(cross-posted at Deny My Freedom and Daily Kos)
A while ago, I wrote an entry on the first charges filed on the latest corporate scandal – the backdating and manipulation of stock options. For a refresher of exactly what stock options are and how they work, you can view my previous entry, which gives a broad overview of the problem, what stock options are, and why the method in which they were granted was troublesome. A quick and dirty explanation, for those who do not feel like reading those entries (they are long, I will admit) is that stock options are being increasingly used as a form of compensation for executives and employees. They give them the right to purchase stock in the company for which they work at a set price. In order for these to be worth anything, the market price of the stock must go above that set price – known as the exercise (or strike) price – at which point the option can be exercised, the employee or executive buys the stock at the lower price, sells it at the market price (which is higher), and keeps the difference as profit.
The bigger issue here, though, is that executives have been ‘backdating’ these options. Most of the time, these stock options are supposed to have an exercise price on the date at which they are set (or some other fair method of valuing them, such as an average of the stock’s closing price in the past month). The main problem has been that there has been an unusual coincidence of options having a strike price set at periodic lows for a company’s stock. This in and of itself is not illegal – as long as the company discloses it. However, with over 100 companies either being investigated by the SEC or voluntarily disclosing their own internal probes, it’s clear that there has been some fishy business going on. Initially thought to be restricted mainly to tech companies – who tend to issue many stock options in lieu of cash compensation when they start up, due to the lack of free cash flow – it has spread to companies outside of the industry, such as The Cheesecake Factory and Barnes and Noble.
In my last entry on this matter, I chronicled how former executives at Brocade Communications had been charged in criminal and civil cases. Today, we hear news that two who had been charged in the criminal case by the US Attorney in San Francisco have been indicted by a grand jury:
A federal grand jury indicted two former executives of San Jose-based Brocade Communications on Thursday on 12 counts relating to a scheme in which they allegedly backdated stock options without the proper regulatory disclosures.
Brocade’s former chairman and chief executive, Gregory Reyes, as well as its former vice president of human resources, Stephanie Jensen, were each charged with eight counts of conspiracy to commit securities fraud, securities fraud, mail fraud, making false statements in filings with the U.S. Securities and Exchange Commission and falsifying books and records.
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The charges are the result of an 18-month investigation, representing one of the first cases involving illegal backdating of stock option grants. In this scheme, employees were given stock option grants at lower prices than what the market value was. It’s not an illegal practice, but it is illegal to hide it from investors, who aren’t able to gauge the true expense of such grants.
If this is the culmination of an 18-month investigation, imagine how long this issue is going to be in the spotlight. This isn’t an issue that is going away anytime soon. The fact is, this could have immediate impacts on companies, particularly with getting their financial statements (filed quarterly) submitted on time. Apple, the most notable company to review its practice of granting stock options, has received an unusual notification for delisting over the issue:
Apple’s troubles regarding the issuance of stock option grants and the surrounding fallout came to a head Friday. In a statement issued by the company after the close of the market, Apple disclosed it had requested a hearing with a NASDAQ committee following the receipt of a letter threatening the company with delisting its shares.
“The Company anticipates that there will be significant changes in the results of operations for the quarter ended July 1, 2006 compared to the quarter ended June 25, 2005, including significant increases in the Company’s revenue and expenses,” Apple said in the filing.
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While the process of delisting notification by the NASDAQ is not all that rare, it is rather uncommon for large corporations like Apple to be the target of such letters. The process allows for the company to request a hearing on the matter, and in the meantime Apple’s stock would remain on the market.
At least one tech company, Mercury Interactive, was delisted over a similar spat with the NASDAQ.
It’s unlikely Apple would be delisted from the Nasdaq, considering the repercussions that such a move would have on the overall stock market. However, delaying the submission of financial statements often makes investors and analysts antsy. They would prefer to have the most recent information on a company available when making a decision. Furthermore, a delay in submitting 10-Qs (the quarterly filings) and 10-Ks (the annual filings) almost always signal trouble. Without knowing the true state of a company’s financial health, investors will have to make more bets instead of being able to accurately project, based on the data, where a company may be headed.
In addition, a second company has now had former executives charged for the manipulation of stock options:
NEW YORK — Three former top executives at Comverse Technology Inc., a leading maker of voice-mail software, hatched a scheme to pocket millions of dollars by secretly manipulating stock options, authorities said Wednesday.
A criminal complaint unsealed in federal court in Brooklyn alleges that former CEO Kobi Alexander, former finance chief David Kreinberg and former senior general counsel William Sorin conspired to falsify dates on which the options were granted.
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From 1991 through 2005, Alexander exercised options and sold stocks worth approximately $150 million, making $138 million profit, according to the criminal complaint. Of that, about $6.4 million was generated by backdating options.
In addition, Alexander and Kreinberg put hundreds of thousands of backdated options in a secret slush fund, the complaint said. Alexander awarded those options to “favored employees,” the papers added.
Advocates of a laissez-faire economy would be in a veritably difficult position if they tried to justify letting corporations roam free without regulation. The question of whether any executives deserves $138 million in profits is questionable, but it’s clear that the $6.4 million was, in effect, stealing from the shareholders. The secret fund for favored employees is another blatant abuse – employees that make more money should do so on the merits of their work, not because they are better-liked, regardless of the reason. What the backdating of stock options really comes down to is conspiracy: it’s a concerted effort by certain executives to hide from investors money that is being questionably pocketed. A lot of companies are going to get nailed on this – and that’s not even counting the companies that haven’t been rooted out yet.
This isn’t just a problem that is contained within individual companies. According to a Wall Street Journal article today, there are conflicts between multiple companies when it comes to granting stock options. What’s even more worrisome is that there are political ramifications involved in this growing scandal. The opening paragraphs speak for themselves:
The board of UnitedHealth Group Inc. met on May 1 to deal with questions about unusually well-timed stock-option grants to top executives such as Chief Executive William McGuire. The gathering heard a briefing from a lawyer who was running UnitedHealth’s internal probe of how the options were dated.
One director whose recollections would be important to the investigation was Thomas H. Kean, a former New Jersey governor who had served on the compensation committee that approved options grants.
The same day as the board meeting, some UnitedHealth directors and executives were supporting a campaign by Mr. Kean’s son for a U.S. Senate seat from New Jersey. Some of them attended a fund-raiser for Tom Kean Jr. that day, in UnitedHealth’s home state of Minnesota. It isn’t clear whether Dr. McGuire and his wife attended, but each donated $2,000 to the cause. So did Richard T. Burke, who sits on a special board committee that is overseeing the options investigation. All told, UnitedHealth-affiliated donors have contributed $25,000 to the campaign.
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When the donations to the Kean Senate campaign were described to former SEC Chairman Harvey Pitt, he said they struck him as “ill-advised and strange” and something that could be seen as an attempt to influence a witness because of the senior Mr. Kean’s role on the compensation committee. A spokeswoman for the Kean campaign said the fund raising came at a “UnitedHealth breakfast” hosted by Minnesota Republican Sen. Norm Coleman, and there was absolutely no effort to curry favor with the elder Mr. Kean. The former New Jersey governor didn’t return calls seeking comment.
I’m sure that Senator Bob Menendez will probably be able to make some political hay out of this, but to me, it’s not a partisan issue. Given how much money flows into the political system, if there are serious conflicts of interest that warrant even further investigation, political scandals could possibly erupt as a result. I have no idea if there are any other sort of glaring conflicts of interest such as this instance, but it’s worth checking into. If politicians are profiting off of an illegal practice, they should be held equally accountable. Strict liability may be a bit of a harsh test to apply in this case, but even though politicians have plenty on their plates, they damn well (should) know who is funding them.
Don’t expect corporations who are ‘voluntarily’ investigating themselves to be the best arbiters, either. From the same WSJ article, we get to examine the business version of a thoroughly impartial investigation:
At Affiliated Computer Services Inc., a technology outsourcer in Dallas, the board is probing a pattern of unusually well-timed options grants to former Chief Executive Jeffrey Rich and others. The grants allowed Mr. Rich to earn millions of dollars in profits. His grants often were dated just ahead of steep rises in the company’s stock. A March analysis by The Wall Street Journal found that the likelihood of such propitious grant dates occurring by chance was approximately one in 300 billion. The grants are under scrutiny by federal authorities as well.
Whereas many companies mounting an internal probe ask a small committee of independent directors to oversee it, ACS has put its entire seven-member board in charge of the process, assisted by outside legal counsel. So the oversight group includes board Chairman Darwin Deason. Mr. Deason both received some of the options in question and had a role in their timing, the company has said. ACS says its four member audit committee also is monitoring the situation.
Of the six other directors overseeing the probe, two received some of the well-timed options in question. Two others, who are outside, independent directors, were on the compensation committee that approved grants. The remaining two directors, also independent, are men with whom Mr. Deason has had various past ties.
Who knows what other possible revelations may bring – it probably won’t be pretty, as corporate scandals in the recent past have revealed scurrilous practices. Only two companies have had past executives charged, but there are still plenty of companies being scrutinized closely, and there could be even more on the way. These are the kinds of things that shake the confidence of investors and the average American in the corporations that dominate our economy (and, some would say, our politics). The argument against regulation is weak in the face of the backdating scandal, which once again shows corporate executives more interested in making as much money as possible instead of selling the best product or service that they can.
Stay tuned…because this latest black eye on the face of corporate America isn’t going away in the near future.