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Stock option scandal hurts tech industry in more ways than one

Posted: 07 Jun 2006 ?? ?Print Version ?Bookmark and Share

Keywords:stock option? scandal? SIA? SEC? Attorney's Office?

The flap over the tech industry's stock options scandal is spreading like wildfire across the valuable acreage of Silicon Valley, and both investor confidence and employee morale lie in the likely path of destruction.

At least 19 high-tech companies have acknowledged that their past stock option grants are being investigated by the U.S. Securities and Exchange Commission, the U.S. Attorney's Office or both. Many of those companies, as well as several others, face shareholder lawsuits challenging their historical option-granting practices. Some have acknowledged that they will have to restate at least some past earnings to account for improper grants. Most have seen their share prices decline!in four cases by more than 10 percent!since disclosing they were being investigated.

By just about any measure, most of the 19 companies!a list that includes software vendors, chipmakers, semiconductor capital equipment vendors and contract services manufacturers!are suffering. But falling share prices, regulatory penalties and shareholder suits are short-term threats.

Potentially more damaging are the longer-term losses the industry could sustain: of the public trust, investor confidence and employee loyalty.

"It's going to be one more thing that leads employees to think that their employers are focused on how rich they can make their CEOs," said Corey Rosen, executive director of the National Center for Employee Ownership (NCEO), a nonprofit consultancy. Recent surveys, Rosen noted, have found that as many as 75 percent of the overall workforce would consider changing jobs within the next year. Allegations that top executives have benefited from fat paydays as the result of stock option grant manipulations could worsen the trend by "devastating employee morale" and undermining worker confidence in corporations, Rosen said.

"The notion of corporate loyalty has been destroyed," he said. "Workers don't see corporations as being concerned about them. These kinds of allegations keep adding to that."

Rosen said it is conceivable that public and investor backlash over the stock options scandal could eventually result in more regulatory legislation in the mold of the oft-derided Sarbanes-Oxley Act of 2002. He added that recent talk of softening Sarbanes-Oxley requirements might be hurt by this latest scandal.

Rosen and other knowledgeable observers reached by EE Times last week emphasized that the alleged offenders constitute a minority of companies that grant stock options. "Certainly, most companies shouldn't be painted with that brush," Rosen said.

Still, the wave of allegations and revelations is disconcerting, he said, noting, "If your crime rate increased from 1 person in 500 to 10 in 500, you'd be awfully concerned."

Bad backdating
The options controversy has centered on backdating!retroactively dating stock option grants for fair market value at times when a company's stock price was relatively low, thus increasing the option holder's potential for profit. Issues of legality aside, the practice violates the spirit of stock options, which are intended as an incentive for high-ranking executives to increase a company's stock price, not as a way to pad guaranteed compensation.

David Larcker, a professor at Stanford University's graduate school of business, called backdating "incredibly bad behavior" but said he does not suspect a systemic problem in the industry. "I'd be really surprised if it were hundreds of companies doing this," Larcker said.

"I just can't imagine that this [wave of implications] will continue," said Charles Mulford, a professor of engineering and faculty director of the MBA program at Georgia Tech. By now, he said, common sense would dictate that all companies would have examined their own options programs and disclosed any potential problems, given that regulators are on the lookout for improprieties and that finding evidence of them is an easy matter. Dates of stock option grants for top executives are typically a matter of public record, and comparing those dates against historical stock performance to uncover evidence of backdating is a relatively straightforward procedure. "It defies logic," Mulford said, that companies would ignore the issue in the current climate.

But Mulford also noted that the growing number of companies that have been subpoenaed by U.S. Attorney's Offices takes the potential consequences of improper practices to a troubling level. While the SEC has the power to enact civil regulatory penalties and fines against offending companies, it lacks the power to bring criminal indictments, he said. The involvement of the U.S. Internal Revenue Service, which has reportedly taken an interest in the stock option practices of at least one implicated company, insurer UnitedHealth Group Inc., further raises the stakes, he said.

"The tax angle is an interesting one," Mulford said, because "it suggests that the taxable income of these officers was also in error. These can be some very serious allegations. If you can demonstrate that there was a concerted effort by an officer to grant him- or herself an option at an inappropriate price, I wouldn't be surprised to see the word fraud used. When you get the justice department involved and the IRS involved, it's a 'take no prisoners' approach."

Questions about stock option programs have dogged tech companies since the 1990s, when options came into their own as a compensation tool. The SEC began investigating historical options granting at Analog Devices Inc. in 2004. That action led to a tentative settlement last November that imposed a $3 million fine on the company as well as a $1 million civil penalty against CEO Jerald Fishman. Despite the tentative settlement, ADI recently acknowledged it had been subpoenaed by the U.S. Attorney for the Southern District of New York to produce records dating to 2000 relating to the company's stock option program.

The vast majority of companies implicated have only been notified of SEC and/or U.S. Attorney investigations in the past two to three weeks. In addition to those that have disclosed external investigations, a growing number of companies have "self reported," publicly disclosing internal investigation in the wake of news reports over the controversy. High-profile memory intellectual-property vendor Rambus Inc. was one of several companies to join that group last week, saying that its board "has commenced an internal investigation of the timing of past option grants and other potentially related issues."

Another of the companies in this category, computer security software vendor McAfee Inc. last week terminated the employment of its general counsel in connection with its previously announced internal investigation. Several other companies have been implicated as potential backdaters through analyses done by The Wall Street Journal and several analysts.

Cut and dried
Tech industry trade groups have had little to say about the scandal thus far. Reached for comment by EE Times last week, a spokesman for the Semiconductor Industry Association (SIA) said the matter is "pretty cut and dried: It's inappropriate to backdate stock options to ensure highest possible value." The one prominent SIA member company that has been implicated in the scandal, Altera Corp., has "certainly taken responsible action, making a public disclosure and taking appropriate steps," the spokesman said.

Asked if there was concern within SIA that investor backlash in the wake of the scandal might lead to more Sarbanes-Oxley-type legislation, the spokesman said there had not yet been any discussion within the group about that possibility. "If there is a proposal for legislative or regulatory action, we'll have to take a look at that and see whether we feel it is appropriate for our membership," he said. "It appears that there are already regulations on the books against this practice."

NCEO's Rosen said he does not think that the options controversy will reach the magnitude of the corporate scandals at Enron and WorldCom. But "we don't know exactly how many companies are involved, and I don't think the dust will settle for quite a while," he added.

The U.S. Attorney's Office in San Francisco did not respond to a request for comment by press time. The U.S. Attorney's Office and the SEC typically do not comment on ongoing investigations.

- Dylan McGrath
EE Times

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