Authorities Probe Improper Backdating of Options --- Practice Allows Executives To Bolster Their Stock Gains; A Highly Beneficial Pattern
By Mark Maremont
11 November 2005
The Wall Street Journal
(Copyright (c) 2005, Dow Jones & Company, Inc.)
Federal regulators and academics, scrutinizing a broad pattern of well-timed stock-option grants, are exploring the extent to which companies improperly backdated grants to provide insiders an extra pay windfall.
One Silicon Valley software company, Mercury Interactive Corp., admitted to such a practice last week, in an outgrowth of a broader probe of option-granting by the Securities and Exchange Commission which has made backdating a focus. Mercury said its chief executive and two other top officials resigned after an internal investigation found they "benefited personally" from widespread manipulation of stock-option grant dates.
Mercury is one of about a dozen companies currently being looked at in the SEC investigation, which was launched last year. Helping drive the probe is longstanding academic research that shows an overall pattern of stock prices dropping ahead of the reported dates of option grants and rising just afterward.
Options to buy shares at a preset "strike" price -- a point at which recipients can convert them to shares -- became a widespread form of compensation during the 1990s boom, especially at technology firms. Along the way they attracted controversy, in part because some executives made huge fortunes off them as their stock prices soared.
Backdating -- which is not necessarily illegal -- bolsters the gains. Typically, strike prices are set at the market price of the underlying stock on the day an option is granted. Recipients often must hold options for a set period before they can exercise them -- meaning they could gain in value if the stock price rises, or become worthless if it falls.
By tying strike prices to earlier, more favorable dates, executives granted options can instantly lock in a paper gain -- and, if a stock goes up, increase their real gain when they exercise them.
"The whole point of a stock option is that you only profit if the stock goes up," said David Yermack, an associate professor at New York University's Stern School of Business who is credited with the earliest research on option-grant timing. "If you fix it in advance so that it's already deep in the money, it eliminates a lot of the risk."
Some experts point to recent academic research as offering evidence that backdating may have been widely used during and just after the boom.
One study, by Erik Lie, a finance professor at the University of Iowa's business school, looked at thousands of option grants. On average, he found a pattern of stocks dipping sharply just before the date of option grants, then rising immediately afterward -- even after adjusting for overall market returns. Equally striking, he found market prices as a whole tended to rise after grants -- which he suggested shows that executives may have backdated options, already knowing how the market moved.
A second study, by Prof. Lie and Randall Heron of Indiana University's business school, showed the patterns all but ceased after August 2002, when rules put in place by the Sarbanes-Oxley corporate-reform law began requiring executives to report option grants to regulators within two days, instead of the weeks or months previously allowed. With less leeway to choose a favorable grant date, "most of the effect disappeared," said Prof. Lie.
He said any backdating likely occurred at only a small fraction of companies. But given the widespread use of options for compensation, he said, the practice could have resulted in a total of "billions of dollars" in extra pay going to insiders at those companies.
SEC investigators previously had posited that companies were timing grants to benefit from positive corporate news that would drive up stock prices, such as strong earnings. But increasingly they are focusing on backdating.
Some experts are skeptical of the backdating theory. David Aboody, an associate professor at UCLA's Anderson School of Management who also has researched option-grant timing, said he would be "shocked" if backdating was a systemic practice. To get the large aggregate effects that Prof. Lie found, he said, hundreds of companies would need to have been engaged in what amounts to "criminal activity."
That would "require systematic stupidity in the corporate world, which I find hard to believe," he said. "I'm assuming they have lawyers."
But Prof. Yermack, of NYU, who first proposed that the manipulation of news explained the stock pattern, said he now believes backdating could account for much of the unusual stock behavior seen around options grants. "The data look very systematic to me," he said.
Though backdating options isn't necessarily illegal, trouble can arise over such issues as disclosure, said Alan Dye, a securities attorney at Hogan & Hartson LLP in Washington. For instance, companies may report in proxy statements that the strike prices for options are always equal to the market value on the date of a grant -- generally when directors vote on the award -- but then choose a different date when the market value is lower.
That could constitute a securities-fraud violation for misleading disclosures, Mr. Dye said. Moreover, companies that engage in backdating may have violated accounting rules, by failing to include as an expense the extra compensation they gave employees in the form of discounted stock options, he said.
Besides Mercury, companies that have disclosed they are under investigation by the SEC include Brocade Communications Systems Inc., Siebel Systems Inc., Nyfix Inc. and Analog Devices Inc. No charges have been filed against any companies related to the probe.
It isn't clear if backdating is specifically under investigation at any of the companies. Brocade earlier this year said it had incorrectly backdated some option grants to new employees on their date of hire rather than their first day at work, and also found "improprieties" in documentation related to some grants. The company's then-CEO departed, as it said it would need to restate several years' worth of earnings.
A Brocade spokeswoman declined to comment for this article, as did a representative for Seibel.
Mercury, whose software monitors Web-based business applications, didn't discuss specific awards and a spokesman wouldn't comment beyond the recent disclosures. In all, Mercury said it found 49 instances of misdating that affected grants to employees at all levels in the company. Since 1996, insiders have sold about $250 million in stock, much of it obtained through options exercises, according to Thomson Financial.
Amnon Landan, the former CEO who resigned last week, sold more than $73 million in stock during his tenure at the company. Mr. Landan could not be reached for comment.
In a statement, Mercury said the executives asserted "they didn't focus on the fact that the practices . . . were improper." The company also said members of past compensation committees had "reasonably, but mistakenly" relied on management to properly document grants.
Mercury has said it will need to restate its past results back to at least 2002 due to the options-timing problems.
The company's stock-price pattern shows it chose low points for every major grant from 1996 to 2002. For instance, Mercury gave 1.3 million options to executives on March 31, 1997. Its stock, which trades on the Nasdaq Stock Market, fell 21% over the 10 prior trading days, and rose 22% in the 10 days afterward.
Similarly, on Jan. 6, 2000, top executives were given 1.2 million new options. The stock had dropped 20% over the 10 previous trading days. It rose 56% in the 10 trading days afterward -- creating a paper gain of $27 million for the recipients.
Nyfix, a Stamford, Conn.-based supplier of financial trading technology, is in the midst of a second restatement of past financial results after finding that it had misdated some past options grants. Its outside auditor recently resigned, and it has been delisted by Nasdaq for failing to file timely financial results.
Its CEO, Peter Hansen, who founded the company in 1991, said any misdating of options was inadvertent, and due to confusion about complex accounting and legal rules for option grants.
"We didn't, in our view, backdate anything," he said. "We provided dates we thought were the correct dates."
One problem, he said, is that executives typically set companywide grants for employees on certain dates, and when the board later voted to grant options to top executives, they made the grants effective as of the earlier date of companywide awards. Another problem was that the company sometimes set the prices of options for new employees when they were hired, not when the board later ratified those options, he said.
Mr. Hansen also said he has never sold shares of Nyfix in the open market.
At Analog Devices, a Norwood, Mass.-based maker of specialized computer chips, stock-option grants were given to executives at varying times from 1998 to 2002.
One such grant, on Nov. 10, 2000, at $44.50, came at the bottom of a sharp dip in the company's stock price. The stock had closed at $62.31 five days before that grant, and started rising immediately afterward, hitting $57.75 on Nov. 15, the first trading day after it released strong quarterly earnings.
Maria Tagliaferro, a company spokeswoman, said the SEC appears to be looking into the fact that some of the grants were made just before the company released positive earnings news. She declined to comment on whether backdating issues have surfaced, but said option prices are set on the day the board authorizes grants.
Ms. Tagliaferro said Analog is "very conservative. We do document our policies, and we believe that everything we did conformed with the regulations that were in place at that time."
Asked if the company was considering granting options on fixed dates every year, Ms. Tagliaferro said, "That could be a solution going forward."