The Dating Game

Scores of companies have admitted to playing games with the timing and pricing of their incentive stock options, thus rewarding their top brass, as well as ordinary employees, for stock market "arrows" that were already fired, rather than strictly for how their stocks performed in the future.

This is more than just an obscure accounting matter. The former CEOs at Brocade Communications and Comverse Technology have been indicted for federal securities fraud in what's expected to be just the opening shot of a wide-ranging civil and criminal prosecution. Jacob Alexander, the ex-Comverse CEO, did not appear for his arraignment and is believed to have fled the country, having already wired $57 million to an overseas account.

For shareholders, the story is distressingly familiar — and costly. Investors are discovering that they shelled out much more in executive compensation than they were led to believe, and now have seen past earnings "restated" — meaning erased. At Brocade alone the hit is over $1 billion. Also, stocks of many of the affected companies have nose-dived.

The scandal underlines the central abuse of the options era — how executives such as those at Brocade could garner hundreds of millions in stock market profits while investors, over the long term, reaped virtually nothing. Already some 80 firms, including marquee names such as Juniper Networks, Apple Computer and Home Depot, have admitted to irregularities in their options disclosures. The total number of offenders is probably much larger. According to one estimate, almost 30% of the companies that doled out options at the height of the tech boom — a time when it was plenty easy to make piles of money legally — misled the public about how and when those options were priced.

Rather than rewarding executives solely on the basis of future performance, the grants were secretly rigged so that even before the ink on them was dry, the execs were sitting on millions in paper gains. This is "moral larceny," accounting expert Jack Ciesielski observes. It's also a total corruption of what options were supposed to be about.

Until the 1980s, stock options were an incidental perk, dispensed in small doses and only to the brass. But as stock prices in the '70s sagged, boards of directors searched for a way to get their executives focused on share prices. Voila — they said — give the managers stock!

Backed by supportive research from academics and, naturally, from paid consultants, directors argued that executives with skin in the game would care more about their share prices. And on balance, they did. Companies such as Intel grew up with an entrepreneurial culture largely because employees as well as executives received options.

However, like other useful Wall Street innovations (junk bonds come to mind), options were soon taken to excess. Grants were so big, and doled out so frequently, that even subpar executives made out like bandits. Worse, the potential lucre that options represented turned many managers into short-term market junkies and tempted a few to cook the books.

The problem wasn't with options per se, but with how they were used. It's as if some well-meaning schoolteacher bought a shipment of Hershey bars to reward her top students but foolishly passed out the goodies before her exams. The backdating scandal is just the latest example of boards' caving in to their executives' sweet tooth.

Options are simply the right to purchase a security at a certain price, known as the "strike" price, within a fixed period of time. For the executive, the lower the strike price, the better — and that is what backdating is all about. Stock options are typically structured so that executives can purchase stock at the price prevailing on the day of the grant. The executive thus gets a much better deal than the ordinary shareholder, because he can wait for as long as the option lasts — usually 10 years — and decide whether to take the plunge only after he sees what has happened to the stock. That's a pretty sweet perk.

But in another sense, the executive and the public shareholder are on equal footing. From the day the option is granted, neither will make any money unless the stock goes up. Or so it was assumed until recently. But in a 1997 study, David Yermack of New York University documented a disconcerting fact. In a disproportionate number of cases, right after options were granted, the stock did go up! Such lucky fellows, those executives. One explanation was that the executives knew so much about what their companies were up to that they could predict when their stocks would rise.

Say, for instance, they were about to report crackerjack earnings — just distribute options a day or two ahead of time. That's a form of cheating, because options are supposed to reward execs for future performance — not for performance that has already occurred.