Backdating OptionsFirst Things FirstMore definitionsOptions GraphWhat is Backdating options?The EffectsContinuedWho Suffers?Diluted Shareholder InterestSlide 10Spring Loading and Bullet DodgingContinued http://money.cnn.com/2006/05/26/magazines/fortune/colvin_fortune_0612/ http://www.dailyreckoning.com/rpt/BackdatingOptions.htmlExample QuestionSlide 14Legality http://www.biz.uiowa.edu/faculty/elie/backdating.htmTime Frame of ScandalWhat actions are being takenPartial list of (120+) companies http://www.usatoday.com/money/companies/regulation/2007-03-08-backdate-list_N.htm http://online.wsj.com/public/resources/documents/info-optionsscore06-full.htmlUnitedHealth Group http://money.cnn.com/magazines/business2/business2_archive/2007/02/01/8398990/index.htm?section=money_latestTake-Two InteractiveMcAffe http://www.usatoday.com/printedition/money/20070228/options28.art.htmClass-action Vs Derivative lawsuitsOverall Effect http://www.issproxy.com/pdf/OptionTiming.pdf http://online.wsj.com/public/resources/documents/info-optionsscore06-exec.htmlBackdating OptionsJoe Pizarek – 1st speakerKevin Quinn – 2nd speakerFirst Things FirstOption - an agreement where the buyer has the right to exercise by buying or selling an asset at a set price (strike price) on or before a future date Since the contract's value is determined by an underlying asset and other variables, it is known as a Derivative.ESO – employee stock option (a performance based compensation)More definitionsAt the Money- when the strike price equals the security's current price In the Money- when the strike price is below the security's current price Out of the Money - when the strike price is above the security's current price Options at-the-money or out-of-the-money have an intrinsic value of zeroOptions GraphStrike Price = $25Blue – Out of the MoneyRed – At the MoneyGreen – In the MoneyWhat is Backdating options?Backdating is the practice of marking a document with a date that precedes the actual date.The Effectshttp://www.biz.uiowa.edu/faculty/elie/backdating.htmContinuedEnd of the year price = $85Exercise price of backdated option = $30Amount of shares issued to executive = 100,000Intrinsic Value = (current price – exercise price)*amount of sharesIntrinsic Value = ($85-$30)*100,000 = $5,500,000Who Suffers?The shareholdersThis defrauds the firm's shareholders because the company receives less money for the shares than it should.Diluted Shareholder InterestBroadcom Corp. (BRCM) is the biggest example of suspicious option grants to employees.Company says they granted options at a quarterly low in May 2000, but did not complete the process until later in the summer.Diluted Shareholder InterestOptions issued as a percentage of total shares was at one point as high as 20% for Broadcom. Since 2002 it has gone down to 4-6%.Possible restatement of $750 millionSpring Loading and Bullet DodgingThe practices of timing option grants to take place before expected good news or after expected bad news.Continuedhttp://money.cnn.com/2006/05/26/magazines/fortune/colvin_fortune_0612/http://www.dailyreckoning.com/rpt/BackdatingOptions.htmlErik Lie first discovered this trendHis research discovered that unless executives had amazing talents to forecast precise overall movements in the market, they had to be backdating the grants.Example QuestionWhat is the intrinsic value of a backdated stock option at the end of quarter 4, with the exercise price at the trough (lowest stock price)?Number of shares equals 50,000Example QuestionA $2,500,000 B $1,000,000C $1,500,000 D $0Correct Answer: C (50-20)*50,000Legalityhttp://www.biz.uiowa.edu/faculty/elie/backdating.htmYes…But need to follow strict regulations:Publicly announced to shareholdersProperly stated in earningsCorrectly taxedRarely are these conditions satisfied.Time Frame of ScandalBackdating practices have been around since the late 1990’s or even earlierBackdating made harder in 2002 because of the Sarbanes-Oxley Act.Companies now have 2 days after granting options to report to the SEC.Large scale investigation began summer of 2006 after Erik Lie’s research.What actions are being takenJustice Department along with Securities and Exchange Commission are investing companies.Slow process due to hidden nature of claims.Some companies use second lowest price date to throw off investigators.Over 130 companies being investigated, many upper management on trial too.Partial list of (120+) companieshttp://www.usatoday.com/money/companies/regulation/2007-03-08-backdate-list_N.htmhttp://online.wsj.com/public/resources/documents/info-optionsscore06-full.htmlAble EnergyActelActivisionApple ComputersBed Bath & BeyondCNET NetworksDean FoodsHome DepotMcAffeMonster WorldwidePixarTake-Two Interactive SoftwareUnitedHealth GroupUnitedHealth Grouphttp://money.cnn.com/magazines/business2/business2_archive/2007/02/01/8398990/index.htm?section=money_latestOne of the Largest Backdating casesCEO William McGuire had over $1 billion dollars of unexercised stock options at the end of 2005.McGuire resigned, giving up about $200 million in proceeds.Had to correct accounting dating back to 1995Lowered earnings by $1.55 billion dollarsPaid $100 million in additional taxesTake-Two InteractivePublisher of video game Grand Theft AutoFormer CEO Ryan Brandt pleaded guilty to falsifying business records.Had to pay SEC civil charges of $7.3 million dollars.Never officially admitted or denied wrongdoingMcAffehttp://www.usatoday.com/printedition/money/20070228/options28.art.htmKent Roberts (former controller) was indicated by grand jury on charges of fraudulent dating of stock-options.If convicted could face 20+yrs in jail, along with millions of dollars of fines.Company could also face $150 million in charges.Class-action Vs Derivative lawsuitsClass-actionSettlement goes directly to shareholdersHas 5 year statute of limitationsBackdating has been dated back to the late 1990’s.May not be appropriate for older cases.Derivative lawsuitsSettlement goes towards the companyShould indirectly help the shareholdersOverall Effecthttp://www.issproxy.com/pdf/OptionTiming.pdfhttp://online.wsj.com/public/resources/documents/info-optionsscore06-exec.htmlBy number of firms under