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.

It's implausible to think that executives could predict the movement of the entire stock market. Only one explanation remained. The options hadn't really been awarded on the stated grant dates. Boards had awarded them later and backdated them to periods when prices were lower. Not coincidentally, the practice mostly ceased after 2002, with the passage of the Sarbanes-Oxley Act. That Enron-era reform has been much maligned, but in this case, it has worked like a charm.

Prior to 2002, companies waited an average of six months to report their options grants. But prompted by the revelation that Ken Lay had been selling Enron stock even as he urged his employees to invest, Congress required corporations to disclose all insider transactions, including options grants, within two business days. Backdating didn't entirely disappear, because a few companies failed to comply with the new rules. But the practice, which was rampant before Sarbanes-Oxley, has been sharply curtailed. According to an estimate by Lie, backdating was involved in a mind-boggling 23% of all executive options granted prior to the legislation.

Lie told SmartMoney that he sent his results to the Securities and Exchange Commission in the summer of 2004 — they were published last year in Management Science, an academic journal — but doesn't know whether the SEC acted on his tip. However, in late 2005, Mercury Interactive, a Mountain View, Calif., software concern, disclosed that the SEC was investigating its options grants. Subsequently, an internal corporate probe identified 49 occasions of backdating.

Ironically, Mercury specializes in software that helps corporations comply with federal regulations. It's a successful, growing company, and in this it was emblematic of options abusers: It didn't need to cheat. The CEO and two other officers, each of whom benefited from the backdating, have gotten the sack, and three of its directors, who served on the compensation committee, face possible action by the SEC. The company also must wipe out $567 million of previous pretax profits.

The Mercury disclosure was followed by a Wall Street Journal revelation that others, including UnitedHealth Group and Comverse Technology, apparently committed similar offenses. Comverse has indicated it will have to restate more than five years of results. UnitedHealth Group has said it must wipe out $286 million of its previous net earnings. These bombshells have moved corporate sleuths, especially in options-happy Silicon Valley, to pore through their records.

Some people, pointing to the arcane nature of the offense, have wondered what the fuss is about. But make no mistake, backdating was a gross betrayal of the shareholders. Rather than align the executives' interests with those of investors, it gave executives a guaranteed head start and thus eviscerated the need for them to perform. In that sense, backdating is a symbol of everything else that has gone wrong with options — and by extension, executive pay.

According to a recent poll of institutional investors conducted by consultant Watson Wyatt, 90% think the standard corporate compensation package, which is heavily dependent on options, results in too much pay. Perhaps even more surprising, only 22% think compensation has had the intended effect of improving corporate performance.

But it could. And if the structure of options packages were reformed, options could still be a good motivational tool. One important reform is that options should be distributed less frequently so that executives are rewarded for long-term achievement as distinct from momentary blips in the stock price. Also, options should reward executives only for truly outstanding performance (salary and bonus are more than enough for executives who are less than outstanding).

There is a way to fix option programs so that investors' interests are protected and the people entrusted with their capital are properly motivated. The key is to raise the hurdle for executives by setting the strike price above the price on the grant date. In other words, instead of giving execs a head start (as with backdated options), let them start, say, 10% to 20% under water. Such "premium-priced" options don't begin to pay off until the stock has made up the premium.

From the point of view of shareholders, premium-priced options foster just the right incentive. Almost every stock rises by some amount over 10 years, and there is no reason to reward executives for mediocre appreciation or worse. Thus, a premium-priced option pays off only for the portion of the stock's increase that represents above-average performance. "If [premium] options had been more widespread," says Paul Hodgson of The Corporate Library, "this crisis would never have occurred. This is yet another argument" for options that are truly pegged to on-the-job performance.

No one formula will suit every company, but for a CEO, a one-million-share grant, priced at 15% above the market and intended to be the only grant awarded over 10 years, strikes this writer as right. Of course, that would be in addition to a normal salary and bonus. And if every executive were paid that way, he would know that stellar performance would pay off handsomely but also that, if the stock were to crash, his dream retirement might slip out of reach. Just as it would for shareholders.