FAQ: Behind the stock options uproar

At least 80 companies are under SEC investigation for backdating stock option grants. Is the practice illegal?

The tech industry's stock option backdating scandal appears to be gathering steam.

Last week, federal investigators announced criminal charges against former executives of Brocade Communications Systems, and they're hinting that more cases may be on the way. Meanwhile, Silicon Valley's top lawyers are scrambling to assuage their clients' fears, and the U.S. Security and Exchange Commission has said that the investigation will expand beyond technology companies to other publicly traded outfits. Already, some companies have begun restating years worth of financial results.

To try to answer some questions about what's going on, CNET News.com has compiled the following list of frequently asked questions.

Q: What is stock option backdating?
Backdating, which refers to the practice of altering the dates of grants, is a way for employees of a company to make additional money from stock options. While it's not necessarily illegal, in many cases it could be.

Q: Which companies are under investigation?
The Securities and Exchange Commission said last week that at least 80 companies are the subject of a probe.

Also, some companies have independently confirmed that they've been contacted by federal investigators. Those include Altera, Applied Micro Circuits, Asyst Technologies, CNET Networks (publisher of CNET News.com), Equinix, Foundry Networks, Intuit, Marvell Technology Group, RSA Security and VeriSign. In addition, other companies, such as Apple Computer and The Cheesecake Factory have announced their own, preemptive investigations.

Q: How do stock options work?
Stock options give the recipient the right to buy a share of a company's stock at a price called the strike price, which is equal to the value of the stock on a certain date. If, for example, the strike price is $10 and the shares now trade at $15, each option would be worth $5. (The options would be worthless if the stock fell to, say, $7.)

Think of options as coupons you can sell. If you have a coupon to buy a Ferrari for $110,000, and the market price of the car is $120,000, your coupon is worth $10,000. But if you're lucky enough to have a coupon that lets you buy a Ferrari for a mere $50,000, your piece of paper would have a far more handsome market value of $70,000.

The same goes for stock options. If an executive is able to change the grant date of an option retroactively--for instance, to when the stock was trading at a lower price--the options become more lucrative. That's what some corporations allegedly did.

Stock options by themselves are not problematic or controversial. They're a way to recruit and retain good employees, and they tend to align employees' interests with those of shareholders. Millions of Americans hold stock options. What's at issue here is whether some top executives--typically CEOs--committed fraud when obtaining them.

Q: How widespread is the practice of backdating?
Nobody knows for sure. One method academics have used to measure the pervasiveness of backdating is to review stock option grants to executives to see if an unusual number are clustered around dates when the stock is trading at a low value. Then, when the stock increases, the executives benefit.

Q: What has this technique shown?
Erik Lie, a finance professor at the University of Iowa's College of Business, has evaluated thousands of option grants and found that it was statistically improbable for them not to have been backdated at many companies.

A paper (click for PDF) that Lie and Randall Heron, an associate professor at Indiana University's business school, published on July 14 estimates that 18.9 percent of unscheduled grants to top executives from 1996 through 2005 were backdated or manipulated. The pair estimates that 29.2 percent of firms manipulated grants to top executives at some point between 1996 and 2005.

Q: Under what circumstances is backdating legal or illegal?
Backdating is not necessarily illegal. If a company's executives are up-front about it with shareholders and the government, everything's probably fine.

The problem, though, is that the allegations that have come to light have not included full disclosure to shareholders, payment of extra applicable taxes, and earnings statements that reflect the modified grant dates. Any of those three categories could yield civil (and perhaps criminal) legal action.

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