Backdating Battle

The SEC investigates stock option backdating at a dozen companies.

Rich Duprey
Rich Duprey
Apr 20, 2006 at 12:00AM

Although the Fool advises investors not to try to time the market, in reality we all try to time our entry and exit points. In general, we look to buy good companies and hold on to them -- if not forever, then certainly for years and years -- and we likewise look to enter stocks at the right time. Usually, that point is when the stock is lower and poised to go higher. I mean, really, other than short sellers, who wants to get into a stock and watch it go lower?

Yet some people seem extremely fortuitous in their entry points. Fool contributor Selena Maranjian noted the extraordinary ability of some members of the U.S. Senate to buy stocks just before they had a run-up. Indeed, according to one study, senators had the uncanny ability to best the market by as much as 12% during the 1990s, which was one of the greatest bull markets in history. Apparently the SEC, which has chosen not to investigate, sees nothing odd there.

Lately, though, the regulatory agency has cast a jaundiced eye on another group of investors who also seem to propitiously acquire their stock just before it makes a big move up. Some corporate insiders and executives have apparently been granted stock options that were miraculously awarded just before a large run-up, obviously making those option grants more valuable.

The latest smack of alleged impropriety has hit Vitesse Semiconductor (NASDAQ:VTSS), whose CEO, CFO, and executive vice president have been placed on administrative leave while the company investigates the allegations. The SEC is flexing its muscle again, too, and will be looking into just how lucky these three executives can actually be. Between 1994 and 2001, for example, founder and CEO Louis Tomasetta received nine option grants, eight of which preceded double-digit gains in its stock.

UnitedHealth (NYSE:UNH) is another company that apparently had a string of fortunate option grants to its CEO, William McGuire. The SEC is looking into the matter there, too, and the executive has called for a sweeping reform of the company's compensation packages, including the elimination of stock-based pay. Nice, when you consider that his exercisable, in-the-money options are worth almost $2 billion and that three-quarters of them remain unexercised.

The issue in question at Vitesse and UnitedHealth -- as well as at Brocade Communications (NASDAQ:BRCD), Comverse Technology (NASDAQ:CMVT), Brooks Automation (NASDAQ:BRKS), and about a dozen or so other companies under investigation -- is whether these companies engaged in option grant "backdating" -- that is, changing the dates of awards to coincide with big moves in company stock.

While the companies in question deny that they were engaged in any such illegal activity, that the timing was just "blind luck," a Wall Street Journal report last month says the chances of these companies having such good fortune run into one in the hundreds of millions, if not billions. In fact, so prescient were the folks at Affiliated Computer Services (NYSE:ACS) that the chance of their option grants being so lucky were one in 300 billion. As the Journal noted, the chances of winning the multistate Powerball lottery are one in 146 million.

Ownership of company stock by executives and insiders is usually considered a positive development because it shows a belief in the company's prospects. An investor should be warmed by the sight of high insider ownership; after all, Tom Gardner has made it a virtual prerequisite for the stocks in our Motley Fool Hidden Gems newsletter service.

Yet not all ownership positions are created equal. Executives' insider purchases on the open market show a far more real commitment than gratis stock options. Although they are supposed to align the interests of management and shareholders, these stock options are a technique to enrich insiders at the expense of shareholders. Now, after a long and arduous battle, companies are now finally required to include those costs in their financial statements.

Should the SEC's investigation uncover actual instances of wrongdoing at these or other companies, not only should the executives themselves be held accountable for their actions, but the boards of directors should be punished as well. Boards today include compensation committees that oversee the pay and benefits of executives. They sign off on such arrangements, and even if their actions were only negligent and not criminal, it makes one wonder why they were signing off on the grants in the first place and points to the need for tighter internal controls.

UnitedHealth's McGuire may have just the solution to the problem of stock option abuse, which is to altogether suspend the practice of granting them to executives. With the level of pay executives receive these days bordering on the obscene (even at companies whose performance is middling at best), executives can afford to buy shares of their companies on the open market -- just as they want each of us to do.

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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.