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Backdated Options Cause Little Backlash: Repricing Options Not Hurting Company Stock

As the list of companies embroiled in the brouhaha surrounding backdated options continues to grow, the effect on their stocks, and the mutual funds that hold them, seems to be shrinking.

"It's a matter of half-empty or half-full," said Erik Lie, whose research at the University of Iowa first cracked the case, and drew regulators' attention to this latest version of covert executive compensation. "The fact that we are discovering these things, setting examples, and setting regulations to prevent scandals from erupting again might give investors more confidence," Lie said.

The issue centers around a practice common in the late 1990s, particularly among technology companies, of issuing stock options to executives with cost-basis dates at earlier, presumably lower, prices. By the time executives exercised those options, they often reaped greater gains than had the options been properly recorded. The crux of the problem is that shareholders had no way of knowing.

Last month, the Securities and Exchange Commission first announced it was investigating 50 companies for backdating options, then revised it to 80, and then again upped the number to 90.

"Clearly, there are thousands of companies [that backdated options], and we're validating that," said Jack Zwingli, chief executive officer of Audit Integrity in Los Angeles. Using computer models, Audit Integrity charts common behavior among option backdaters against the financial filings of public companies.

Zwingli's list of suspects includes some blue-chip names, such as Microsoft, IBM and PepsiCo; those well-known to consumers, such as Starbucks, Ruby Tuesday and Krispy Kreme; and others that should have known better, including American International Group, Capital One Financial and T. Rowe Price.

"There is a price to be paid for lack of disclosure," said Zwingli, whose business is based on scouring its customers' books for potential liabilities like these.

Already, executives and attorneys at companies like McAfee, UnitedHeath Group and Mercury Interactive Corp. have announced they will restate earnings due to options repricings, while federal prosecutors have filed criminal charges against executives at Brocade Communications Systems. For its part, QuestSoftware announced in early July it would restate earnings for the five years ending in 2002, while UnitedHealth has warned it, too, may restate earnings by as much as $286 million.

But for the most part, the impact on stock value, or by extension the funds that contain them, has been mild.

"Look at the last 25 announcements. What has the stock done? It's barely moved," said Bruce G. Vayo, co-chairman of the securities litigation practice at Katten Muchin Rosenman in Los Angeles. "People are taking an, OK, another one of these,' type of attitude," he said.

In part, that's because the backdating issue is ancient history in the fast-paced world of financial markets. Most of those implicated have either since changed their habits, or their management. And that might even mean bargains for value investors, especially among those invested in already hard-hit tech or even growth funds, said Pat Dorsey, a senior stock analyst with Morningstar in Chicago.

"If the stock is cheap, and there's a new team in charge, why wouldn't I want to buy that?" Dorsey said.

Another reason the market has been forgiving may be that unlike the seismic shake delivered by the Enron and WorldCom scandals during the bear market of 2000-2002, this scandal, although broader in terms of the number of companies, has hit while the market is chugging along pretty smoothly, Dorsey noted.

To be sure, companies that are forced to restate will face substantial costs, potential fines, and maybe even shareholder lawsuits, but those are all one-time costs, not events that will effect company's profitability over the long term. And large companies may be able to absorb those costs more comfortably than small ones, Dorsey said.

For those worried about mutual funds, that means large-caps are pretty well insulated, said Andrew Clark, a senior analyst with Lipper of New York.

"There's much more exposure on the tech and growth side," he said. Still, that shouldn't trigger a sell off, Clark said, but, rather, make for more cautious investors. "Take a look at the prospectuses," he said.

If a fund seems heavily invested in companies that have been implicated, it might be time to sell, but if those companies have righted their course or made reforms, even if they dip, they should soon rebound.

Lie agrees that while literally hundreds of companies could be identified as options backdaters, the issue will soon fade from the public spotlight, as regulators run out of resources and patience. "In most cases the evidence is weak," Lie said.

Furthermore, the practice all but ended in 2002, when reforms such as the Sarbanes-Oxley Act demanded that full accounting of total executive compensation packages be made public.

"I am not sure how many more companies will be caught, or that it will increase," he said. The regulators, he said, simply "wanted to set an example."

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