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Sound Advice For Gatekeepers of Corporate America

According to a press release by the AFL-CIO, after recently meeting with the “Big Four” accounting firms, the union sent letters to the firms’ CEOs recommending “steps to help accounting firms better detect the manipulation of stock option grants and spur further reform of the audit process.” In the letter, Secretary-Treasurer Richard Trumka noted that “shareholders count on independent auditors to safeguard the value of their investments in companies through the early detection and disclosure of problems with stock option grants.” Moreover, investors are extremely concerned with the backdating epidemic infecting in today’s top boardrooms as this “malfeasance threatens the retirement security of America’s working families, including union members who participate in pension and retirement plans with more than $5 trillion in assets.” 

Unfortunately after the meetings, AFL-CIO concluded and points out in the letter that “no accounting firm had comprehensively addressed the backdating and spring-loading of stock options” until the scandal was reported in the Wall Street Journal. In addition, the union believes that “independent auditors need far broader access to senior management and the board of directors than they have typically been” given in order to appropriately handle the manipulation of stock option grants.

As such, AFL-CIO recommended that auditors need to exercise “professional skepticism” in reviewing stock option grants. Specifically, the union expects an auditor to adhere to the standard of assuring that the financial statements of a company “are free of material misstatement, whether caused by fraud or error” as outlined in AU Section 316.11, Consideration of Fraud in a Financial Statement Audit. Also, the union expects an auditing firm to comply with the recent guidance issued by the SEC and Public Company Accounting Oversight Board on stock options and the “standards governing the detection of fraud in financial statement audits.” Moreover, to effectively prevent “future manipulation by corporate executives and directors,” the union recommends, among other things, that an auditing firm directly inquire “members of the board who are responsible for oversight” of the process in granting stock options; verify the dates of the options with the compensation committee; examine the timing of grants to see “if those dates coincided with the low stock price for the quarter or the year;” and “examine the legal documents authorizing the equity award grants.”

Corporations Hire “Partner In Crime” to Review Stock Option Practices

The phrase “it takes one to know one” has achieved new meaning in Corporate America.  As reported in previous Pomtalk blogs, over 150 public companies have announced investigations of their stock option practices.  Almost all of these companies have relied upon “independent reviews” to assist them in determining whether backdating actually occurred.   As part of these reviews, companies retain outside consultants to analyze their stock option practices to determine if they were properly administered.  These consultants scrutinize e-mails or other documents and interview employees in order to ascertain whether the company engaged in any wrongdoing. 

It appears as if many of these companies under fire for backdating options have found a “partner in crime” to assist them with their internal reviews.  According to a recent Wall Street Journal article, Navigant Consulting, Inc., a forensic economics firm, has been hired by nearly 50 companies to assist in internal investigations relating to stock options backdating.  The catch—Navigant itself was a long time backdater of option awards.  A number of Navigant’s options awards from 1997-2000 were granted on suspiciously low trading dates.  In a filing in May 2000, the company admitted that 16 people, including five non-employee relatives of the company’s former CEO, received backdated options.

In recent months, the Paulson Committee and its ilk have hatched several ideas intended to give corporations a wash for wrongdoing and limit investors’ rights.  One of these proposals advocate that the U.S.enter into a “self regulatory” regime whereby a company is allowed to handle any corporate misfeasance on its own.  They reason that a corporation is the party best suited to correct any wrongdoing committed against its shareholders.    The Committee has further argued that to the extent outside regulation is required, the SEC is well equipped to deal with these issues, without the nuisance of private litigation. 

Corporate America’s hapless reaction to the stock option scandal belies these arguments.  As demonstrated by Apple and other “independent” reviews, the internal reviews conducted by these corporations amount to nothing more than an opportunity to clear their executives of any “willful” misconduct and to put the best possible light on patently fraudulent behavior.  In fact, many of these internal reviews are headed by compensation committee members, directors who either willfully or recklessly allowed backdating to occur on their watch.  These corporations then hire consultants such as Navigant, who themselves have unclean hands with respect to options backdating.   Regarding SEC enforcement, the Commission has clearly indicated that it will only pursue the most egregious cases of backdating, giving everyone else a pass.

Paulson’s formula is all too clear.  Allow the corporations to sweep their misconduct under the rug, and let them move on with their dirty deals.

Institutional Risk Analytics calls for Steve Jobs to resign from Apple amid options probe

With Apple Computer's largest annual event, MacWorld, scheduled to begin Tuesday, Institutional Risk Analytics has called for CEO Steve Jobs and certain directors to resign over their role in Apple's options backdating scandal.  The firm, which bills itself as a consultancy focusing on corporate risk,  noted that Apple's recent 10-K filing conceded that "Jobs was aware or recommended the selection of some favorable grant dates."  However, the company stated that "he did not receive or financially benefit from these grants or appreciate the accounting implications." 

Institutional Risk Analytics gave four reasons why Jobs and the implicated directors should step down as soon as possible: (1) by failing to disclose the options grants accurately they apparently violated federal securities laws; (2) according to the civil lawsuits Jobs himself received a sizable options grant in January 2000 that was "spring loaded," contradicting the company's claim that Jobs did not benefit from the practices; (3) by engaging in these practices, Jobs and the other directors breached their fiduciary duties to shareholders and exposed the corporation to operational risk; and (4) because Jobs and the implicated directors are defendants in numerous civil suits and are rumored to be targets in a federal criminal investigation, their ability to serve the corporation is compromised.

Glass Lewis' Lynn Turner has also criticized Apple's attempt to whitewash Jobs' role in the options backdating scandal:

“It appears as if Jobs is playing the role of a monkey: See no evil, hear no evil, speak no evil. If he truly were fulfilling his role as C.E.O., it is highly questionable as to why he didn’t know about such poor management and oversight of the option granting process.”

We agree with Investor Risk Analytics and Lynn Turner.  While Steve Jobs has been heralded as a strong executive for Apple Computer, he has also dragged the company into an ethical and legal quagmire.  At the very least, he should take a leave of absence until the external civil and criminal investigations are completed. 

Compensation Consultant Embroiled in Option Scandals

In the latest twist to the ongoing option scandals, Bloomberg News has reported that Cablevision’s shareholders have added the company’s compensation consultant, Lyons, Benenson & Co as a defendant in their amended complaint in a state lawsuit in Nassau County.  The plaintiffs, including two institutional investors, claim that the consultant “directly participated in the process” of misdating Cablevision’s stock options.  Specifically, the plaintiffs allege that “LBC was aware that the options were being backdated and the assigned exercise prices of the options were less than the market price of the stock on the actual date of the grants.”  Moreover, according to the amended complaint, the pay consultants were aiding Cablevision’s compensation committee by “providing them with documentation to facilitate the making of the backdated grants.”  It appears that LBC had strong motives to assist in the Cablevision scheme as it was also granted backdated stock options that were accounted as if those options were awarded to an employee.

ACS Finally Ends Whitewash of Options Backdating Scandal

From the moment reports surfaced suggesting that its executives had lined their pockets by backdating large options grants to favorable grant dates, Affiliated Computer Systems (ACS) engaged in a public relations offensive to downplay the significance of the scandal.  Over the holiday weekend (a perfect time for a serial offender to release bad news), the company finally admitted what was obvious to independent observers: that top executives were guilty of intentional backdating.

ACS' attempts to whitewash the scandal began days after they received notice that the SEC was investigating its options practices.  Using the boilerplate contained in the SEC notice, the company encouraged investors to ignore the investigation:  "The Company was advised in the Commission’s notice that the Commission’s request should not be construed as an indication by the Commission or its staff that any violations of law have occurred; and nor [sic] should the request be considered an adverse reflection upon any person, entity or security."

Then, after University of Iowa professor Erik Lie calculated the odds of ACS stock grants falling on such favorable dates absent malfeasance to be an astounding 300 billion to one, or roughly 2,000 times more remote than winning the Powerball lottery, the Company denied any intentional wrongdoing.  In a 10-Q report filed on May 10, 2006, ACS stated: "based on the initial findings of our internal investigation, we do not believe that any director or officer of the Company has engaged in the intentional backdating of stock option grants in order to achieve a more advantageous exercise price."

Now the internal investigation is complete, and the company has had to back down from that lie.  It has finally admitted that "in a significant number of cases Mr. Rich, Mr. King and/or Mr. Edwards used hindsight to select favorable grant dates."  The company also admitted that its May 10, 2006 denial was false:

Further, with respect to the Company's May 2006 Form 10-Q, the investigation concluded that Note 3 to the Consolidated Financial Statements which stated, in part, that the Company did "not believe that any director or officer of the Company has engaged in the intentional backdating of stock option grants in order to achieve a more advantageous exercise price," was inaccurate because, at the time the May 2006 Form 10-Q was filed, Mr. King and Mr. Edwards either knew or should have known that the Company awarded options through a process in which favorable grant dates were selected with the benefit of hindsight in order to achieve a more advantageous exercise price and that the term "backdating" was readily applicable to the Company's option grant process.

CEO Mark King and CFO Warren Edwards, both implicated in the wrongdoing, resigned immediately.  The aptly-named former CEO Jeff Rich retired in the beginning of the year, but not before taking an $18.4 million buyout of his backdated options.  Now that the internal investigation has concluded that the options were grossly overvalued by illegal backdating, will ACS go after this payment?  We hope so, but the company's actions indicate it is more likely to sweep the problem under the rug.

UnitedHealth CEO forced to step down after options investigation confirms backdating

When the final chapter on the options backdating scandal is written, perhaps the most striking aspect will be the senselessness of the practice.  Most recipients of backdated options were already compensated beyond belief, receiving millions of dollars in annual compensation before the backdating.  Yet they all pushed for even more, and jeopardized everything--reputation, jobs, and in some cases freedom--just to get a larger slice of the pie.

In the end, the shareholders will be the biggest losers.  The damage caused by the unfettered greed of these executives goes far beyond the unearned compensation they effectively stole from corporate coffers by backdating options. The companies, and ultimately their shareholders, now face costly investigations, tax penalties, and financial restatements.  Worst of all, these companies will likely lose the executive talent responsible for their growth.

No case is more emblematic of this tragedy than that of UnitedHealth Group and its CEO, Dr. William McGuire.  Before the options backdating scandal hit, McGuire was widely considered to be the most talented CEO in his industry.  He is credited on Wall Street for building UnitedHealth from a regional insurer into the nation's largest and most powerful health insurer.

McGuire was well-rewarded for his efforts.  During his tenure, McGuire was granted options valued at $1.6 billion (as of the end of 2005), in addition to a generous annual salary and bonuses that totaled approximately $8 million in 2005.  The company estimates that it will have to restate approximately $286 million in compensation and other expenses due to backdated options granted to McGuire and other executives. In other words, McGuire's total compensation would have been staggering with or without the backdating.  Even if one were to deduct the total amount of the restatement from his take, McGuire still would have received options alone worth over $1.3 billion.  How much is enough?

The investigation conducted by law firm WilmerHale and released on the company's website reveals that "many" of the options granted to McGuire were illegally backdated, and that McGuire failed to disclose a financial relationship with William Spears, the director who chaired UnitedHealth's compensation committee.  As a result, the company announced that McGuire will step down from the board effective immediately and will leave the company no later than December 1.

Top Lawyer Intertwined In Pretexting and Stock Options Scandals

It has been reported that one of Silicon Valley’s top lawyers, Larry Sonsini, the Chairman of Wilson Sonsini Goodrich & Rosati, who has been intertwined in the Hewlett-Packard pretexting scandal, might have been granted stock options by Novell Inc. when the stock was at an annual low and immediately before positive financial results.  Specifically, on October 26, 1999, “when the stock was priced at a 17 month low” and while Sonsini was a member of Novell’s board of directors, Sonsini and two other directors received 50,000 options each.  Within two months of the grants, the stock price more than doubled, making those options worth more than $1 million on paper.

Stock Options Scandal -- FBI Is At the Door

According to data compiled by Bloomberg, the backdating stock options scandal “has so far cost investors at least $7.9 billion in market value.”  With independent investigations by the Justice Department and the SEC into companies’ stock options grant practices, the FBI is also investigating at least 52 companies -- and if the FBI gets its way, more cases will follow.

Investor Group Ready to Rock the Board

An investor group calling itself the Committee For Concerned Cyberonics Inc. Shareholders led by a hedge fund, Metropolitan Capital Advisors Inc., sent a letter to the Board of Directors of Cyberonics reiterating their earlier intention to nominate three candidates for election the company's Board.  As the company has been implicated in the options scandal, the letter said that the company has made "a series of bad decisions on the part of senior management and an ineffectual board of directors."  Now with the culmination of separate investigations by the SEC and the U.S. Attorney's Office, the investor group believes that Cyberonics's backdating problems "raise serious questions about the Board's judgment and showed a disdain for the interests of shareholders."  Furthermore, concerns over the company's stock options demonstrate "serious ethical lapses by senior management and the Board of Directors."

Click here for the letter.

The Plot Thickens at Broadcom

The depth of corporate misfeasance with respect to the stock options scandal continues to stagger the investing public.

Broadcom, Corp., one of the first corporations to be plagued by the options backdating scandal, has now announced that its anticipated restatement will be $1.5 billion, double the $750 million that it had previously forecast.  Broadcom, a supplier of chips used in communications devices, announced that it has discovered additional stock option grants with fraudulent dating.  Months ago, the company uncovered grants awarded between June 2000 and 2002, in which the measurement dates differed from the grant dates.  The measurement date is the day the stock price on the option is determined, while the grant date is the actual date that the option is received by the employee.  These dates should be identical.

The Company has now found additional grants awarded between June 1998 and May 2003 that also had differing measurement and grant dates.  To the extent that the price of the stock on the grant date exceeds the share price on the measurement date, the stock option award must be expensed.  Because Broadcom failed to expense these options, it must restate its financial results.

To read more about this issue, click here.