If stock options isn't bad enough, the backdating of these stock options are even more blatant!
Here are two set of articles on this issue.
- http://news.morningstar.com/article/article.asp?id=170053
Personally, I think the backdating issue is less about valuation and more about the character of the folks running the companies that are involved. This is something that matters a lot to some investors, and relatively little to others. The first step here is to look into the continuity of the board and executive team from the time the alleged backdating took place until today. In some cases, you may find that there's been near-wholesale turnover in the executive suite, and if that's the case, you may be looking at a stock that's selling off unnecessarily. Don't forget the board, though--if the same board members are still in place, they should be held accountable. (And if any board members received backdated options as a part of their annual grants, they should be publicly flogged.)
So, if the same folks are still running the company, what do you do? In my opinion, backdating options ranks up there with the most blatant accounting frauds by misleading investors on a variety of fronts. It deliberately severs the link between pay and performance while presenting the veneer of a performance-based compensation plan, and it causes overstated cash flow by claiming a tax deduction for a potentially nondeductible expense.
However, all of these issues pale in comparison to one simple point: Executives who engaged in backdating were not putting shareholders first. They were not acting as owner-partners seeking to maximize the value of the firm, but rather as grasping hired hands seeking to maximize their own wealth at the expense of others. At the end of the day, that's all you really need to know.
Here's an article posted on Fortune recently.
- Monday, October 16, 2006
The real options-backdating culprits
Almost every day there's another one, a top executive thrown out of his job for backdating options. These are some otherwise perfectly respectable people we're talking about: William McGuire at United Health, Shelby Bonnie at CNET, Andrew McKelvey at Monster. Even Apple's Steve Jobs has gotten tangled in the backdating web, although there are no signs that he'll lose his job over it.
When supposed wrongdoing is this widespread, one can't help but wonder: Are there really this many willful rule-breakers in corporate America, or did somebody change the rules on these guys in midstream?
I'm tempted to lean ever-so-slightly toward the second answer. What was done was clearly against the rules, but those rules were until recently treated with such disdain in the business world and even by many investors that it's perhaps understandable that so many executives saw no harm in breaking them.
First, a brief explanation of options backdating: Say your company's stock is trading for $15, and it gives you 100 options--expiring in 10 years--to buy that stock at $10 a share. So far, so good. As Holman Jenkins argued in The Wall Street Journal last week (not available online unless you have a financial relationship with Dow Jones & Co.), there's nothing intrinsically wrong with giving employees' in-the-money options. It's just like giving them restricted stock, or cash.
What's wrong is reporting in a company's financial statements that the $10 options were granted at some time in the past when the stock happened to be selling for $10 a share. Until this year, options priced at the money (that is, with the stock trading for $10, you get an option to buy a share for $10) were considered free for accounting purposes--while an option granted in the money (with the stock at $15, you get an option to buy it for $10) was counted as a compensation expense.
This accounting distinction was of course entirely loopy. When last I checked this afternoon, United Health stock was trading at $48 a share. Meanwhile, an option to buy a share of United Health for $50, expiring in Jan. 2009, was selling on the American Stock Exchange for $10. That is, even out-of-the-money options have value.
In 1993, after long deliberation, the members of the Financial Accounting Standards Board--the people who determine what constitutes a General Accepted Accounting Principle--acknowledged this truth with a proposed accounting standard requiring that all employee options be valued with one of the mathematical models widely used in the options-trading world (the Black-Scholes model or the related binomial model).
Then all hell broke loose. In what should go down as one of the most shameful episodes in modern business history, corporate America bullied FASB into backing down. Silicon Valley was loudest in its opposition, but all the big business groups joined in. Joe Lieberman was enlisted as the chief hatchet man on Capitol Hill (his more vocal allies included Bill Bradley, Barbara Boxer, and Phil Gramm), sponsoring a 1994 resolution--which passed 88-9--urging FASB not to change accounting for options, and making threatening noises about effectively shutting the board down if it didn't comply.
There were and still are valid objections to the method FASB proposed for valuing options. It takes a fleeting estimate--the valuation set by the Black-Scholes or binomial model on the day the option is granted--and sets it in earnings-statement stone.
But you can't make a serious accounting case for treating options as free, which is what most of FASB's opponents were after. So they couched their argument in economic terms: By motivating employees and aligning their interests with shareholders, options were promoting economic growth. Expensing options would thus hurt the economy, which made it a bad thing. The same argument can be made about expensing cash paychecks, of course, but that didn't seem to bother anybody at the time.
This victory of politics over accounting logic had consequences. As Warren Buffett, a lonely voice in support of FASB back in 1994, told me in 2002: "Once CEOs demonstrated their political power to, in effect, roll the FASB and the SEC, they may have felt empowered to do a lot of other things too." Buffett was referring to the accounting shenanigans at Enron and Worldcom, but the connection to the options backdating scandal is much more direct.
After the Enron and Worldcom meltdowns, the political climate shifted. More and more companies began expensing options voluntarily, and in 2004 FASB finally pushed through its rule. Starting this year, all options granted to employees have to be expensed.
But the backdating offenses coming to light now (thanks to the work of University of Iowa business school professor Erik Lie) almost all predate 2002. They were committed back in a day when virtually every significant business organization in the country was arguing that options shouldn't be expensed, a view endorsed by the Big Six accounting firms (yes, there were six back then), Congress, and even a lot of big money managers. In such an environment, it wasn't all that out of line for the people at United Health and CNET and Monster and Apple and Comverse and Broadcom and Brocade to think tweaking the grant date of an option was a mere technicality.
I am not saying don't blame them, blame society. I'm saying blame them and society--society in this case consisting of the American Electronics Association, the Business Roundtable, the big accounting firms, Joe Lieberman, you name it. The guilt is shared pretty widely here.
And as if that is not all, how about this article? Back Door Options!
- As backdating options continues to ensnare corporate officers, a Boston-based company called American Tower has faced questions from the SEC and U.S. Attorney's office over its use of backdating. But backdating isn't the only eyebrow-raising element of their compensation strategies.
American Tower (Charts) has a market cap of $15 billion and owns the infrastructure, such as towers and rooftop structures, that wireless companies lease. Last May the company announced that a special committee of independent directors was reviewing its option-granting practices; in September, American Tower said it will have to restate more than three years of financial results. But a close look at its filings also reveals that top executives have made tens of millions from stock in subsidiary companies - information you won't see in the compensation table of its proxy statement.
hidden numbers
In the standard table in American Tower's proxy - the one that lists the salaries, bonuses and other compensation for the five highest-paid employees - you see that an executive named Michael Gearon, the company's vice chairman and the president of its international business, has earned $2 million in cash over the past three years and has gotten 665,000 options.
In 1998, Gearon sold Gearon Communications to American Tower and joined the company. He still lives in Atlanta, where his firm was based, and is a part-owner of the Atlanta Hawks. General counsel William Hess earned $1.8 million in cash and got 370,000 options over the past three years.
But in the tables detailing options exercises there's a footnote that says that during 2004, American Tower's Brazil operation, called ATC South America, granted "certain employees," including Gearon and Hess, options to purchase common stock of ATC South America at an exercise price of $1,349 per share. Those separate options were exercised in October 2005.
The footnote says that the "value realized" by Gearon and Hess was approximately $11.5 million and $2.7 million, respectively, and refers you to another section of the proxy called "Related Party Transactions." This section of proxies became notorious in the wake of Enron, because it's where CFO Andy Fastow's infamous partnerships were actually disclosed to investors.
In this section of American Tower's proxy, you learn that in March 2004 Gearon paid $1.2 million for a 1.6 percent stake in ATC South America; in October 2005, American Tower expects to pay him $3.7 million for that stake. Plus, Gearon got options - worth some $11.5 million a year and a half later - to acquire 6.7 percent of ATC South America. (Hess's options allowed him to acquire 1.6 percent of ATC South America.)
And you learn about another entity, ATC Mexico. Back in 2004, Gearon and Hess exercised their "previously disclosed" rights to require American Tower to buy their stakes in that entity. Afterward Gearon collected $36.2 million, much of it in American Tower stock that has since more than tripled.
If you check American Tower's 2005 10-K, you'll learn - in footnote 11 - that Gearon used just $1.7 million of cash plus a $6.7 million loan from American Tower to buy his stake in ATC Mexico.
So Gearon picked up cash and stock worth well over $30 million (a figure that doesn't take into account the stock's recent uptick) in these side deals - payments that aren't reflected in the compensation table in the proxy.
Hess and the others got some $20 million. Why would Gearon get all this additional money for running the international business when his job description is to run the international business? Why isn't this compensation disclosed in the compensation tables?
"It's a matter of judgment on the part of the company and its advisors," says Kenneth Laverriere, a partner at New York law firm Shearman & Sterling. "It's a close call."
James Taiclet, American Tower's CEO, says these agreements were put in place in 2001 when the international business didn't exist, and were done to provide Gearon and his team with the "incentive to take the risk" of building the business. He points out that Brazil and Mexico now account for 13 percent of the company's revenues and says "shareholders have benefited tremendously." He also says the agreements are "very thoroughly disclosed in the appropriate places."
Not that investors seem to care about any of this. American Tower's stock has doubled since 2005. That has helped Gearon, who's sold stock worth $40 million over that time period, grow his fortune even more
See the same ironic issue? Investors does not seem to care because American Tower's stock has doubled since 2005!
Doh!
Does this mean that as long as the stock doubles, the company and the exceutives could play their funky music any which way?
My oh my, what a wonderful world.
Here's the summary of the Back Door Options as stated on the cnn article.
- How Backdoor Options Work
Deep in American Tower's proxy lurks a sneaky scheme.
1. American Tower sets up a subsidiary.
2. Executives are allowed to purchase stock in the subsidiary.
3. Execs acquire stock through cash and a loan; they also get options to buy more shares.
4. The executives can force AT to buy them out within a certain period of time.
5. AT's purchases net employees millions in profits.
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