irregularities’ relating to their practices of granting stock options. Microsoft recently revealed that it gave employees the ability to be granted options at monthly lows – for a seven-year period. Even though the firm already wrote off the costs in 1999, executives continued to have the ability to be given options at monthly lows. The original CNN article states that at least 50 companies, most being tech firms, are currently being investigated – Monster, Sycamore Networks, RSA Security, and Marvell Technology Group, are a few of these companies facing SEC scrutiny over their practices of granting options.
Why do I say it’s going to get worse before it gets better? For one, there has been a domino effect when it comes to investigating this latest scandal; firm after firm has been forced to voluntarily investigate itself or to respond to SEC inquiries, and it does not look like it will be slowing down any time soon. Even bigger, though, is the news that federal prosecutors are beginning to investigate the matter themselves:
The top federal prosecutor in San Francisco has formed a task force with the FBI to investigate whether Bay Area companies and executives fraudulently backdated stock-option grants.
The move by U.S. Attorney Kevin Ryan is the first public announcement of a dedicated probe into a financial scandal that has swept up more than 60 companies, at least 25 of them in the Bay Area.
[…]
“We will investigate whether individuals and companies may have deliberately backdated stock options with the intent to defraud,” Ryan said Thursday afternoon at a news conference in San Francisco.
Here’s a list of some of the companies being investigated – and keep in mind that this is only companies in the San Francisco area.
They include Altera of San Jose, Applied Micro Circuits of Sunnyvale, Asyst Technologies of Fremont, Cnet Networks of San Francisco, Equinix of Foster City, Foundry Networks of San Jose, Intuit of Mountain View, Linear Technology of Milpitas, Maxim Integrated Products of Sunnyvale, Openwave Systems of Redwood City, Power Integrations of San Jose, Redback Networks of Sunnyvale, VeriSign of Mountain View and Zoran of Sunnyvale.
As the article mentions, backdating itself is not necessarily illegal (if not an ethical practice to begin with). However, if there is demonstrable evidence that there is a fraudulent attempt to take advantage of the system or an attempt to hide the practices, there is the possibility of securities fraud and wire fraud charges. However, one would have to be the ultimate optimist to believe that it’s merely a coincidence that options happened to be dated at cyclical lows and furthermore, the fact that dozens of firms are now revealing this information means that there was not an attempt to hide this practice.
Finally, some believe that this may not be the only thing that is uncovered by these inquiries into backdating:
“I don’t think the stock market realizes how big this problem really is,” said Randall Heron, an Indiana University associate professor of finance whose research into deceptive option awards helped focus attention on the issue. “If people were willing to push the envelope in this area of accounting, it’s possible these investigations are going to dig up other skeletons in the accounting closet.”
Accounting is a highly discretionary tool that can be easily manipulated to portray the financial results that a firm wants outsiders to see. I have no doubt that if entire firms were audited by the SEC and other regulatory agencies, some very unpleasant things would be uncovered. So grab your popcorn if you will – because we’re only scratching the surface on what is clearly being shown to be a widespread practice of backdating stock options, and it’s going to be a long time before this mess is cleaned up.
