backdating options joe pizarek – 1 st speaker kevin quinn – 2 nd speaker
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Backdating Options
Joe Pizarek – 1st speaker
Kevin Quinn – 2nd speaker
First Things First
Option - an agreement where the buyer has the right to exercise by buying or selling an asset at a set price (strike price) on or before a future date
Since the contract's value is determined by an underlying asset and other variables, it is known as a Derivative.
ESO – employee stock option (a performance based compensation)
More definitions
At the Money- when the strike price equals the security's current price
In the Money- when the strike price is below the security's current price
Out of the Money - when the strike price is above the security's current price
Options at-the-money or out-of-the-money have an intrinsic value of zero
Options Graph
0
5
10
15
20
25
30
35
40
45
1stQtr
2ndQtr
3rdQtr
4thQtr
Stock
Strike Price = $25
Blue – Out of the Money
Red – At the Money
Green – In the Money
What is Backdating options?
Backdating is the practice of marking a document with a date that precedes the actual date.
The Effects
http://www.biz.uiowa.edu/faculty/elie/backdating.htm
Continued
End of the year price = $85 Exercise price of backdated option = $30 Amount of shares issued to executive = 100,000 Intrinsic Value = (current price – exercise
price)*amount of shares Intrinsic Value = ($85-$30)*100,000 = $5,500,000
Who Suffers?
The shareholders This defrauds the firm's shareholders
because the company receives less money for the shares than it should.
Diluted Shareholder Interest
Broadcom Corp. (BRCM) is the biggest example of suspicious option grants to employees.
Company says they granted options at a quarterly low in May 2000, but did not complete the process until later in the summer.
Diluted Shareholder Interest
Options issued as a percentage of total shares was at one point as high as 20% for Broadcom. Since 2002 it has gone down to 4-6%.
Possible restatement of $750 million
Spring Loading and Bullet Dodging
The practices of timing option grants to take place before expected good news or after expected bad news.
Continuedhttp://money.cnn.com/2006/05/26/magazines/fortune/colvin_fortune_0612/http://www.dailyreckoning.com/rpt/BackdatingOptions.html
Erik Lie first discovered this trend His research discovered that unless executives
had amazing talents to forecast precise overall movements in the market, they had to be backdating the grants.
Example Question
What is the intrinsic value of a backdated stock option at the end of quarter 4, with the exercise price at the trough (lowest stock price)?
Number of shares equals 50,000
0
10
20
30
40
50
60
1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
Stock
Example Question
A $2,500,000 B $1,000,000 C $1,500,000 D $0 Correct Answer: C (50-20)*50,000
Legalityhttp://www.biz.uiowa.edu/faculty/elie/backdating.htm
Yes…But need to follow strict regulations: Publicly announced to shareholders Properly stated in earnings Correctly taxed
Rarely are these conditions satisfied.
Time Frame of Scandal
Backdating practices have been around since the late 1990’s or even earlier
Backdating made harder in 2002 because of the Sarbanes-Oxley Act. Companies now have 2 days after granting
options to report to the SEC. Large scale investigation began summer of
2006 after Erik Lie’s research.
What actions are being taken
Justice Department along with Securities and Exchange Commission are investing companies.
Slow process due to hidden nature of claims. Some companies use second lowest price date to throw off
investigators.
Over 130 companies being investigated, many upper management on trial too.
Partial list of (120+) companieshttp://www.usatoday.com/money/companies/regulation/2007-03-08-backdate-list_N.htmhttp://online.wsj.com/public/resources/documents/info-optionsscore06-full.html
Able Energy Actel Activision Apple Computers Bed Bath & Beyond CNET Networks Dean Foods Home Depot McAffe Monster Worldwide Pixar Take-Two Interactive Software UnitedHealth Group
UnitedHealth Grouphttp://money.cnn.com/magazines/business2/business2_archive/2007/02/01/8398990/index.htm?section=money_latest
One of the Largest Backdating cases CEO William McGuire had over $1 billion dollars
of unexercised stock options at the end of 2005. McGuire resigned, giving up about $200 million in
proceeds. Had to correct accounting dating back to
1995 Lowered earnings by $1.55 billion dollars Paid $100 million in additional taxes
Take-Two Interactive
Publisher of video game Grand Theft Auto Former CEO Ryan Brandt pleaded guilty to
falsifying business records. Had to pay SEC civil charges of $7.3 million
dollars. Never officially admitted or denied wrongdoing
McAffehttp://www.usatoday.com/printedition/money/20070228/options28.art.htm
Kent Roberts (former controller) was indicated by grand jury on charges of fraudulent dating of stock-options. If convicted could face 20+yrs in jail,
along with millions of dollars of fines. Company could also face $150 million in
charges.
Class-action Vs Derivative lawsuits
Class-action Settlement goes directly to shareholders Has 5 year statute of limitations
Backdating has been dated back to the late 1990’s. May not be appropriate for older cases.
Derivative lawsuits Settlement goes towards the company
Should indirectly help the shareholders
Overall Effecthttp://www.issproxy.com/pdf/OptionTiming.pdfhttp://online.wsj.com/public/resources/documents/info-optionsscore06-exec.html
By number of firms under investigation, backdating is the largest scandal in over 20 years.
Pension funds and large stakeholders are leading the charge filing class-action and derivative lawsuits.
57 corporate officials have step downed, retired, resigned, or have been fired due to scandal.
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