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Thursday, Dec 8, 2022

Options Return to Haunt Executives in Backdating Scandal


An oft repeated expression is “beware of what you ask for; you just might get it.” No doubt some of the public companies and senior executives caught up in today’s fast-expanding backdated stock options scandal wish they had paid heed to the wisdom of those words back in the early 1990s.

In 1993, the independent accounting standards-setting body known as the Financial Accounting Standards Board suggested a rule change that would require public companies to list their employee stock option grants as an expense on the company’s balance sheet.

What happened next was pure theater. FASB’s proposal unleashed a firestorm of protest from some segments of corporate America, the most vehement of which came from high-technology companies in Silicon Valley.

CEOs from both high-technology and other companies descended on Washington like a pack of wolves, determined to stop FASB’s proposal to expense stock options dead in its tracks. Companies held emotional rallies with national press coverage to rail against FASB and the SEC for daring to interfere with the way their companies paid their executives. This was especially true for the high technology companies that fiercely defended their right to issue whatever stock options they wanted as an absolute necessity for attracting top talent to their industries.

Instead of making reasoned arguments based on whether expensing stock options was a good accounting practice that would more realistically and honestly describe the financial results of a public company, CEOs and senior executives made emotional and inflammatory arguments that expensing stock options would damage American capitalism and slash much-needed American jobs.

What wasn’t mentioned in all the hullabaloo was that these same CEOs and top executives were the ones most likely to benefit from these inflated pay packages, which relied heavily on the issuance of stock options. If stock options had to be expensed, profits at many companies, especially high-tech companies, would be drastically reduced. This would drag down stock prices and CEOs and senior executives would lose millions of dollars in stock option grants. This fact was not well understood by the public in the 1990s because often companies went to great lengths to obfuscate the true size of total executive compensation and government-mandated executive pay disclosure requirements were minimal.

Companies won

The CEOs and the companies won the stock option battle in the 1990s. Congress sided with them not necessarily because it was the right thing to do for American businesses and the economy, but more likely because both Democrats and Republicans were beholden to companies that gave large cash contributions to their re-election campaigns. Congress voted overwhelmingly to issue a non-binding resolution against expensing stock options, and Arthur Levitt, then chairman of the SEC, convinced FASB to drop its proposal to expense stock options a move Levitt later admitted he deeply regretted.

Throughout the 1990s, stock options were increasingly issued with abandon, growing to staggering proportions and creating a new class of “hired-hand” corporate executive mega-millionaires and even billionaires.

Flash forward to today. More than 100 companies, including a very significant number of high-tech Silicon Valley companies, are currently being investigated by federal regulators for allegedly manipulating the timing of some of these stock options awards in the 1990s.

On Sept. 9, Orange County-based Broadcom Corp. reported that it will have at least a $1.5 billion restatement, and possibly much larger, because of unreported expenses relating to the timing stock options.

Already, five executives have been indicted the former CEO, CFO and senior general counsel of Comverse Technology Inc. and the former CEO and Vice-President of Human Resources of Brocade Communications.

The irony is that if these CEOs and companies had not pushed so hard to thwart the expensing of stock options in the 1990s, they probably would not be mired in scandal today. Today’s new stringent federal requirements under the Sarbanes-Oxley Act of 2002 make it much more difficult for companies to manipulate stock options. Under Sarbanes-Oxley, stock option awards must be reported almost immediately after the options are made. Most, if not all, of today’s civil and criminal cases and massive restatements resulting from the backdating scandal are for 1990s, not current behavior.

Hopefully today’s crop of business leaders will take heed and learn from the mistakes of their predecessors. This backdating scandal is going to hurt.

Linnea McCord is associate professor of business law at the Graziadio School of Business and Management at Pepperdine University. She is an occasional contributor to the Business Journal’s Commentary section.


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