Backdating Options

1. Backdating Options Joe Pizarek – 1st speaker Kevin Quinn – 2nd speaker

2. 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)

3. 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

4. Options Graph Strike Price = $25 Blue – Out of the Money Red – At the Money Green – In the Money

5. What is Backdating options? • Backdating is the practice of marking a document with a date that precedes the actual date. 

6. The Effects • http://www.biz.uiowa.edu/faculty/elie/backdating.htm

7. 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

8. Who Suffers? • The shareholders • This defrauds the firm's shareholders because the company receives less money for the shares than it should.

9. 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.

10. 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

11. Spring Loading and Bullet Dodging • The practices of timing option grants to take place before expected good news or after expected bad news.

12. Continuedhttp://money.cnn.com/2006/05/26/magazines/fortune/colvin_fortune_0612/http://www.dailyreckoning.com/rpt/BackdatingOptions.htmlContinuedhttp://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.

13. 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

14. Example Question • A $2,500,000 • B $1,000,000 • C $1,500,000 • D $0 • Correct Answer: C (50-20)*50,000

15. 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.

16. 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.

17. 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.

18. 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

19. 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

20. 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

21. McAffehttp://www.usatoday.com/printedition/money/20070228/options28.art.htmMcAffehttp://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.

22. 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

23. 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.