San Diego You'd love to place a bet on a horse after the race is over and collect your winnings without getting caught and fitted for cement boots. Don't laugh: almost daily we're finding out that top corporate executives have been pulling off such chicanery. Not surprisingly, San Diego got in on the caper early.
In the last couple of months, about 50 corporations have admitted they are being investigated for backdating stock options. In the 1990s and into the early 2000s, it appears to have been one more way for greedy executives to screw their stockholders. The practice seems to have abated sharply in 2002 after Congress passed the tough Sarbanes-Oxley Act, which business lobbying organizations now want to emasculate.
Stock options give executives the future privilege of buying shares in their company at the price they were trading for when the board of directors approved the arrangement. Presumably, good management will cause the stock price to rise, netting the execs a nice profit and tying their performance to the stock's price.
But criminal and civil investigators are looking into a repugnant practice: secretly backdating that stock option to the lowest possible price. The executives then get a double-martini effect: because the original price was artificially low, their profit is artificially high. The practice can be legal if it is disclosed in corporate filings (as is typical, many smelly activities are technically legal if disclosed in legal Latin in fine print).
Early this year, the Wall Street Journal did a series of stories exposing options backdating. But one of San Diego's examples actually came to light three years ago in the charges by the Securities and Exchange Commission against Peregrine Systems, the biggest fraud in San Diego's history.
The agency charged in 2003, "At each quarterly board meeting, Peregrine's board of directors approved the total number of stock options that could be granted to employees before the next quarterly board meeting. Peregrine then allocated the options to employees during the quarter but did not price the options until the day after the next quarterly board meeting. On that day, Peregrine's stock administrator looked back at the market price of Peregrine's stock between the two quarterly board meetings to find the lowest price at which Peregrine's stock had traded. That is where Peregrine set the stock option exercise price, to benefit those who received the stock option." (Italics mine.)
Under accounting rules, Peregrine should have recorded those nifty sub-rosa bonuses as compensation expenses. It didn't do so. So the Securities and Exchange Commission said that Peregrine had thereby understated its expenses by approximately $90 million during the period of the fraud.
The company that backdates stock options may use other backdating techniques to rig its books. As criminal and civil charges have revealed, Peregrine was an expert at fraudulent backdating. It usually used backdating ruses to overstate sales, not understate expenses. Repeatedly, it used these tricks to shift sales from the quarter in which they had taken place to the previous quarter, so the company could meet Wall Street's expectations.
The U.S. Attorney's indictment of Peregrine officers in January 2003 listed several of those backdating bunco games. The defendants "would backdate, white-out, and remove fax headers from sales documentation in order to fraudulently conceal the fact that these deals had actually closed after the end of the fiscal quarter," charged the grand jury. Peregrine had a fax machine "that magically time-stamped any contract as having arrived before the end of the fiscal quarter."
Peregrine executives joked that contracts were signed on the 37th day of the month. One of the indicted executives, Douglas Powanda, joked that he wanted to start a company, "End of Quarter.com," that would "specialize in signing sham deals for public companies in exchange for money," said the grand jury. (Powanda had a knack for accumulating money. He sold $25 million of Peregrine stock before the collapse. He also sold his Rancho Santa Fe digs to none other than former representative Randy "Duke" Cunningham for $2.55 million.)
Many of the companies under backdating investigation behave the way Peregrine did: execs and board members are more interested in running up the stock than running a reputable company. The Securities and Exchange Commission and U.S. Attorneys' offices in both Northern and Southern California are looking into past practices at Applied Micro Circuits, which just recently moved its headquarters from San Diego to the Silicon Valley but still has a big plant here. This company's stock peaked at $110 in 2000 and now trades below $3.
Former chief executive David Rickey was known for his rich compensation. From early 1998 to early 2000, he reduced his number of shares from 3.5 million to 604,000 when the stock was zooming toward $100. He had paid 7 cents apiece for his initial shares. In addition, by early 2000, he was sitting on options worth $220 million. In early 2001, the New York Times reported that Rickey had amassed $170 million by dumping 99 percent of his stock beginning in 1999. Rickey attacked the paper and said he still had options on 5.7 million shares.
Applied Micro Circuits named a new management team last year. It has delayed filing its annual report while it investigates options backdating over a seven-year period. It is not known whether the investigation involves shares granted Rickey.
Some prominent companies known for excessive executive pay are being probed for backdating. William McGuire, chief executive of Minnesota-based UnitedHealth Group, holds options worth $1.6 billion that are exercisable. He also is in line to get $100 million in pension benefits. The chief financial officer could cash in $663 million of options today. The state attorney general is looking into the company's option policies. So are the U.S. Attorney for the Southern District of New York and the Internal Revenue Service.
The Securities and Exchange Commission is looking into home-improvement retailer Home Depot, which is infamous for fat executive pay. The company found that some executives had been awarded options at below-market prices. Options expense of $10 million had not been recorded.