Options scandal? Ho-hum

Kathleen Pender

Published 4:00 am, Thursday, August 17, 2006

Are investors growing immune to the options scandal?

When the backdating brouhaha started unfolding earlier this year, most companies that ‘fessed up to an options problem saw their stock prices whacked, at least initially.

But as more companies get pulled into the fray — the number of firms under scrutiny has passed 100 and grows larger by the day — the shock seems to be wearing off.

“If enough companies are implicated, it’s seen as systematic risk, like exposure to rising oil prices,” says Todd Fermandez, a senior research analyst at Glass Lewis & Co., which researches investment risk for large investors.

In the past two weeks, PMC-Sierra, Cablevision, i2 Technologies, Alkermes and Nvidia all disclosed that they had or might have mispriced or misdated options. As of Wednesday, all of their stocks were higher than before the announcements.

It doesn’t hurt that the market overall, especially Nasdaq, is up over the past two weeks. This rising tide is lifting most boats, including those that got sunk earlier by the options scandal.

Take Apple Computer Inc. The company announced June 29 that it discovered “improprieties” in certain options grants, including one to chief executive Steve Jobs. Apple stock fell almost 3 percent, to $57.27, the next day and as low as $50.67 by mid-July.

Since then, it has recovered those losses and then some. It closed at $67.98 on Wednesday.

Some implicated companies have announced good news that has overshadowed their options problems, at least for the time being.

Decline could resume

“I suspect these stocks that are tainted will resume their decline when the stock market rolls over,” says Fred Hickey, editor of the High-Tech Strategist newsletter.

It’s odd that investors are shrugging off options risk at a time when government investigations into backdating are just getting under way.

Most of the investigations revolve around whether companies used the right grant dates when they awarded options to senior executives and, in some cases, lower-level employees.

An option bestows the right to buy stock at a fixed price, called the exercise or strike price, at any time during a certain number of years, usually 10.

Expensing options

Under the old accounting rules, companies did not have to deduct options as a compensation expense on their income statement as long as they set the strike price equal to or greater than the market price on the grant date. In such cases, the option had no value unless the stock price rose.

If the company set the strike price lower than the market price on the grant date, it created a discounted option, which had to be expensed on the income statement.

It now appears that some companies — to lure employees or enrich their top executives — might have awarded options that were priced not at that day’s market price, but on an earlier date, when the price was lower.

To avoid recording these discounted options as an expense — which would have reduced their earnings — some companies might have doctored grant dates.

New accounting rules require all options to be expensed. But the options in question were awarded long before the rules changed.

Some companies have attributed mispriced options to unintentional errors.

‘No manipulation’

This week, Redback Networks announced that a board committee, assisted by outside lawyers, found that certain option grants had been misdated “as a result of administrative or processing delays.” It said the investigation “did not find any evidence of intentional backdating of stock-option grants or manipulation of stock-option grant dates.”

Redback concluded the investigation by taking a $300,000 charge. It said it couldn’t be sure the Justice Department or the Securities and Exchange Commission would conclude their investigations into the matter as well.

Redback stock is up 25 percent this week.

To date, only a few companies and individuals have been charged in the backdating scandal. But these cases should be giving investors pause.

Last week, the SEC charged that three former senior executives of Comverse Technology engaged in a “decade-long fraudulent scheme to grant undisclosed, in-the-money options to themselves and to others by backdating stock-option grants to coincide with historically low closing prices of Comverse common stock.”

It said Comverse’s former Chairman and Chief Executive Officer Jacob Alexander and David Kreinberg, its former chief financial officer, created a “slush fund of backdated options” that were issued to fictitious employees and later used to recruit and retain key personnel.

Criminal charges

Alexander, Kreinberg and William Sorin, Comverse’s former general counsel, are also facing criminal fraud charges. Alexander’s whereabouts are unknown and he has been branded a fugitive.

Comverse stock is down almost 38 percent since it was implicated in mid-March, although it has been rising in recent days.

A recent study by Forbes.com found that shareholders have suffered the most at companies that have ousted executives because of the backdating scandal. These include Comverse, Brooks Automation, Mercury Interactive, Mc-Afee, Newpark Resources, Power Integrations and Vitesse Semiconductor.

Excluding Mercury, which has received a generous takeover offer from Hewlett-Packard, this group’s shares fell more than 22 percent on average between their respective announcement dates and Monday, Forbes.com says.

Looking at a group of 73 companies that have announced financial restatements or government investigations related to options practices, Forbes.com found that their share prices fell only 8.7 percent on average.

Stocks trade off future earnings and many investors are probably thinking that because most of the option grants in question happened years ago, they won’t impact the stock price, even if companies are forced to restate past earnings.

IRS penalties

But Dane Mott, an accounting and tax analyst with Bear Stearns, says, “The financial statement impact is not the only impact. Companies typically get tax benefits for many options. If some of those tax benefits are negated or reduced, that could result in fines and interest penalties from the IRS.”

There is also a risk that investigations might distract executives from day-to-day business, especially if they think they personally might be implicated. The company also might have to spend resources to defend itself and its executives against government and shareholder suits.

Another risk is that key executives could be forced to leave, which could hurt the company and its stock price, says Pat McGurn, special counsel with Institutional Shareholder Services.

Steve Sidener, an attorney who represents shareholders (though none in backdating suits so far) says that stocks trade mainly off revenue and that backdating has no impact on revenue, past or future. But, he says, it would be a mistake to conclude that backdating doesn’t matter.

“It goes to honesty and or trustworthiness. If you are backdating options, you also might be cutting corners and cooking books in other areas,” he says.