Backdating Blues

Some people think this stock options issue is trivial – or that it will go away soon. Don't bet on it.

The options practices of many technlology companies are now under investigation for a variety of options abuses – most notably "backdating," or retroactively giving employees a lower strike price from a date prior to when the options were issued. (See Options Scare Hits SafeNet, Juniper, Vitesse Gets Subpoenaed, SafeNet Gets Subpoenaed, Feds Call on Juniper, Backdating Could Bite Juniper Execs, and SEC Informaling Broadcom .)

But the dismissive reaction we've heard from technology companies on potential stock options abuses has led me to one conclusion: Most technology executives still put shareholder interests a rung below their own.

I believe that stock options, in general, are a beautiful and beneficial thing. They help motivate the management and employees and align their interests with shareholders. When handled properly, the use of stock options to spur achievement is a great American business practice. There is no reason to do away with stock options. Let's just do it right.

When handled improperly, stock options can be treated like the worst fiat currency – Monopoly™ money printed at will and used to inflate salaries unjustifiably. In the heady days of the 1990s, it seemed as if many employees took leave of their senses and never thought of stock options as being related to a company's earnings potential. Many learned to think of them merely as risk-free poker chips that could be had at no cost – and flipped when the market hit a hot streak.

Some people are surely going to argue that even if backdating was done, in many cases it was perfectly legal and thus a reasonable thing to do. Cheating on your wife is legal, too, so does that mean you should do it?

Now, we don't yet know all the details of which companies did exactly what. But it is clear from much of the evidence that some of the practices were likely pervasive, and that many employees still treat stock options in a cavalier manner.

So what's the problem? Well, options costs the shareholders money. In simple terms, a company must print up, or buy, additional shares of stock so that they can issue new options to employees. This results in dilution of the share base – or a depletion of cash from a company's bank account when it has to buy back stock to counter the dilution. In the cases in which options were retroactively dated, employees are being rewarded ahead of the shareholders. This equates to taking money straight out of shareholder pockets.

Options granted to employees are supposed to serve as an incentive for performance as measured by earnings. Funny though, you are supposed to get the reward after the perfomance, not regardless of it.

In fact, backdating frontloads the reward, without regard to performance. Let's say an option is granted a lower price established in the past, when we know for a fact that the stock is 10 percent higher today. That's not a reward for performance, that's a gift. This is the equivalent of handing that person money, prior to the delivery of any results.

Hey, I know a good deal when I see one – and in Vegas I've never been told what the next blackjack card was going to be before I bet. Backdating is cheating, pure and simple.

Now, there are complexities, but the paper trail is sure to unwind. As the details of the backdating practices are unraveled, you can be sure that many technology executives are going to whine that their lawyers and accountants told them to do it. That's the saddest part of the whole thing.

Might some brave executive finally come out behind the lawyer/accountant firewall and just fess up that the whole thing is wrong? I doubt it. Greed and cowardice dance well together. But those who try to obscure the issue will find an unhappy ending: Investors won't like it one bit, and they'll sell their stock.

As we learned with Enron, just because your lawyers and accountants say it's OK, it may not actually be the right thing – or the smart thing – to do.

Options backdating is just wrong and, for the remaining bubbleheads who don't believe this, it's time to finally get a clue.

— R. Scott Raynovich, Editor in Chief, Light Reading

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