Cashing in on a new sure thing

Dozens of executives have been granted stock options in ways that ensure big payouts. Are they illegally gaming the system?

June 11, 2006|By BERNIE KOHN | BERNIE KOHN,SUN BUSINESS EDITOR

THAT NUMBER — William McGuire probably deserves to be well-compensated for building UnitedHealthcare from next to nothing into a health care giant. But $1.5 billion?

That number - the value of McGuire's unexercised stock options - could have become merely the flash point for another round of garden-variety hand wringing over excessive executive pay. But McGuire now stands accused in shareholder lawsuits of gaming his company's options program to ensure the maximum possible payout.

Those claims might just become Exhibit A in a burgeoning scandal that could land as many executives in courtrooms as Enron, WorldCom, Tyco and Adelphia put together.

McGuire is accused of backdating stock options - a phrase likely to make the average reader's eyes glaze over. So think of it this way: The betting windows at Pimlico just reopened. If you bet on Barbaro, go on over and reclaim your money.

Juries of ordinary working folks may have a tough time grasping off-balance-sheet partnerships, spinning of hot initial stock offerings or revenue recognition accounting, but they know good old-fashioned cheating when they see it.

Douglas Ober has been a successful investment professional for 25 years. He runs two Baltimore investment pools, Petroleum & Resources and Adams Express. Like any competitive fund manager, he's judged each year on his results compared with market benchmarks. But even after all these years, he doesn't try to time the market's crests and falls - because he knows it can't be done beyond a lucky strike or two.

Yet, in at least a couple of dozen cases reported so far, public documents show that executives managed - time after time, year after year - to be granted options on days when their company's share price was at or near the bottom of significant price dips. Essentially, this meant the executive locked in a few extra bucks per share of potential profit for the day when he exercises the option and buys the stock at the grant price - money he'd never get if the option was awarded at some annually scheduled date or even randomly.

Habitually and perfectly timing the stock market makes these CEOs and their posses clairvoyant, smarter than any investors who have ever lived or lucky enough to hit the jackpot in Vegas at every visit. Or, as Ricky Ricardo would say to Lucy, "Someone's got some 'splainin' to do."

Already, at least a dozen corporate executives have lost their jobs in recent weeks over suspicions of gaming option awards. Among the companies the feds are looking at is Harford County-based SafeNet Inc., whose chief executive has repeatedly over the past five years received options at the bottom of short-term price dips and been given permission to exercise those options immediately.

Erik Lie, a University of Iowa finance professor whose research was the basis for a run of Wall Street Journal articles exposing the practice, estimated last week in an interview with Bloomberg News that up to 10 percent of all option awards before 2002 may have been backdated. (Aspects of the Sarbanes-Oxley reform law passed that year made it somewhat more difficult to hide backdating, he contends.)

Even in unquestionably clean circumstances, the granting of stock options can be a minefield.

Under relatively new accounting rules, options have an identifiable value that companies must count as an expense item when they are granted. For every option granted, each share held by current stockholders becomes worth a little bit less, since there's a future share of stock tied to each option. And if executives are awarded options whenever they or the board of directors feels like it, as opposed to the same day every year or in some other regular pattern - even if there is no backdating - it's hard to refute that a fix is in.

All this helps explain why Ober's companies don't grant executive stock options anymore and look askance at companies that do. If executives were truly looking out for the long-term interests of shareholders, Ober says, it shouldn't make any difference whether they get the option at $25 as opposed to $20.

"Companies at best have been extremely sloppy in their option grant practices. And at worst, they're attempting to game grant dates to inflate executive compensation without proper disclosure," says Iman Anabtawi, a law professor at the University of California, Los Angeles, who first wrote about options practices in 2004.

Kurt Schacht, executive director of the CFA Centre for Financial Market Integrity, says that if proved, any instances in which corporate executives secretly changed the dates of option grants after they were made are "flat-out fraud, illegal behavior." Along those lines, Anabtawi concedes that she paid little heed to secret backdating until recently because it is so blatantly illegal and provable, she couldn't believe anyone would do it.

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