American economy under threat from notes on a scandal

The Times December 09, 2006

Tom Bawden in New York

In March it was merely a scandal, laid bare by the news that the Securities and Exchange Commission (SEC) was investigatng suspected cases of stock-option back-dating at a dozen companies in the United States. Now that scandal, itself getting bigger and deeper almost by the day, is threatening to do real damage to the American economy.

Since March, the number of American companies that have disclosed internal or government probes into their stock- option practices has soared to more than 160. Affiliated Computer Services (ACS) was the first company to be named in the SEC’s investigation, but, after it was named, it quickly became apparent that the watchdog suspected that scores of other companies could be guilty of the practice.

At the time, the investment community drew comfort from the fact that suspected cases were almost exclusively confined to fledgeling Silicon Valley companies during the dotcom boom of the late 1990s. These companies, it was argued, did not have the cashflows to pay skilled executives, so instead had lured them with mouthwatering stock-option packages, made sweeter by manipulating the “grant” date to a time when they would be more beneficial to the holders.

The admission in October by Apple Computer, by no means a fledgeling company, that it, too, had manipulated stock options blew a large hole in that notion.

At around the same time, chief executives at some of the companies under investigation began to fall like dominoes. To date, at least 60 senior departures have been clocked up. Mark King, chief executive of ACS, was among the victims, resigning with his finance director at the end of last month. An internal investigation concluded that they had been closely involved in manipulating stock options.

Last week came the biggest scalp so far when William McGuire, the chairman and chief executive of UnitedHealth Group, the health insurer, was sacked after 15 years. UnitedHealth’s board voted unanimously to dismiss him after deciding that his explanations for a pattern of unusually well-timed stock- options grants did not add up. Dr McGuire and Stephen Hemsley, who succeeded him this month, agreed to forfeit a combined $390 million (£200 million) in stock-option compensation, by far the biggest payback of the scandal.

And still there is more. This week Home Depot, America’s second-biggest retailer and its largest DIY chain, admitted to “routinely” changing the dates of its stock-option grants to benefit employees from 1981, the year in which it went public, to November 2000, the month before Robert Nardelli took over as chief executive.

Larry Brown, Professor of Accountancy at Georgia State University, said: “The Home Depot case tells us that the back-dating of stock options is not just a high-tech phenomenon and not just something that happened in the late 1990s.

“It has been going on at much larger firms and for much longer than we thought. It is bound to put some foreign investors off the US as they draw the conclusion that the US is more corrupt than they previously thought.”

The practice of back-dating has accounting implications for companies because “in-the- money” stock options must be treated as compensation and accounted for as an expense, since they are, essentially, income. As a result, scores of companies are likely to have to restate several years of earnings. Normally stock options are not accounted for in this way, because when they are granted nobody knows whether the share price will rise or fall so their value cannot be calculated.

It is not clear, either, if the practice is a thing of the past. While the manipulation of stock options is more difficult since a law was introduced in 2002 requiring companies to inform the SEC within two days of granting an employee share options, Professor Brown says that it will be difficult to police effectively. What remains of greatest concern, however, is just how pervasive the practice has been in the recent past and how much of a public relations blow this will be for the American economy.

How the mighty have fallen


March 18 SEC investigation into suspicious practices at 12 companies is revealed


July 26 New rules to combat stock-option fraud


August Kobi Alexander, former chief executive of Comverse Technology, flees to Namibia rather than face charges relating to alleged stock-option fraud


October 4 Apple Computer admits changing grant date of stock options made on 15 days between 1997 and 2002


September 22 Cablevision admits it awarded lucrative options to the late Marc Lustgarten and made it look like he was alive


November 8 William McGuire and Stephen Hemsley of UnitedHealth agree to forfeit about $390m in stock-option compensation


November 26 Mark King, ACS's chief executive, resigns


December 7 Home Depot admits manipulating stock options from 1981 to 2000