Companies Should Confess, Correct Backdating

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The New York Sun

What is the real cost of the backdating scandal? It’s the skidding back to “Go” on the path to rebuilding investor confidence.The fault lines between investors and managements created by the Enron, WorldCom, and Tyco scandals have only begun to close; new fissures have now opened in the wake of disclosures from more than 60 companies that their options grants were tainted.

The other real cost is the squashing of any real probability that the more cumbersome aspects of Sarbanes-Oxley would be watered down. In particular, a softening of Rule 404, which charges management with guaranteeing internal controls, and the easing of compliance for smaller companies which seemed possible, especially with the imminent retirement of Senator Sarbanes, a Democrat of Maryland, and Rep. Michael Oxley, a Republican of Ohio. The number of companies choosing to list on overseas markets, eschewing the complications of U.S.regulation, fed the enthusiasm for a rethink on Sarbox.

We’d like to meet the legislator who is going to advocate for loosening the regulatory ties. Americans have become genuinely hostile to corporate managements. The all-too-recent scandals, combined with many instances of outrageous executive compensation, have not sat well in a period of restrained hiring and only modest wage increases. The options scandal feeds this distaste.

The bad news is that there is apparently a lot more to come. Hundreds of people listened in on a conference call last week hosted by Institutional Shareholder Services during which a University of Iowa professor, Erik Lie, one of the leading academic authorities on the issue, suggested that as many as 1,000 companies may have engaged in backdating of options, or, to use his words “did something fishy.”

In an e-mail message, Mr.Lie said the number is actually closer to 2,000. He recently co-authored a paper on the subject with Randall Heron of Indiana University, in which they conclude that an estimated 29% of nearly 8,000 firms studied manipulated stock grants to executives between 1996 and 2004. Especially prone to abusing the options process were tech firms, small companies, and companies with volatile stock prices.

This is bad news, indeed. The possibility of a quick resolution to the options issue flies out the window if there are hundreds more cases to come. Although there are certainly other problems weighing on the market, a widespread corporate scandal cannot be helping.The tech stocks have been particularly bruised by the scandal, as that sector more than most relied on options as a competitive weapon in hiring and retaining employees.

What’s to be done? The other participants in the conference call, ISS’s Patrick McGurn and a Chartered Financial Analyst Institute representative, Kurt Schacht, called for companies to come clean about their options programs as quickly as possible. Both acknowledge that many of the timing issues were not criminal, but agree that attempting to cover up misdeeds may lead to criminal or civil charges.

There is urgency in this suggestion because all parties recognize that it is the shareholder who will get hurt, yet again. The longer the uncertainty persists, the greater the toll taken on stock prices. Mr. Schacht urged shareholders to refrain from rushing to judgment, pointing out that the real financial impact of backdating for most companies was modest at worst and insignificant at best. While not defending the practice, he also reminded listeners that options backdating did not constitute putting cash illegally in someone’s pocket, but rather gave the recipient a head start on a several-year process of benefiting from a rising stock price.

There is some solace that regulations imposed in 2002 apparently stemmed much of the backdating activity. According to Mr. Lie, incidences of fishy behavior definitely dropped. They did not altogether disappear,however.Consequently, recent suggestions sent to the SEC by the CFA attempting to stem the practice by increasing director oversight will likely receive a warm welcome.

Mr. Schacht, in a telephone interview, said the proposals focus on creating complete transparency in the options granting process. The CFA suggests that all information relating to meetings of the compensation committee and to awards granted by the committee be included in a company’s proxy statement or 8-K filings. It further asks the comp committee to “determine and disclose” if any grants were timed to profit from the release of material information.

Mr. Schacht said he believes the SEC is likely to incorporate the CFA suggestions into its upcoming overhaul of executive compensation disclosure. According to John Heine of the SEC, the agency will review staff suggestions on management compensation in the next few months; disclosure about options and stock awards will undoubtedly receive a lot of attention.

It seems unlikely that the backdating and “springloading” controversies will be resolved any time soon. As Mr. Schacht points out, it is not yet clear what the legal issues are; even the SEC is divided. Further, even if backdating has been made more difficult by narrowing the reporting requirements, spingloading is still in play. Echoing the CFA and ISS, the best resolution may well be for companies to “confess and correct.” The sooner the better, please.

The New York Sun

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