A trio of Irvine companies are caught up in a widening controversy over questionable tactics to wring extra dollars from stock options.
Chipmaker Broadcom Corp., business software maker Quest Software Inc. and telescope maker Meade Instruments Corp. have come up in recent reports looking at the timing of options grants.
The three companies said they’ve started internal reviews of their options grants.
Meanwhile, Minnesota’s UnitedHealth Group Inc., which bought Cypress-based PacifiCare Health Systems Inc. in December, is facing shareholder lawsuits and may restate earnings because of the timing of options grants.
Broadcom, Quest and Meade haven’t been charged with wrongdoing and aren’t known to be under investigation by regulators.
But options story headlines last week have stirred concerns and hit stock prices. Broadcom’s shares fell about 11% last week, in part over concerns about the options issue.
The controversy comes down to timing.
The Securities and Exchange Commission, the Justice Department and other regulators are looking at least a dozen companies to see whether they backdated options for executives to make them more lucrative.
Regulators are looking at whether companies picked low points for their stocks as the dates for granting options.
Backdating instantly gives executives a paper profit on the options. 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.
More companies could come under scrutiny in the coming months as more experts pore over the timing of options grants.
“It’s likely to expand and get even broader,” said John Rizzuto, an analyst with Lazard Capital Markets LLC in New York. “We don’t think we’re through it yet.”
Erik Lie, a professor at the University of Iowa, was the first to release what’s been called the watershed study on backdating options last year. The number of companies involved could grow, he said, because trends show many companies seem to pick favorable dates for options grants.
“I think it’s really widespread,” he said.
Backdating can be hard to prove, according to Lie.
Companies that granted options on a lucrative date might just have gotten lucky. Companies also might have picked a date with a low price, but not necessarily the lowest. They may not even get close to the lowest price at other times.
“I think most companies will escape scrutiny,” Lie said. “Only the companies that did this in a very blatant manner will eventually be caught.”
The Center for Financial Research and Analysis in Rockville, Md., was one of the first to look at Broadcom’s grants.
The chipmaker stands by its options grants, spokesman Bill Blanning said.
“We remain confident of the integrity of our options granting process,” he said. “Obviously, with the CFRA report and all the media attention this issue is getting, we are conducting our own internal analysis. We have not been contacted by any external agencies.”
A report by Merrill Lynch & Co. analyst Joe Osha looked at grant timing among chip companies that make up the Philadelphia Semiconductor Index.
Report: Broadcom a ‘Standout’
Its finding: The “standout” companies where executives had the most “excess returns” over investors included Broadcom.
Osha stressed his report wasn’t designed to conclude whether the companies actually backdated options.
The analysts said his review led him to believe that “it is difficult to avoid concluding that the timing of options pricing for the period we studied has been very advantageous for executives that received options.”
From 1997 to 2002, Osha’s study showed a wide gap between what an investor would have made in a given year compared to what the insiders made with options that could be cashed in 20 days after their grant date.
Broadcom was No. 6 on the study’s list of “excess option pricing returns.” The top 7 showed the most excess with a big drop-off after that on the list of 20, according to the report.
In 1998, the first year of trading for Broadcom, investors fared better than the executives with a 125% return. Senior executives pulled in a 68% return on an annualized basis.
In 2000, Broadcom senior executives began to beat investors. They posted returns of 748% on an annualized basis versus a 38% loss for investors.
In 2001, senior executives posted returns of 255% on an annualized basis while investors lost 51%. In 2002, executives got 64% in annualized returns while investors lost 63%.
The average return gap between Broadcom investors and executives was 312%.
Quest Software on May 19 saw an analyst downgrade its shares to “in-line” from “outperform,” given the overhang of the options issue, according to Goldman Sachs Group Inc.’s Sarah Friar.
Friar said her look at Quest found “somewhat well-timed option grants.”
A third of Quest’s grants from 1998 to 2002 are at lows for 40-day periods, she said.
“The company believes that in all cases the board either met on that day (as is the case for all but one of the grants) or there was a written consent for a short delay while final touches were put to a companywide grant,” Friar wrote.
Quest, which has formed a committee of independent directors to look at options grants, scores well on corporate governance issues, according to Friar.
The company’s shares lost more than 12% in the days following reports about options grants.
Quest declined to comment on the issue.
The challenge for Quest and others is in keeping focused on business and not getting distracted by the options issue, Lazard Capital’s Rizzuto said.
“One fact of the matter is the market is going to consider you guilty until proven innocent,” he said.
Meade Instruments’ stock has taken a beating as well.
The shares began to fall May 19, the Friday before the Wall Street Journal fingered the company and four others in a front page story on May 22. The stock fell about 10% in a matter of four days.
Meade is a small company with a market value of about $50 million and annual revenue of $120 million. It also had recently delayed its report for the quarter ended Feb. 28 and named a new chief executive, Steve Muellner.
Meade founder John Diebel, who was chief executive until 2003, cashed in on six option grants from 1998 to 2002. He got two grants at 52-week lows.
The odds of getting grants as favorable by simply choosing dates randomly is about 1 in 800,000 for Meade, according to the Wall Street Journal.
Meade’s Response
Meade couldn’t be reached for comment. Diebel told the Wall Street Journal he would be “shocked if there was any inappropriate activity with regard to Meade’s granting of stock options.”
Meade’s legal counsel, Mark Peterson, said the options grants complied with SEC rules and regulations.
Eric Holmes, manager of the Fifth Third Microcap Value Fund in Cleveland, said he cut his holdings in Meade Instruments by about 50,000 shares to nearly 400,000 shares recently, partly because of concerns about potential backdating. Holmes said he is keeping an eye on the issue, but believes Meade has some great products that make it a solid company.
“Any suggestion of accounting issues makes us nervous,” Holmes said. “At this point, there really isn’t enough information to know whether this is a problem or not.”
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