Backdating Options
Joe Pizarek – 1st speaker
Kevin Quinn – 2nd speaker
First Things First
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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
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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
45
40
35
30
25
Stock
20
15
10
5
0
1st
Qtr
Strike Price = $25
Blue – Out of the Money
Red – At the Money
Green – In the Money
2nd
Qtr
3rd
Qtr
4th
Qtr
What is Backdating options?
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Backdating is the practice of marking a
document with a date that precedes the
actual date.
The Effects
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http://www.biz.uiowa.edu/faculty/elie/backdating.htm
Continued
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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?
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The shareholders
This defrauds the firm's shareholders
because the company receives less money
for the shares than it should.
Diluted Shareholder Interest
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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
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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
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The practices of timing option grants to take place before
expected good news or after expected bad news.
Continued
http://money.cnn.com/2006/05/26/magazines/fortune/colvin_fortune_0612/
http://www.dailyreckoning.com/rpt/BackdatingOptions.html
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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
60
50
40
30
Stock
20
10
0
1st Qtr
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2nd Qtr
3rd Qtr
4th Qtr
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
Example Question
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A $2,500,000
B $1,000,000
C $1,500,000
D $0
Correct Answer: C
(50-20)*50,000
Legality
http://www.biz.uiowa.edu/faculty/elie/backdating.htm
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Yes…But need to follow strict regulations:
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Publicly announced to shareholders
Properly stated in earnings
Correctly taxed
Rarely are these conditions satisfied.
Time Frame of Scandal
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Backdating practices have been around since
the late 1990’s or even earlier
Backdating made harder in 2002 because of
the Sarbanes-Oxley Act.
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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
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Justice Department along with Securities and
Exchange Commission are investing companies.
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Slow process due to hidden nature of claims.
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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+) companies
http://www.usatoday.com/money/companies/regulation/2007-03-08-backdate-list_N.htm
http://online.wsj.com/public/resources/documents/info-optionsscore06-full.html
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Able Energy
Actel
Activision
Apple Computers
Bed Bath & Beyond
CNET Networks
Dean Foods
Home Depot
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McAffe
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Monster Worldwide
Pixar
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Take-Two Interactive Software
UnitedHealth Group
UnitedHealth Group
http://money.cnn.com/magazines/business2/business2_archive/2007/02/01/8398990/index.ht
m?section=money_latest
One of the Largest Backdating cases
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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
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Lowered earnings by $1.55 billion dollars
Paid $100 million in additional taxes
Take-Two Interactive
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Publisher of video game Grand Theft Auto
Former CEO Ryan Brandt pleaded guilty to
falsifying business records.
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Had to pay SEC civil charges of $7.3 million
dollars.
Never officially admitted or denied wrongdoing
McAffe
http://www.usatoday.com/printedition/money/20070228/options28.art.htm
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Kent Roberts (former controller) was
indicated by grand jury on charges of
fraudulent dating of stock-options.
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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
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Settlement goes directly to shareholders
Has 5 year statute of limitations
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Backdating has been dated back to the late 1990’s.
May not be appropriate for older cases.
Derivative lawsuits
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Settlement goes towards the company
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Should indirectly help the shareholders
Overall Effect
http://www.issproxy.com/pdf/OptionTiming.pdf
http://online.wsj.com/public/resources/documents/info-optionsscore06-exec.html
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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.