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Stock Option Backdating: Ethical and Accounting Challenges

Stock Option Backdating: Ethical and Accounting Challenges. Rick Fezell, Ernst & Young Kirk Hanson, Markkula Center for Applied Ethics, SCU. What is a STOCK OPTION?.

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Stock Option Backdating: Ethical and Accounting Challenges

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  1. Stock Option Backdating:Ethical and Accounting Challenges Rick Fezell, Ernst & Young Kirk Hanson, Markkula Center for Applied Ethics, SCU

  2. What is a STOCK OPTION? A stock option gives an employee the right to buy shares in the future at the market price on the date a grant is approved. If the stock rises, exercise, sell and make a profit. Grant date – June 30 >> $10.00/share market price 1,000 options granted, vesting over 4 years All exercised at the end of Year 4 >> employee pays $10,000. Sold on the same day, $25.00/share >> employee receives $25,000 Gain >> $15,000

  3. What is BACKDATING? Backdating is selecting a date prior to the actual grant when the stock price was lower, thus increasing the award's value. Grant date – June 30 >> $10.00/share market price “Backdated” grant date – May 19 >> $6.00/share 1,000 options granted, vesting over 4 years All exercised at the end of Year 4 >> employee pays $6,000. Sold on the same day, $25.00/share >> employee receives $25,000 Gain >> $19,000

  4. Types of Stock Option Backdating • Paperwork missing from corporate files • Grant date unclear due to unanimous consent • Company policy to give lowest or average price during a period • Backdating to attract a new employee with in the money options; to sweeten a deal • Backdating to enrich value for all employees • Backdating to enrich value for management • Creating false paperwork to justify options

  5. How Was Backdating Detected? • Academics, analysts and news organizations. The WSJ won a Pulitzer Prize for its investigative reporting, which began in March 2006 – The Perfect Payday • Affiliated Computer Services CEO - all six of his stock-option grants from 1995 to 2002 were dated just before a rise in the stock price, often at the bottom of a steep drop. Just lucky? A Wall Street Journal analysis suggested the odds of this happening by chance are extraordinarily remote -- around one in 300 billion. The odds of winning the multistate Powerball lottery with a $1 ticket are one in 146 million. • Maybe insider trading? No, the SEC eventually came to "an increasing realization that the companies were in fact lying about the timing of the grants."

  6. PRIVILEGED AND CONFIDENTIAL PREPARED AT THE REQUEST OF COUNSEL ALL GRANTS DAILY CLOSING PRICE 1/3/00 THRU 12/29/00 $45.00 $22,000,000 MARKET CAP OF GRANTS INTEGRATED SILICON SOLUTION, INC. DAILY CLOSING PRICE $20,000,000 $40.00 REVIEWED GRANTS $18,000,000 $35.00 $16,000,000 $30.00 $14,000,000 $25.00 $12,000,000 SHARE PRICE *MARKET CAP ON DATE OF GRANT $10,000,000 $20.00 $8,000,000 $15.00 $6,000,000 $10.00 $4,000,000 $5.00 $2,000,000 $0.00 $0 01/00 02/00 03/00 04/00 05/00 06/00 07/00 08/00 09/00 10/00 11/00 12/00 * MARKET CAPITALIZATION OF GRANTS WAS CALCULATED BY MULTIPLYING THE CLOSING MARKET PRICE ON THE RESPECTIVE GRANT DATE BY THE NUMBER OF SHARES ISSUED. V-Charts – “The pictures were telling us a story” - WSJ

  7. Who was doing it? 140 Companies under Federal investigation; 70 executives lost jobs and 10 face federal or state criminal charges. Numerous SEC investigations. • KLA-Tencor – Settled with 3 city/state pension plans for $65 million • Brocade – Settled with the SEC for $7M and CEO Greg Reyes convicted and sentenced to 21 months in prison • Monster Worldwide – Deferred prosecution for terminally ill former CEO

  8. Apple, Inc. “Although the investigation found that CEO Steve Jobs was aware or recommended the selection of some favorable grant dates, he did not receive or financially benefit from these grants or appreciate the accounting implications. The Special Committee also found that the investigation had raised serious concerns regarding the actions of two former officers in connection with the accounting, recording and reporting of stock option grants.” – 2006 Annual Report

  9. Why Was it Done? • Intense competition for employee talent • Non-cash – nobody cares and nobody gets hurt • Everyone else does it

  10. Who should be punished? • CEO who directed it be done • CFO who knew it was being done • General Counsel who knew it was being done • VP Human Resources who processed the paperwork • Individuals who benefited from the backdated options

  11. What punishment is appropriate? • Who should be fired? CEO, CFO, Gen Counsel, VP HR, Compensation manager who processed it? • Legal Penalties: None – victimless crime; just fine the company for back taxes and penalties? • Personal fines for individual who ordered it done? • Jail for individual who ordered it done? • Personal fines or jail for person who did backdating paperwork? • Personal fines or jail for “gatekeepers” who knew it was being done (CFO, GC, HR etc)?

  12. What should we learn from the backdating scandal? • “Bubble” periods are ethically risky • Correct accounting is always worth the time • Tax manipulation and fraud -- is fraud • Falsifying documents is particularly dangerous –Obstruction of justice is worse than the act itself • “Gatekeepers” are expected to stand up for what is right • CEOs and others can go to jail for fraud • Other…………

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