Stock options backdating is the financial scandal of the year.
The controversial practice of timing the date of option grants for instant gains has led to sharp stock downturns, regulatory investigations, and, in some cases, arrests.
The issue has been felt in Orange County, where several of the county’s bigger corporate names have found themselves doing their own options probes to ferret out any improper grants.
Broadcom Corp., Western Digital Corp. and Quest Software Inc. are among the companies caught up in options.
Whether the scandal gets worse from here is unclear. Some see the issue winding down with arrests in the most severe cases.
Regulators could let other cases go if it appears companies are addressing the issue themselves with restatements and other moves.
The issue isn’t likely to spur new regulation since accounting rules already have changed for how options are reported.
Some see the issue as a matter of cleaning up past problems.
“I think most of the cleanup has taken place,” said Justin Cable, director of research at brokerage B. Riley & Co. in Los Angeles. “Under Sarbanes-Oxley, companies’ options practices are much cleaner than they were maybe six years ago.”
Most of the backdating investigations are looking at option grants between the late 1990s and into 2002.
Four years ago, Sarbanes-Oxley ushered in rules that forced companies to reveal any options backdating. The act also requires that option expenses be reported quarterly.
Backdating to a low point for trading in a stock instantly gives grantees a paper profit. It also nixes the motivating force behind options: encouraging holders to work toward boosting the stock price.
Backdating also can violate tax and disclosure rules.
Companies have been doing their own investigations into how much backdating went on in past years. A hundred or more companies have announced internal probes.
These investigations aren’t simple, often drawing on outside lawyers and accountants to help tackle the arcane details of when and how many stock options were granted and where the stock was trading at the time.
In light of all this, directors are taking more time and caution with options.
“The bottom line is people are going to look at it more carefully,” said John Stigi, a securities litigation lawyer with Sheppard Mullin Richter & Hampton LLP in Los Angeles.
Irvine chipmaker Broadcom, OC’s largest technology company, was one of the early companies to get dinged by options backdating back in May after analysts fingered the company for potential issues.
It soon launched an internal probe. The Securities and Exchange Commission also asked the company for documents relating to the matter.
By August, Broadcom said it had found $750 million in expenses that would need to be restated because of options.
In September, the company said the amount had doubled.
That same month, longtime Chief Financial Officer Bill Ruehle stepped down immediately.
Ruehle “decided to accelerate his retirement as a result of Broadcom’s previously announced equity award review,” the company said.
The company released only limited results for the second quarter, sparking a delisting threat by Nasdaq.
Aliso Viejo-based Quest Software Inc., which makes software that helps big programs run more smoothly, also was caught in the backdating option scandal.
In June, Quest said it planned to restate results from 2000 through the first quarter of this year as part of its ongoing look at stock option grants. Quest also received an informal SEC inquiry about past stock option grants.
A special committee looking into Quest’s options found that stock compensation expenses should have been recorded for option grants and recognized over the vesting period of the options.
The additional expense “will be significant,” Quest has said.
Quest reported disappointing revenue for the second quarter and withheld its earnings as it investigates its stock option grant accounting.
In its quarterly announcement, Quest said it did not expect to be in a position to announce more financial results until the committee has finished the investigation and finalized accounting adjustments and restated financial statements.
One of the biggest questions for companies is what the SEC and the Department of Justice are going to do, lawyers say.
Their actions could put the more maverick executives on notice, Sheppard Mullin’s Stigi said.
“A lot of them, they’re young,” Stigi said. “They like the challenge of the technology. The thing that put the fear into them is that of going to jail or the SEC.”
Already, the SEC has charged two officials with San Jose-based Brocade Communica-tions Systems Inc., a networking gear maker that competes with Aliso Viejo’s QLogic Corp.
The most extreme, even bizarre case involves former Comverse Technology Inc. chief Jacob “Kobi”‘ Alexander, who recently was arrested in Namibia.
Alexander is wanted in the U.S. on charges related to options backdating, including conspiracy, securities fraud, making false filings to U.S. regulators and money laundering while running the New York-based networking products company.
Howard Privette, a securities litigation lawyer with Paul, Hastings, Janofsky & Walker LLP in Los Angeles, said some companies that have launched internal probes are working more closely with SEC regulators than they might have a decade ago before the Enron Corp. scandal.
“Companies tend to cooperate,”
Privette said.
Lawyers would like to get more direction from the SEC on what constitutes backdating and what might be, at worst, “sloppiness,” Privette said.
An example of “sloppiness” might be a stock option grant package that’s agreed to by a couple of key executives before being sent to three board members for approval. A couple of board members might be prompt in approving the option grants. A third might take a couple of weeks.
If the stock had gone up in the meantime, that could look like the option grant was timed improperly.
The SEC and the Justice Department have made it “very clear that they are devoting resources to the worst of the worst,” Stigi said.
That could include “falsifying of records, lying to authorities, instances that look like a case of corporate looting,” he said.
Shareholder lawsuits are creeping up.
“It’s almost a knee-jerk reaction,” Privette said. “Whenever a company is subject to one of these investigations or disclosures … you see these derivative cases being filed.”
In June, Broadcom said it faces a shareholder lawsuit that alleges misconduct in the granting of options. Another lawsuit against the company was amended to include the options issue.
Broadcom called both without merit.
The full brunt of cases could be yet to come. The SEC’s conclusions could have a big impact on how many lawyers file, Privette said.
“There’s definitely a wave,it’s just whether it’s a foot or two or a tsunami,” he said.
All this is making it harder for investors to regain confidence in some stocks, Cable said.
“It does go back to the credibility of the management team,” he said.
The issue also can distract executives from focusing on issues like growing revenue and earnings, he said.
Some stocks have been hurt more than others, especially companies that were fingered for potential backdating earlier in the scandal, including Quest and Broadcom.
Western Digital’s stock has been more resilient.
Besides restatement expenses, the cost for a company can come with management changes and lawyers’ fees for investigating the issue.
Restatement expenses can be big. But much of these costs were well in the past and only were paper charges, not costing the company any cash from their coffers.
In other words, the current balance sheet stays intact.
The issue probably will take one to three years until investors largely put it to rest, Cable said.
For now, investors will continue to fold the issue into their buying decisions, he said.
“It will be an ongoing overhang,” Cable said.
How companies compensate their executives could get closer scrutiny.
With new rules requiring stock option expensing this year, companies already were starting to shift their compensation from stock options to more grants.
“What you may well see is that there are going to be more discussions of that by boards,” Stigi said.
The issue: Stock options boomed in the 1990s as a way to line up the interests of shareholders with executives. But with backdating that whole idea is defeated.
Phil Bromiley, professor of strategic management at the Paul Merage School of Business at the University of California, Irvine, questions whether stock options really show how well executives are running their companies.
“During a rising market, mediocre managers will gain enormously for mediocre performance,” he said. “The financial results are not as clear as people would like to imagine.”
Executives may get stock options without a decline in their salary and bonuses, the traditional way of paying people to work.
That means there’s no real loss of income even if the grants don’t yield any gains.
Stock grants are an improvement, but not a panacea, according to Bromiley.
Bonuses are a much cleaner way to compensate people for a job well done, he said.
Still, many defend options and grants as a way to make sure executives care as much about stock price as shareholders do.
“Obviously, it aligns the management team with shareholders,” Cable said.
Young technology companies short on cash always have used options to make up for salaries and bonuses, Stigi said.
That was the case for Broadcom during its formative years.
