Is Backdating Really So Bad?

Considering that nearly 200 companies have been caught in the swarm of scandal surrounding the backdating of stock options, more people are questioning whether backdating is really such a bad thing. Now that Silicon Valley icon Steve Jobs has become one of the highest-profile personalities to become ensnared, perhaps it's really just much ado about nothing.

Perhaps not.

A tempest in a teapot
As we've recounted on these pages many times, a stock option gives the holder the right to buy a stock at a certain price -- called the "exercise" or "strike" price -- at some point in the future. The theory is that options are an incentive to have management work hard to ensure that the company's value increases, and that its share price grows, so that management and shareholders can profit together in the future.

Backdating, on the other hand, pretends that the strike price was actually set earlier than it was, or at some time when the share price was lower than on the day it was actually granted. It gives the manager instant extra profits on the options.

Apple (Nasdaq: AAPL  ) shareholders have been particularly unfazed by the revelation that Jobs was not only aware that backdating was occurring, but also intimately involved in picking the dates to which the stock options were backdated. Many shareholders have rallied to defend Jobs' actions on the basis of his overall performance with the company. They have also sought shelter under the banner that Jobs was no accountant, and thus didn't realize the effects that backdating would render. But you don't need an accounting to degree to know that backdating is wrong. Ethics 101 should have taught you that.

What have you done for me lately?
Critics of prosecuting options backdaters, and basically most of the Apple shareholders who've contacted me, believe that as long as the executive has otherwise performed admirably for shareholders, and as long as shareholders have personally been able to profit from a company's share price growth, it's OK to overlook a few failings.

Few tears were shed when William McGuire, CEO of UnitedHealth (NYSE: UNH  ) , was deposed for his role in backdating that company's stock options. He had led the firm to phenomenal gains over a 15-year period, but perhaps because he was also richly rewarded as a result, it was easier to oust him. And surely few people had problems with the vilification of Kobi Alexander, the CEO of Comverse Technology (Nasdaq: CMVT  ) , when he became a fugitive after his backdating scandal broke. He had to be hauled back to the U.S. to face fraud charges, and ultimately jail.

Jobs' only sin, his defenders will say, was that he was an ignorant shmoe who didn't "appreciate the accounting implications" and didn't personally benefit from the scheme. As a matter of fact, they argue, he actually cancelled the big 7.4 million share option grant he was given. While Saint Steve may not have really understood all the accounting mumbo jumbo that goes into play, it's hard to argue that he didn't benefit. The grants he cancelled would have vested over a period of as much as 10 years. In return, he received less risky restricted shares that would vest within three years, and were valued at $74 million.

Let the punishment fit the crime
I do agree that the extent to which an executive goes to conceal backdating -- like creating fictitious board meetings, as an Apple employee allegedly did in Jobs' case -- should play a role in deciding the size of the penalty imposed. Outright fraud should be dealt with harshly, while other cases, done in plain sight, but out of supposed ignorance, might deserve more of a financial slap on the wrist. For example, Microsoft's (Nasdaq: MSFT  ) backdating was done as a matter of company policy with new hires; options were granted at the date of the lowest price of the month. The practice was entirely spelled out, and nothing was hidden or done surreptitiously.

Backdating stock options carries a real cost to shareholders. When options are granted, they are considered to be "at the money," and companies are required to record an expense for them. Backdating, however, allows companies to artificially issue options that are already "inthe money"; for that, they do not have to record an expense. That's why we're seeing so many companies having to restate their financial reports. UnitedHealth, for example, will have to restate past earnings by as much as $1.7 billion. Apple's restatement will knock $84 million off earnings.

It's easy to understand why beleaguered stockholders, long suffering from languishing shares, would be quick to forgive the foibles of a CEO who's turned around their company's fortunes. Not so with the other apologists, who would allow CEOs to escape the cost of their actions -- just this once! -- when they would not allow the same defense for attempts to misreport inventories or receivables.

Foolish final thoughts
Backdating is a scheme that enriches executives, instantaneously giving them more profit than they deserve. If it were done with any other line item on a financial report, it'd be exposed as sheer accounting fraud.

We should definitely consider the lengths to which a company or an executive went to conceal backdating efforts when meting out punishment. But let's not excuse these people's full awareness that they were giving themselves and others outsized and unearned potential profits. Acknowledge that backdating is wrong, regardless of who committed it; own up to your misdeeds, and allow the company to move on.

Despite the backdating scandal, UnitedHealth is a recommendation ofMotley Fool Inside Value. See why with a free 30-day guest pass.

Fool contributor Rich Duprey does not own any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.


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  • Report this Comment On February 26, 2009, at 4:48 PM, steven107 wrote:

    The Answer to the Title, is 'Yes'.

    The only difference between me walking into a bank and taking some money and someone in a boardroom colluding with others to give themselves extra money that belongs to shareholders (whether it be options backdating, loads of options such as 5% of a companies value per year, or approve large raises to each other, or hiring consulting companies connected to board members, especially golden parachutes as a reward for selling the company, I also don't like when a inside owner does his own stock transaction with a purchasing company, seperately from that of the company but dependant on the company being sold, yet at a higher price than the other shareholders, it is a conflict of interest.) the only difference being that a regular dude robbing a bank for a few thousand will rot in jail. The corporate version of that same offense, will land you 10's, 100's of thousands of dollars or possible M's of dollars, and you will maybe get your hand slapped, be asked to pay a fine/penalty equivalent to what you stole, or at most get 1 year probation at a nice villa.

    The motto is get a Business degree before you rob someone.

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