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Juicy Details in Option Scandal

Times Staff Writer

The stock option backdating scandal hadn’t been reading like great fodder for Hollywood. Then the government laid out its case against former Comverse Technology Inc. executives.

The court papers released last week are rich with material -- imaginary employees, a slush fund named for “The Phantom of the Opera” and a botched coverup. Now we’re getting the kinds of details that can overcome the eye-glazing effect that the term “option backdating” induces.

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

More important, the Comverse case could put to rest the idea that what went on with stock options at many technology companies in the 1990s and early 2000s amounted to a minor bending of the rules -- practices that, even if shareholders had known about them, wouldn’t have troubled anyone much.

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Three years ago, the mutual fund industry had the same initial response to the trading scandal that ultimately enveloped it.

Then, as now, many of the people involved asserted that very little of what went on rose to the level of a crime.

But that wasn’t true about abusive mutual fund trading, and the government clearly thinks it isn’t true about abusive option practices.

“People who are trying to minimize this are missing the point,” says Harvey Pitt, a veteran securities lawyer and a former chairman of the Securities and Exchange Commission. “This is cheating. This isn’t an ambiguous situation.”

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The SEC says it has more than 80 companies under investigation for possible option abuses. Much more frightening to tech executives is that the Justice Department is bearing down with criminal cases, and has filed two in a period of three weeks.

On July 20, federal prosecutors in San Francisco charged two former executives of San Jose-based Brocade Communications Systems Inc. with securities fraud related to how they handled, and handed out, stock options.

Prosecutors in New York followed last week with a criminal case against three former Comverse executives, also alleging deceit in option practices. In a civil case filed against the three, the SEC said it found fraud in Comverse options dating as far back as 1991.

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.

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Get 5,000 options at $20 a share. If the stock zooms to, say, $40, you exercise the options, buy at $20 and then sell at $40. You’ve made $100,000, just like that.

But there are certain rules that companies are supposed to follow in issuing options to employees. One is that the exercise price of an option generally is presumed 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 just one example from the Comverse case, the government alleges that executives had the voicemail-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.

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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 could do the same: Don’t buy a stock now; wait a month, then lock in whatever the lowest price was in the previous weeks. Who wouldn’t want such a deal?

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 “The Phantom of the Opera.”

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

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Prosecutors pray for those kinds of details in complex white-collar crime cases, notes Jacob Frenkel, a former federal prosecutor now in private practice in Maryland. “Making up employees is something that any juror can understand,” he 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? Didn’t everybody win?

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, after he wired $57 million to Israel. (He holds dual U.S. and Israeli citizenship.)

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Patrick McGurn, a corporate governance expert at investor advisory firm 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, in fact, options were handed out at cherry-picked exercise prices below the market price, companies were supposed to record the difference between the two prices as an expense, reducing earnings.

Because no such earnings reduction was recorded by Comverse, or by perhaps hundreds of other companies that may have engaged in option backdating, earnings reported by these firms over the last decade or longer now appear to be lies.

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If lying to your investors isn’t fraud, what is it? And if you lied about your options program, what else did you lie about?

Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the web, visit: latimes.com/petruno.


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