FAQ: Behind the stock options uproar

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.

Q: What kind of legal charges could companies face?
It depends on the individual circumstances. But in general, backdating a stock option (without communicating this to shareholders) could run afoul of tax laws, securities regulations and laws prohibiting fraud.

The Securities and Exchange Commission, the U.S. Attorney's office in San Francisco, and the U.S. Attorney's office in New York have been conducting parallel investigations.

Q: Would the IRS get involved?
Paul Caron, a visiting professor at the University of San Diego School of Law and author of the TaxProf blog, outlined two possible tax law violations in an e-mail to CNET News.com.

One consideration, Caron said: Did the companies take the backdating into account when calculating how much they owed under the tax code, which limits a public company's deduction of employee compensation to $1 million? Second, do the backdated options constitute "nonqualified deferred compensation," in which case the companies may be liable for excise taxes?

Q: Why are companies restating earnings?
If they had stock options that were backdated and not disclosed, that essentially provides executives (or other employees, but typically executives) with extra compensation. That's an expense that must be disclosed to shareholders.

Q: What's going on with Brocade Communications Systems?
Federal officials held a press conference on July 21 in San Francisco to announce civil and criminal charges relating to allegations of stock option backdating by former top executives of the networking-gear manufacturer.

Gregory Reyes, Brocade's chief executive until 2005, and Stephanie Jensen, the company's vice president of human resources from 1999 to 2004, are facing civil and criminal charges. In addition, Antonio Canova, Brocade's former chief financial officer, is facing civil charges.

Q: What are the allegations against Reyes?
The FBI has not alleged that Reyes backdated stock options for his own financial benefit. Rather, he's accused of backdating stock options to lure an unnamed employee to take a "high-level sales position." An FBI affidavit says Reyes told Jensen to backdate an offer letter by more than two months to benefit from a more favorable share price in late 2001.

Reyes' attorney has defended his client as wrongly accused, saying "financial gain is always the motive in securities fraud cases, and here there was none. There is not even an allegation of self-enrichment, or self-dealing."

Q: That's backdating. What's "spring-loading?"
It's almost the opposite of backdating. The stock options are awarded just before news, usually positive, is announced. The shares increase in value and--presto--the options are worth more. It works like this: If a CEO expects to make a new product announcement, he could allocate himself options when the stock is valued at $20. Then, after the announcement boosts the share price to $25, each option would be worth $5.

In a conference call on July 13 to announce a federal stock option task force, U.S. Attorney Kevin Ryan said the task force will be investigating spring-loading as well. "Then you have both insider trading and you have an accounting issue," Ryan said. "An old-fashioned cooking-the-books fraud."

Q: Would fixing executives' grant date to, say, July 1 every year fix things?
Even if grant dates are fixed and happen at the same time every year, there's still room for shenanigans. Academics have found some evidence that CEOs time the release of negative information to happen just before a scheduled grant date, and release positive information after a scheduled grant date.

Q: How did the Sarbanes-Oxley (SOX) law change things?
After Sarbanes-Oxley took effect in August 2002, companies were supposed to report stock option grants within two days. That makes backdating more difficult and is generally thought to have curbed the practice.

But Sarbanes-Oxley probably has not eliminated backdating. A November 2005 paper (click for PDF) by M. P. Narayanan and H. Nejat Seyhun, finance professors at the University of Michigan's business schoool, analyzes grants made before and after the law's effective date.

They found that about 24 percent of stock option grants are reported late. The conclusion? "Backdating and camouflaged timing appear to be practiced even after SOX, especially by smaller firms."

In a follow-up paper (click for PDF), Narayanan and Seyhun add: "We find that executives can increase their compensation even in the post-SOX era by playing the dating game and reporting their options late. Our findings indicate that a manager receiving a large grant of 1,000,000 shares of a typical company's stock can increase the value of their grant by about $1.23 million, or 8 percent, by reporting 30 days late."

Q: Why is there this emphasis on stock options? Why don't CEOs just ask for a raise?
Blame the U.S. Congress. Sec. 162(m) of the U.S. tax code limits companies' ability to deduct pay for certain executives if the amount exceeds $1 million a year.

There's an exception in the tax code, however, for "performance-based compensation," which includes stock options. So companies can save on taxes by handing out lucrative stock options instead of lucrative salaries. In addition, executives themselves benefit by exercising the stock option and waiting a year to sell the stock. That qualifies as a capital gain and is currently subject to only a federal income tax of only 15 percent.

Why else would Apple CEO Steve Jobs, Yahoo CEO Terry Semel, and Google CEO Eric Schmidt only ask for $1 in salary? (In fact, if Congress had simplified the tax code and made CEO salaries fully deductible, it's likely that no backdating scandal would have occurred. Of course, honest CEOs would help too.)

Q: What lawsuits have been filed by investors over stock option backdating?
Apple faces a number of suits filed on behalf of shareholders and pension plans in federal and state courts in California. The complaints, which accuse company executives of manipulating stock options to maximize returns, name past and present officers, such as Jobs, Chief Financial Officer Peter Oppenheimer and even Apple board member and former U.S. Vice President Al Gore.

A handful of cases involving similar allegations and parties are pending in California federal court against chipmaker Rambus. And earlier this month, video game software company Activision revealed in a financial filing that it had been sued in Los Angeles Superior Court for "purported improprieties" in its handling of past stock option grants.

Other targets of similar suits include semiconductor manufacturer KLA-Tencor and wireless and broadcast communications site operator American Tower.

Outside the tech sphere, health care services provider UnitedHealth faces several suits in Minnesota federal court filed by individual shareholders and pension funds claiming the company's top executives and board members received billions of dollars worth of illicit stock option grants.

CNET News.com's Anne Broache contributed to this report.