Aladdin Beckons the Options-Repricing Genie

Many companies were caught changing the dates of stock options during the backdating scandals. If that was improper, if not illegal, why isn't changing the options’ price similarly abhorrent?

Aladdin Knowledge Systems (Nasdaq: ALDN  ) issued a press release late Friday night. You know a company is trying to avoid publicity when it makes an announcement at 7 p.m. the night before a weekend. In this case, Aladdin announced that some 430,000 stock options that had previously been issued at a price of $19.85 when its stock was flying high were being repriced to $8.82 now that the shares have been laid low.

The backdating scandal snared dozens of companies and executives, and a few of them are serving jail terms as a result. Before stepping down, the former CEO of UnitedHealth (NYSE: UNH  ) voluntarily repriced higher the nearly $2 billion in options he was granted when it was discovered that the health-care giant had improperly backdated options. Steve Jobs recently dodged a bullet at Apple (Nasdaq: AAPL  ) for his role in that company's backdating scandal, though its CFO was not so lucky, and the general counsel and one of her associates are still facing charges. Nice of them to take one for the boss.

Also not so lucky was the head of Brocade Communications (Nasdaq: BRCD  ) , who's doing time for his role in that company's backdating mess.

In every case, the executives were caught with their hands in the cookie jar, trying to give executives guaranteed profits using a form of compensation that was supposed to be aligning the interests of management with those of shareholders. By backdating the options to a time when the share price was even more advantageous to the executive, they gave that executive an even greater benefit from the stock's appreciation in value – and we saw that stock options were simply a wealth transfer system.

Still, the stocks at the center of the backdating scandals did in fact increase in value, meaning outside shareholders also enjoyed that increase -- though perhaps not to the same degree.

How much more insidious is it, then, to change the price of the option so that only management benefits, while outside shareholders are left to feel the pain of a fallen stock price?

Moreover, because repriced stock options receive special accounting treatment under SEC rules, earnings take a hit each and every year the stock price moves up until the repriced options are exercised, forfeited, or canceled. And the greater the rise in price, the greater the hit to earnings. So while executives are enjoying the benefits of higher future share prices, the company and outside shareholders suffer from the impact of reduced earnings.

Aladdin, a Motley Fool Hidden Gems recommendation, isn't the only company that's repriced "underwater" stock options -- it’s merely the latest. Tenet Healthcare (NYSE: THC  ) , Hovnanian (NYSE: HOV  ) , and Toll Brothers (NYSE: TOL  ) have all recently received or sought shareholder approval to reprice options. It's a time-honored tradition on Wall Street.

Management may describe repricing in terms of retention and motivation of employees, but in reality, it’s rewarding them for poor performance. Keeping the options priced at their issue level would be a true incentive to improve the company's profitability, and thus its price. Changing the rules -- and the price -- mid-game simply means some insiders will benefit at the expense of all outside shareholders.

More Foolishness:

Aladdin Knowledge Systems is a Motley Fool Hidden Gems recommendation. UnitedHealth Group is a Motley Fool Inside Value selection. UnitedHealth Group and Apple are Motley Fool Stock Advisor recommendations. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Rich Duprey owns shares of Aladdin Knowledge Systems but does not have a financial position in any of the other stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.


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