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September 17, 2006

High Tech Executives Create Volatility In Their Stock to Enable Options BackDating - Elan Corp, Microsoft, Sandisk Corp, Apple Computer Inc

posted by MR WAVETHEORY at 9/17/2006 09:28:00 PM
ISS, the Institutional Investors Service, has put together a wonderful overview of the options backdating scandal. What I find very egregious is the way some of the companies have exploited investors - particularly technology companies - by fattening the wallets of executives at the expensive of individual investors. I will discuss
  • what is options back dating, providing examples of high tech companies that back date options.
  • how options back dating may be the reason why high tech stocks are so volatile
  • why high tech executives purposely create volatility in their stock so that they can backdate their options.
What is Options Back Dating?

An option is the right to buy a stock at a given price. As ISS explains,
Almost all U.S. companies grant options to their top executives “at the money,” i.e., by setting the options' exercise price (purchase price) equal to the stock price on the grant date. That exercise price often is set at the closing share price on the grant date, or at the average of that day’s high and low. Under Section 162(m) of the Internal Revenue Code, at-the-money options are generally considered performance-based compensation that is deductible from corporate tax returns, even if an executive earns more than $1 million a year.
Options back-dating is the process of choosing a favorable date to grant options to executives, oftentimes when the trading price of a company's stock is at its lowest price. As a result, executives get to buy their stock at a low price. The most egregious form of executive greed is spring loading.
A company can also “spring-load” a grant by setting the exercise price right before
the release of news that would cause the company’s shares to rise, or right after the announcement of news that led to a share decline.
Take the example of Elan Corporation, a drug maker, who egregiously practiced spring loading. Elan Corp had a drug candidate called Tysabri which was supposed to be a blockbuster. On February 8th, Elan Corp released earnings and CFO Shane Cook declared triumphantly that Tysabri was going to be a hit,
While it is early days, the initial take-up since launch of Tysabri is exceeding all our expectations and we remain optimistic that we will return to profitability by the end of 2006.
Unfortunately for shareholders, Cook, true to his name, was cooking the books, because less than three weeks later, the company announced that it would be s
uspending trials of Tysabri due to deaths due to 2 severe adverse events that happened in clinical trials. Tell me that they didn't know about the 2 severe adverse events just three weeks earlier! Elan stock cratered from $26.90 to $3 - but not before executives had unloaded several million shares at prices above $20 per share in the three weeks between the earnings announcement and the suspension of Tysabri.
Elan is just one example of spring loading. Take for instance the example of Microsoft which is leading blue chip technology stock. Microsoft consistently practiced options backdating for 7 years according to ISS.
Microsoft awarded stock grants to employees at monthly lows from 1992 to 1999. A spokesman for the software giant said the practice was legal and did not constitute backdating because the grant prices were set at the lowest price in the 30 days after the grants. Also on June 16, Home Depot disclosed three instances before December 2000 where executives received stock options with exercise prices that were below the market price on the day they were approved.
How can this be legal? How could it have gone on for so long? Let's cut to the chase: Springloading is insider trading.

How Options Back Dating May Be the Reason High Tech Stocks Are Volatile?

Every investor knows that high tech stocks are very volatile. It is not unusual to see stocks like Apple Computer Inc, Google, SanDisk Corp can go up or down 20-30-40% during a period of several months and end up at the same place they were at, at the end of the year. Individual investors who buy high tech stocks at their high and sell their stocks at the low lose lots of money due to volatility.

Many people believe high tech stocks are volatile because technology is hard to understand or predict. I disagree. They are volatility because executives want cheap options. Executives of high tech companies are incentivized to create volatility in their stock prices so that they can take advantage of options back dating. The process is simple. Release bad news, make the stock go down, grant yourself options. Release good news, make the stock go up, exercise your options. Think about it. This is free money. If you were awarding yourself options, why not create volatility? If Microsoft stock stayed at the same price all the time, then how would a Microsoft executive make money?

When executives know they can get away with spring loading and backdating, investors lose money and suffer from inefficient markets.

Why does volatility benefit executives? Why do investors lose?

Volatility benefits executives by allowing executives to grant themselves cheap options. It's that simple. When a stock is mispriced due to misinformation in the markets, high tech executives are implicitly stealing from shareholders who paid a fair price for their stock. They are granting themselves stock at a discount to fair value. In any rational sense of the word, this is theft. The list of high tech companies that are back dating offenders is very long. Calpers sent letters to some of the best known companies in Silicon Valley regarding backdating.
Affiliated Computer Services Inc, Altera Corp, American Tower Corporation, Analog Devices Inc, Brooks Automation Inc, Caremark Rx Inc, Comverse Technology, F5 Networks Inc, Jabil Circuit, KLA-Tencor Corp, Maxim Integrated Products, McAfee Inc, Meade Instruments Corp, Medarex Inc, Openwave Systems, Power Integrations Inc, RSA Security, SafeNet Inc, Semtech Corporation, Sepracor Inc, Sycamore Networks (Nasdaq SCMR), Trident Microsystems (Nasdaq TRID), UnitedHealth Group Inc, and Vitesse Semiconductor (Nasdaq VTSS).
The Cure
When all is said and done, options do not align the interests of managers with shareholders.
Options incentivize managers to create extreme deviations between price and value of a company's stock, so that managers can benefit from a stock's recovery to fair value. In order to cure this problem, a solution must be implemented that makes options backdating and spring loading crimes with steep penalties. I propose the following 3 steps to be taken retroactively on perpetrators of backdating and spring loading.

1) Fine CEOs and board members of companies who approve back-dated stock options grants. The source of the problem of backdating is oftentimes the lack of board control over the compensation process or board members and executives turning a blind eye on the process. Nailing the source will cure the problem. While recent improvements in financial securities law like Sarbanes Oxley have placed stricter guidelines around public reporting companies, Sarbanes Oxley only requires CEOs and CFOs to sign off on the the accuracy of their financial reports and financial controls, not the integrity of their compensation programs. A law similar to Sarbanes Oxley should be created to create standards around companies that are granting executive stock options.

2) Fine the grant recipients treble (3x) the value of the options granteed. Make recipients disgorge not only the options granted but 3X the value of the grant. This will reinforce a corporate ethic that alerts executives to the fact that employees work for shareholders and not the other way around. They serve at the pleasure of shareholders.

3) Set strict federal sentencing guidelines around options backdating. When the laws are clearly set, there is no way to dispute that someone is breaking the law. When insiders act on their on behalf to benefit themselves using material non public information, it is insider trading. Backdating is insider trading.

Shareholders and investor have a duty to protect their rights. When simple insider trading laws are not strictly enforced by organizations like the SEC, the government has failed to protect shareholders and investors who lose their hard earned money. We are in an era where the value of information has increased so significantly that backdating and spring loading must be eradicated.

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