As bad as the options backdating scandal seems to be, one of its worst consequences may not become apparent for another two or three years. That's when we may all discover that the cleanup of options cheating, a practice pretty much stopped in August, 2002, has diverted financial regulators from detecting and stopping some new scandal taking root now.
The latest malfeasance may involve insider trading on leveraged buyout offers. Or it could be phony valuations of derivatives portfolios by hedge funds playing the credit markets. There's no telling—which is the point.
MASSIVE SCALE. Instead of checking for the latest twists on financial fraud, hundreds of securities market cops, prosecutors, short-sellers, accounting watchdogs, and auditors are busy digging through stock trading patterns, option grants, and e-mails from the 1990s. The Securities & Exchange Commission is investigating more than 100 companies for possible fraudulent option grants. Many of those companies have disclosed they are also being investigated by the Justice Dept. and the Internal Revenue Service.
On Sept. 8, Broadcom (BRCM) provided another sense of the massive scale of the probes when it said it expects to restate earnings to subtract $1.5 billion of options expenses, twice as much as it had estimated on July 14. Broadcom said additional sums are the result of more investigation of its accounts since the earlier announcement.
The company also warned that there's more work being done, particularly on whether it may owe additional taxes. Employee stock options typically are deductible expenses for corporate taxes, but not if they were improperly granted. Linear Technology (LLTC) in a Sept. 8 filing said the IRS had requested documents on Sept. 5, following prior inquiries from the SEC and Justice.
STOCK SHOCK. Broadcom's expected $1.5 billion of additional compensation expense is to be a noncash reduction to past earnings, but it shows how some of the investigations are focusing on companies' formative years. Broadcom, which produces semiconductors for communications, had revenues totaling only $5.5 billion from 1998 through 2003, its first years as a public company and the key period to be covered by the restatement.
Each year it issued new options for shares that amounted to about 15% of its outstanding stock. Broadcom said the $1.5 billion of additional expense is so high because it relied more heavily on options to pay employees than did more mature companies. The options' value was also high because Broadcom's stock was volatile. The shares climbed more than 1,600% from the company's 1998 initial public offering to early 2000.
This may seem like old history, but it still must be sorted out. The numbers are sweeping, with a broad array of Silicon Valley players such as Apple Computer (AAPL) caught up in the probes, along with numerous others: Cablevision Systems (CVC), Home Depot (HD), and UnitedHealth Group (UNH). The need is more than the public's desire to learn if people under suspicion really did do wrong. The companies also need to move on and get their stock prices back up.
Broadcom's stock, for example, is down more than 40% since the scandal blew wide open in mid-March. The average loss in market value to shareholders of companies implicated in the scandal is about 8%, or $500 million per company, according to a new study by professors at the University of Michigan.
Investors are wary of the stocks because of several unanswered questions, says Robert Willens, a tax and accounting expert at Lehman Bros. (LEH). Those include possible cash outlays for additional taxes, the possibility of penalties to remedy loan defaults triggered by the restatements, and the prospect that key executives will be forced out.
CLOSED WINDOW. Still, it is not satisfying to know that the time and money being spent on the investigations won't do much to end any cheating going on today. The gambit of backdating to add extra value to options all but ended in August, 2002.
That's when the Sarbanes-Oxley Act took effect and shortened to two days from as much as one year the time companies have to report changes in executives' holdings of stock and options. The quick disclosure effectively stopped issuers from being able to look back weeks or more and chose a grant date that would result in lower exercise prices for the options.
Evidence of the end of backdating games was reinforced on Sept. 8 in a study by the Center for Financial Research & Analysis, a research service for institutional investors. CFRA said it reviewed options grants at 367 companies that came public since Sarbanes-Oxley and found only nine that had any grants suspiciously timed at stock price lows.
And even among those companies, there was no clear pattern of a series of suspicious grants like those that frequently occurred before August, 2002. The CFRA study was consistent with other studies from professors at the University of Michigan and the University of Iowa.
Alas, the provision of Sarbanes-Oxley that so effectively discouraged backdating wasn't put into the law to stop the practice. Congress added it for anther reason: to stop executives from secretly selling their personal holdings while promoting their stock to investors, as the late Ken Lay did at Enron. At the time, regulators at the SEC didn't even know that option backdating was a problem. That raises the all-important question: What are they missing now?