The Backdating Fiasco - Part Two

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...continued from Part One

WHAT EXACTLY IS BACKDATING?
Determiningthe proper strike prices for options packages has always been a problem for firms. Their seeming inability to decide on a strike, along with a fair amount of greed, is thegenesis for the backdating scandal that is currently sweeping thefinancial world.

Common sense tells us that the strike price ofan executiveís options should be at or around the trading price of thecompanyís stock when the options are issued. If the stock is tradingaround $60 when the options are issued, then the strike price of theoptions should also be around $60. It is a very simple concept thateven the least options-savvy compensation committee should be able tograsp. Unfortunately, that does not seem to be the case.

In an effortto increase the payouts to their executives, many companies have beenblatantly fudging with the strike prices of their executivesí options.Some companies wait for a period of months or even a year beforeissuing their options. They then backdate those options to a strikeprice equal to the lowest trading price of the stock during thatperiod.

The list of firms entangled in this scandal includes some ofthe biggest names in the corporate world. Apple, Intuit, Home Depot,McAfee, Computer Associates (CA), and Microsoft have all been caught upin the backdating fiasco. Many firms have already restated theirearnings to the tune of tens and even hundreds of millions of dollars.In a spectacular example of greed and fraud, Broadcom recently restated their earnings to the tune of $2.2 BILLION as a result of their backdating activity.

Just about every firm under investigation for backdating has seen a significant dropin their stock price and many are facing the prospect of SEC fines andshareholder lawsuits. The problem has become so endemic that manyfinancial consulting firms have established new business unitsspecifically geared toward corporate options accounting and regulation.Unfortunately, itís a growth industry with no end in sight.


IS THERE AN ALTERNATIVE?
Properly valuing corporate options packages has become so difficult that somefirms are opting for unique solutions.  So far, the most unique are Employee Stock Option Appreciation RightsSecurities (ESOARS). ESOARS operate on the premise that the best way todetermine the value of an asset is to open it up to a competitivebidding process.

Instead of using an options pricing model to valuetheir options, firms auction off a block of ESOARS. The valuedetermined by this auction process is then used to determine the valueof their options.

While this is an interesting concept, ESOARS arehardly a simple alternative for anyone who is overwhelmed by theconcept of options valuation. They are essentially derivatives ofderivatives, with their value derived from the expected intrinsic valueof the companyís options. However, unlike the holders of the underlyingoptions, holders of ESOARS have no exercise rights. In fact, they onlyreceive a payout when the employees decide to exercise their options.On top of that, there is currently no viable secondary market forESOARS, leaving their owners at the mercy of others to determine whenand if they ever receive a payout.

Google is investigating another interesting twist on the auction concept. Starting in April, non-executive Google employees with vested stock options will be able to sell those options in a specialized secondary market. This market will essentially be an auction system in which approved financial institutions can bid for an employee's options. Morgan Stanley will oversee the auction system

By opening up corporate options to competitive auction, it will greatly improve the accuracy of their valuations. This could dramatically increase employee returns on their compensation packages. Additionally, a strong secondary market for corporate options will provide an alternative source of liquidity and hedging for options traders. All in all, it's a very exciting idea.

SOX TO THE RESCUE
Therehas been a significant backlash against Sarbanes-Oxley in recent years,with many opponents claiming the law is too onerous on businesses.While the provisions of the law are strenuous, no one can argue withits effect on the world of corporate options.

One of the biggestproblems in the corporate options world was the lax reportingrequirement. Firms were required to report their option grants withinone month of the date of issuance. However, with a little bit of legalwrangling, they were able to stretch that deadline out to one year.This made it very easy to backdate options to the most opportune priceover that period. Sarbanes Oxley cut that reporting period down to onlytwo days. The fact that few backdating scandals have occurred after2002 is a testament to the impact of this simple yet necessary change.While more clearly needs to be done, including more guidance on howcorporate options should be issued and valued, Sarbanes-Oxley hasdefinitely been a step in the right direction. 

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