Too Safe A Bet?
Regulators want to know whether executives improperly profited from the backdating of their stock options
You could make a fortune if you could place a bet now on last month's Kentucky Derby. Too bad you can't find a sucker dumb enough to take it. But many corporate executives have found a similar sure thing--obtaining the right to buy company stock in the future at an old, lower price.
Evidence is growing that dozens of executives have been enriching themselves by "backdating" their stock options to lock in low purchase prices from previous days or weeks. Although backdating per se is legal, the Securities and Exchange Commission and federal prosecutors are investigating companies' options practices because, in many cases, hiding or lying about backdating is illegal.
The SEC and federal prosecutors are investigating whether the giant insurer UnitedHealth Group, for example, misled investors by failing to subtract from its revenues the true annual expense of Chief Executive Officer William McGuire's options. McGuire's employment contract for many years allowed him to pick the date he wanted his options to be granted. He built up a stock option kitty that was worth as much as $1.6 billion before the scandal broke this spring. UnitedHealth has announced it may have to subtract $286 million from its profits over the past three years to make up for what it called a "significant deficiency" in its accounting.
The Internal Revenue Service is also now snooping around UnitedHealth and several other companies. The reason: Tax law allows companies to deduct any executive's pay that exceeds $1 million only if that pay is "performance based." But executives who get to backdate their grants to previous stock prices lower than the current market price profit no matter the performance. So companies with backdated option grants could face big tax bills.
"Appalling." At least two dozen companies, including Analog Devices, Juniper Networks, and Sepracor, have reported they are being scrutinized by regulators or prosecutors. "Stock options are supposed to align the interests of executives and shareholders," complains Nell Minow, cofounder of the Corporate Library, an investor rights research firm. "But shareholders don't get to pick the date of their prices. ... Why isn't it illegal? Probably because it is so appalling no one thought anyone would do it."
The disclosure of the practice comes at a time when the average CEO of a large company is already doing quite well, having received a 38 percent pay raise in 2005, collecting $8.2 million in salary, bonus, incentives, and perks, according to consultants Pearl Meyer & Partners. And that doesn't count stock options, which for the average CEO added $3.1 million to his take.
There may be more revelations to come, say the two business professors who were instrumental in bringing the practice to light. Erik Lie of the University of Iowa says that 13 percent of the reports supposed to be filed with the SEC within two days of an option grant are late. And those late filers' stocks, on average, happen to rise more than 7 percent in the 30 days following the date their option price was set. The odds that so many executives would get so lucky are infinitesimally low, concluded Lie and Randall Heron, an associate professor at Indiana University's Kelley School of Business.
The pair note that the number of questionably dated option grants has fallen by about half since the 2002 Sarbanes-Oxley Act required companies to report options quickly. Back then, Lie estimates, about 10 percent of companies were backdating options. Now, besides the late filers, a few companies appear to be taking advantage of the SEC's two-day window to choose slightly better stock prices for executives, he says.
SEC officials say they are doing their best to comb through the 250,000 option forms filed each year and have imposed many $6,500 fines on those who miss the deadline. In addition, they say the commission will probably issue rules this summer requiring companies to tell investors exactly on what days and at what prices options were issued, thus making it difficult to hide backdating.
But closing that window could still leave doors wide open. In a study released last week, the Corporate Library found a suspiciously frequent pattern of companies issuing good news shortly after their executives received option grants, thus making the grants profitable immediately. "Investors have to question how many different ways these folks can nickel-and-dime us to death in ways that are, if not illegal, unconscionable," says Ted White, who advises the Council of Institutional Investors on corporate governance issues.
This story appears in the June 19, 2006 print edition of U.S. News & World Report.
advertisement
