True or false: Firms rigged options to make bundle for CEOs


In case you had any remaining delusions that, for some executives, running a publicly traded corporation is a career or a solemn civic obligation rather than a get-rich-quick scheme, keep reading.

The unfolding "options timing" scandal, as triggered by regulators, The Wall Street Journal and a finance professor at the University of Iowa, looks like another low of cynicism and bad faith from corporate leaders, even if some of it doesn't turn out to be illegal.

As bad as Enron and WorldCom? Not in terms of dollars stolen or stock value destroyed. But emerging details on options timing seem likely to reveal a new crop of unscrupulous and selfish bosses, just when you thought last week's Enron convictions closed the book on the 1990s.

By the Journal's count, about two dozen companies, including Belcamp-based SafeNet, have disclosed they are being investigated by federal authorities or their own boards for potential options improprieties. New probes are revealed almost daily.

What investigators suspect, and a look at SEC filings suggests, is that some already highly paid bosses are rigging the exercise price on their options to coincide with extreme lows in their stock, thus enriching themselves far beyond what would have been possible if the options were granted randomly or on a strict schedule.

Options give the right to buy shares at a given price - the strike price - which is usually equal to or a little more than the market price the day of the grant.

The idea is to induce executives to increase the value of the stock, in the same manner that sugar pellets can alter the behavior of lab rats.

A weird pattern

The bigger the difference between the strike price and what the stock sells for on the open market, the more an option is worth. If you have options to buy 100 IBM shares at $50 and IBM trades at $80, then the options are intrinsically worth $30 each, or $3,000. But if the strike price is lower - say $25, then the options are worth $55 each, or $5,500.

A few years ago Erik Lie, an associate professor of finance at the University of Iowa, analyzed a weird pattern in stock prices just before and after unscheduled option grants, that is, options not issued on predetermined dates but at the discretion of the company.

Stocks were in the habit of plunging just before executives got grants - thus giving the grants an abnormally low strike price. And stocks tended to rise sharply right after the grants, making them immediately valuable. Even if the executives didn't cash in the options for years, the low strike price made them much more lucrative than they otherwise would have been.

Two explanations

How could this be? Two explanations suggested themselves.

Perhaps, Lie mused, executives had suddenly become financial clairvoyants, able to consistently predict short-term stock increases. Or maybe, he thought, they were manipulating the process, getting option grants after sharp stock recoveries but then backdating them to coincide with a dip, so that the strike price was much lower than the current market price.

Both explanations might have seemed unlikely. Would executives owing a great fiduciary duty to shareholders game the system to the shareholders' detriment? Surely not. Can executives really predict the financial future when dozens of academic studies and a million floundering day traders have proven this impossible? Surely not.

As Sherlock Holmes said, if you eliminate the impossible, whatever remains, however improbable, is the truth. In what turned out to be a brilliant piece of inductive reasoning (in which investigation of evidence leads to a broad theory, which can be tested by further evidence), Lie figured bosses must be backdating their options.

Amazing coincidences

Sure enough, a look by the SEC and the Journal showed either amazing coincidences of timing, as executives repeatedly got grants when company stock was at quarterly or yearly lows, or apparent shenanigans.

UnitedHealth Group, the huge Minnesota insurer, is the most prominent corporation caught in the scandal. Its boss, William W. McGuire, and other executives were granted options at or near the low points for UnitedHealth stock before 2002, the Journal reported last month. At the end of last year his options were worth a whopping $1.6 billion. UnitedHealth has said it might restate prior earnings by as much as $286 million after it completes an investigation into options.

Much but not all of the irregular activity took place before the 2002 Sarbanes-Oxley law, which requires companies to quickly disclose granted options.

Backdated options may not be illegal per se, but they can lead to illegal behavior if official documents are altered or if they are not properly accounted for. If companies handed out options that were already "in the money" (with a strike price below market price), they should have recorded them as a cost against profits. If they didn't, it's fraud.

It stinks

But the whole idea stinks. Options are supposed to align executives' interests with those of shareholders to boost the long-term price of the stock. But shareholders can't backdate their "buy" tickets. And the 10 or 20 days that it took executives to reap abnormal gains after grant dates, according to Lie's research, is not long term.

"I'm sort of thinking of it as giving someone a little sports car," Lie said of options backdating, in an interview. Having a sports car is not illegal, he said, but people who own sports cars are more likely to run red lights and break speed limits.

So it's time to trade these Maserati options practices for Buicks or Toyotas.

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