Backdating Scandals Enter Final Lap

In the end, the backdating hullabaloo seems as though it was much ado about nothing. I'm sure that Brocade Communications (Nasdaq: BRCD) ex-CEO Gregory Reyes thinks differently, since he'll be paying a fine of $15 million and spending almost two years in the clink. But considering that he faced upward of 20 years of incarceration, he should find the virtual wrist-slap he got for backdating stock option grants to be a major relief.

Maybe fatigue set in over the backdating flap. The many scandals that erupted have been dragging on for years now, and with the market mired in a slump, aren't there really more important things to worry about? Backdating is so last bull market.

Or maybe backdating just became socially acceptable, since "everyone" was doing it. From Apple (Nasdaq: AAPL) to Microsoft (Nasdaq: MSFT) and seemingly everyone in between, if hundreds of companies committed the crime, could it actually be so bad?

Stock options give 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 set earlier than it really was, or at some time when the share price was lower than on the day it was actually granted. It gives the employee instant extra profits on the options.

Well, to my thinking, that was a bad thing to do, and it remains so. I'm willing to acknowledge that some companies backdated options in a non-criminal way. Microsoft, for example, openly had a company policy of awarding options to new hires at the lowest share price of the month. Others, though, were clearly trying to circumvent not only the knowledge of their boards of directors and shareholders, but also the securities laws themselves.

That's what tripped up Reyes, and that's why he's shuffling off to jail. Among other counts, he was found guilty of fraud and filing false financial statements resulting from his backdating activities.

Backdating stock options in cases such as Reyes' misleads shareholders and potential shareholders. Earnings become inflated because stock option expenses are underreported, ultimately by the extra value (i.e., the artificially lower strike price) granted to the option recipient. And this is why we're seeing so many companies having to restate their financial reports.

For example, UnitedHealth Group (NYSE: UNH) had to restate past earnings by more than $1.5 billion. Its former CEO, William McGuire, ended up agreeing to repay about $620 million in stock option gains and retirement pay for his role in that company's backdating scheme.

A person who has to spend two years in jail will have a hard time believing he got off scot-free. I'm sure Reyes will be pondering why he's wearing prison stripes while, say, Steve Jobs gets to keep his black turtleneck. Perhaps Reyes will come to the conclusion that he was caught when the race was yet to be run, instead of near the end, when prosecutors seemed cramped and unable to finish the lap.

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