Integrity Matters
July 12, 2006

Options dating opens the door to abuse

Question: (E-248)

Dear Jim:

U.S. investigators are examining more than 50 companies' option-granting practices, including back-dating and spring-loading options. Even though this is not illegal - yet - it seems to lack integrity.

Response:

Cheating investors confirms, again, a breakdown in the social contract that needs to exist between and among all stakeholders: customers, owners, investors, employees and government agencies. Manipulating options seems to be widespread. If it is not yet at the Enron and WorldCom level, soon we will learn how pervasive this option-cancer has spread. Backdating involves changing the grant date of a stock option from the day it was actually granted to an earlier date when the stock was trading at a lower price. Not fraudulent on its own, backdating may be considered fraud if the company granting the options does not properly disclose that it backdated the options.

Spring-loading is different from back-dating in that it is not retroactive. Rather, a company will set an option grant date and exercise price on a day shortly before the company intends to release news expected to boost the stock price.

The stock options are immediately worth more because the exercise price is lower than the current share price. Spring-loading can involve insider trading violations, or trading on non-public material information to realize an unfair gain. Backdating can also lead to accounting fraud if a company does not properly record the difference as a compensation expense. Experts describe backdating as essentially giving the option holder free money because the options are immediately worth more.

Investors' faith in corporate accounting again is under siege. Over the past few months, 50 companies, and counting - most of them technology firms - have disclosed that they were under investigation by federal authorities for possibly manipulating executives' stock option grants to boost the potential payoffs. Even so, stocks of many tech firms have taken steep hits in recent months as the probes have been reported. With memories of 2002 still fresh, some investors appear to be selling first and asking questions later.

When businesses fail in their values, they decay from the inside. In the late 1990s, values came to be viewed as expensive and conservative relics of the old economy. Many of today's option-probes involve those granted before the 2002 Sarbanes-Oxley corporate reform law. Prior to that, companies had 40 days after the grant date to file a Form 4 with the U.S. Securities and Exchange Commission reporting a stock option grant, giving a company a 40-day window to pick a grant date. Sarbanes-Oxley cut that reporting deadline to 48 hours.

Fattening the "pay packages" of a special few erodes public trust and investor confidence. Corporate leaders, "wake up" and exercise appropriate compensation integrity.

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