In options backdating scandal, shareholders are real victims

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The stock-option backdating scandal hadn't been looking like great fodder for screenwriters. Then the government last week announced its case against Comverse Technology Inc.

Imaginary employees, a slush fund named for "Phantom of the Opera," a fugitive chief executive--now we're getting the kinds of details that can overcome the eye-glazing effect that the term "option backdating" can induce.

This ought to at least be good for a cheap made-for-TV movie.

The initial response from some technology companies caught up in the option mess was that people were misinterpreting some long-standing industry practices, and that very little of what went on really rose to the level of a crime.

But the government clearly has a different view. The Securities and Exchange Commission says it has more than 80 companies under investigation. And in a period of three weeks, the Justice Department has brought two criminal cases.On July 20, federal prosecutors in San Francisco charged two former executives of Brocade Communications Systems Inc. with securities fraud related to how they handled, and handed out, stock options.

Prosecutors in Brooklyn, N.Y., followed last week with a criminal case against three former Comverse officers, also alleging deceit in option practices.

Even if the charges prove true, were these victimless crimes? Some of the rhetoric from defense lawyers makes it sound that way. But if shareholders and potential shareholders of these companies were deceived, as the government alleges, weren't they victimized?

Options--rights to buy stock at a specific price for a set period--have been the currency of the technology realm for two decades. Companies used them as a tool to recruit and retain workers. If a business prospered, and its stock soared, options were tickets to magnificent wealth.

But companies are supposed to follow certain rules in issuing options to employees. One is that the exercise price of an option generally is supposed to be the market price of the stock on the date the option is granted.

At the heart of the backdating scandal is that some firms played fast and loose in deciding on option grant dates in the '90s and early 2000s. If you could cherry-pick the grant date, after the fact, you could boost the potential payoff from an option.

In one example from the Comverse case, the government alleges that executives had the voice mail technology company's board approve option grants on Nov. 28, 2001. But instead of pricing them that day, when the stock closed at $21.01, the officers reached back to price the options as of Oct. 22, 2001, when the stock ended at $16.05--which just happened to be the second-lowest price of that year.

So recipients of those options, who included the three executives charged in the case, had an instant paper gain of nearly $5 a share on those grants.

Imagine if average shareholders had such a deal: Don't buy a stock now; wait a month, then lock in whatever the lowest price was in the previous weeks.

The former executives of New York-based Comverse, led by founder Jacob Alexander, had an even more complex fraud going for years, the government alleges: They created make-believe employees and submitted the phonied-up names to directors for option-grant approval. Those grants then were transferred to a slush fund account under the name of "I.M. Fanton," which was derived from phantom--as in "Phantom of the Opera."

The unnamed assistant who kept track of the phantom account so named it after seeing the movie version of "Phantom of the Opera," according to an FBI affidavit filed in support of the government's case. The assistant chose that name because "it fit what he/she was being asked to do (i.e., create phantom employees)," the affidavit said.

Alexander awarded the slush-fund options to real employees as he saw fit, but without the board's approval, prosecutors say. One use, former Comverse Chief Financial Officer David Kreinberg allegedly told investigators, was to deal with "disgruntled" workers who might seek to leave the company if they didn't get more compensation.

Therein is one of the angles defense attorneys are likely to use in arguing that backdated option awards helped, rather than hurt, shareholders of the companies involved: If the options allowed the company to hang on to talent, wasn't that good for shareholders?

It would be interesting to hear from Alexander on this subject. But he seems to have disappeared; the government said last week it was trying to find him.

Patrick McGurn, a corporate governance expert at Institutional Shareholder Services, puts it this way about option backdating: "If it was such a wonderful practice, why wouldn't you disclose it?"

Indeed, the basic issue the government has with backdating is that public shareholders never knew about it. They were told almost uniformly by companies that options only were issued at the price on the date of the grant.

If lying to your investors isn't fraud, what is it?

Tom Petruno is a columnist for the Los Angeles Times, a Tribune Co. newspaper.

Copyright © 2014, Los Angeles Times
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