Backdating Options

Joe Pizarek – 1st speaker

Kevin Quinn – 2nd speaker

First Things First

Option - an agreement where the buyer has the right to exercise by buying or selling an asset at a set price (strike price) on or before a future date

Since the contract's value is determined by an underlying asset and other variables, it is known as a Derivative.

ESO – employee stock option (a performance based compensation)

More definitions

At the Money- when the strike price equals the security's current price

In the Money- when the strike price is below the security's current price

Out of the Money - when the strike price is above the security's current price

Options at-the-money or out-of-the-money have an intrinsic value of zero

Options Graph

0

5

10

15

20

25

30

35

40

45

1stQtr

2ndQtr

3rdQtr

4thQtr

Stock

Strike Price = $25

Blue – Out of the Money

Red – At the Money

Green – In the Money

What is Backdating options?

Backdating is the practice of marking a document with a date that precedes the actual date. 

The Effects

http://www.biz.uiowa.edu/faculty/elie/backdating.htm

Continued

End of the year price = $85 Exercise price of backdated option = $30 Amount of shares issued to executive = 100,000 Intrinsic Value = (current price – exercise

price)*amount of shares Intrinsic Value = ($85-$30)*100,000 = $5,500,000

Who Suffers?

The shareholders This defrauds the firm's shareholders

because the company receives less money for the shares than it should.

Diluted Shareholder Interest

Broadcom Corp. (BRCM) is the biggest example of suspicious option grants to employees.

Company says they granted options at a quarterly low in May 2000, but did not complete the process until later in the summer.

Diluted Shareholder Interest

Options issued as a percentage of total shares was at one point as high as 20% for Broadcom. Since 2002 it has gone down to 4-6%.

Possible restatement of $750 million

Spring Loading and Bullet Dodging

The practices of timing option grants to take place before expected good news or after expected bad news.

Continuedhttp://money.cnn.com/2006/05/26/magazines/fortune/colvin_fortune_0612/http://www.dailyreckoning.com/rpt/BackdatingOptions.html

Erik Lie first discovered this trend His research discovered that unless executives

had amazing talents to forecast precise overall movements in the market, they had to be backdating the grants.

Example Question

What is the intrinsic value of a backdated stock option at the end of quarter 4, with the exercise price at the trough (lowest stock price)?

Number of shares equals 50,000

0

10

20

30

40

50

60

1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

Stock

Example Question

A $2,500,000 B $1,000,000 C $1,500,000 D $0 Correct Answer: C (50-20)*50,000

Legalityhttp://www.biz.uiowa.edu/faculty/elie/backdating.htm

Yes…But need to follow strict regulations: Publicly announced to shareholders Properly stated in earnings Correctly taxed

Rarely are these conditions satisfied.

Time Frame of Scandal

Backdating practices have been around since the late 1990’s or even earlier

Backdating made harder in 2002 because of the Sarbanes-Oxley Act. Companies now have 2 days after granting

options to report to the SEC. Large scale investigation began summer of

2006 after Erik Lie’s research.

What actions are being taken

Justice Department along with Securities and Exchange Commission are investing companies.

Slow process due to hidden nature of claims. Some companies use second lowest price date to throw off

investigators.

Over 130 companies being investigated, many upper management on trial too.

Partial list of (120+) companieshttp://www.usatoday.com/money/companies/regulation/2007-03-08-backdate-list_N.htmhttp://online.wsj.com/public/resources/documents/info-optionsscore06-full.html

Able Energy Actel Activision Apple Computers Bed Bath & Beyond CNET Networks Dean Foods Home Depot McAffe Monster Worldwide Pixar Take-Two Interactive Software UnitedHealth Group

UnitedHealth Grouphttp://money.cnn.com/magazines/business2/business2_archive/2007/02/01/8398990/index.htm?section=money_latest

One of the Largest Backdating cases CEO William McGuire had over $1 billion dollars

of unexercised stock options at the end of 2005. McGuire resigned, giving up about $200 million in

proceeds. Had to correct accounting dating back to

1995 Lowered earnings by $1.55 billion dollars Paid $100 million in additional taxes

Take-Two Interactive

Publisher of video game Grand Theft Auto Former CEO Ryan Brandt pleaded guilty to

falsifying business records. Had to pay SEC civil charges of $7.3 million

dollars. Never officially admitted or denied wrongdoing

McAffehttp://www.usatoday.com/printedition/money/20070228/options28.art.htm

Kent Roberts (former controller) was indicated by grand jury on charges of fraudulent dating of stock-options. If convicted could face 20+yrs in jail,

along with millions of dollars of fines. Company could also face $150 million in

charges.

Class-action Vs Derivative lawsuits

Class-action Settlement goes directly to shareholders Has 5 year statute of limitations

Backdating has been dated back to the late 1990’s. May not be appropriate for older cases.

Derivative lawsuits Settlement goes towards the company

Should indirectly help the shareholders

Overall Effecthttp://www.issproxy.com/pdf/OptionTiming.pdfhttp://online.wsj.com/public/resources/documents/info-optionsscore06-exec.html

By number of firms under investigation, backdating is the largest scandal in over 20 years.

Pension funds and large stakeholders are leading the charge filing class-action and derivative lawsuits.

57 corporate officials have step downed, retired, resigned, or have been fired due to scandal.