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WSJ Analyzes Stock Option Backdating

WSJOptionsGraphicThe WSJ Saturday edition is quickly becoming one of my favorite reads. The weekly interview in the editorial section is well done and pulls in important people with a low public profile (past guests include Jean LePen, Newt Gingrich, Carlos Ghosn). Page one typically features some in-depth investigative journalism. Last week it was statistical trends on mortgage refinancing. This week it was a well documented article on options backdating, when companies retroactively set the strike price for employee stock options. My previous employer, Vitesse Semiconductor (VTSS) and CEO Lou Tomasetta was profiled as one of the ‘accused’.

VTSS Options Grants

Options backdating is much tougher to execute today. Before Sabanes Oxley, companies had two months to report to the SEC that an option grant event had taken place. In effect, a company could wait to issue options until a clear trough in the stock price emerged during the previous two months, then report that date as the strike date for issued options. New laws have compressed that to two days. Companies could still use their knowledge of future events to choose when to issue options, but the ability to cherry-pick a good price from the last 2 months is no longer possible.

Since new regulations make it more difficult to engage in this behavior today, it looks like the WSJ decided to pull some skeletons out of the closet for entertainment and educational value. Even their own statistical analysis stopped in 2002, when the SOX reforms went into effect.

An excerpt from the WSJ article:

Mr. Tomasetta got a grant in March 1997 that, adjusted for later stock splits, gave him the right to buy 600,000 shares at $5.625 each. The date they were priced coincided with a steep fall in Vitesse’s stock, to what turned out to be its low for the year. He pocketed $23.1 million in profit when he exercised most of these options between 1998 and 2001. Had the grant come 10 days earlier, when the stock price was much stronger, he would have made $1.4 million less.

In eight of Mr. Tomasetta’s nine option grants from 1994 to 2001, the grants were dated just before double-digit price surges in the next 20 trading days. The odds of such a pattern occurring by chance are about one in 26 billion.

What struck me about the article was the fact that it was entirely focused on CEO pay. Reporting like this never fails to strike a chord with those who beat the drum that some CEOs are overcompensated, and it is true that some are.

I decided to pull my old option statements from Vitesse. It turns out that the strike prices and dates that Lou received were identical to mine. I benefited, as did all other employees, in the same way as the CEO.

Singling out the CEO as the only one who profited from these machinations is misleading but makes for great press.

I’m not commenting from an independent perspective considering I profited both financially and intellectually from my years at Vitesse. But backdated or not, options are crucial for incentivizing the entire workforce of technical companies, not just the CEO.

Options should be treated as compensation in the P&L statement. If options are counted as compensation, then backdating really doesn’t matter. Companies that engage in this practice will erode shareholder value faster and post poorer results.

Folks with strong opinions on this subject would enjoy John Bogle’s Battle for the Soul of Capitalism.

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