(Business 2.0) – Early in September, Microsoft had a small confession to make. Back in December 2000, the company had lent its president, Rick Belluzzo, $15 million, taking some of his stock options as collateral. Though the options were underwater and had no value at the time, Microsoft figured its stock would eventually go up. But by last August, when Belluzzo resigned, the options were even further submerged. So the software giant forgave the loan--it had no choice under the deal Belluzzo had struck--charged off the $15 million, and said its belated disclosure was "appropriate" because the loan was really just an "advance."

Corporate scandals are so big and bountiful these days--Tyco and WorldCom were getting the headlines the week Microsoft made its disclosure--that the significance of the little item was easy to miss. Next to alleged accounting fraud and corporate looting, the practice of making and pardoning insider loans, even multimillion-dollar ones, seems like small beer. And why single out Belluzzo? He hadn't left his company in tatters like Lucent's Richard McGinn, Mattel's Jill Barad, Webvan's George Shaheen, and the few other executives who made news by having their multimillion-dollar company debts erased as they headed out the door. Compared with WorldCom's Bernie Ebbers, whose officially disclosed unpaid loans stand at $160.8 million, Belluzzo hardly seems to rate.

Yet Belluzzo symbolizes an aspect of the ongoing revelations about boom-time corporate excess that, until now, has escaped notice: Insider lending and the subsequent forgiving of those loans didn't just benefit a few alleged corporate rogues and failed executives. It was astoundingly common.

Roughly three-quarters of the nation's top 1,500 companies--1,133, to be precise--have disclosed loans to insiders in recent regulatory filings, according to a study due to be published in November by the Corporate Library, a firm based in Portland, Maine, that analyzes corporate data and advocates greater accountability to shareholders. Of the companies that disclosed loans, 510 made them for the purchase of stock, for a handful of other uses such as housing and tax payments, or for purposes that weren't specified at all. The average loan was about $5.5 million. Most of the remaining loans were interest-free advances made to fund life insurance policies, which can often produce investment windfalls for executives.

Insider loans have been around for decades and aren't inherently bad. Their proliferation during the boom years was driven to a large degree by sound business purposes and market forces. Companies used insider loans to lure executive stars during the frenzied bidding wars for talent that broke out as the economy and the stock market roared. As compensation tools, insider loans have certain advantages over other forms of pay, like bonuses or big salaries; they're not immediately taxable, for instance. Corporations also cited insider loans made for the purchase of company stock as a way to meet the years-long clamor from shareholder activists to better align managers' and shareholders' interests.

The problem, critics of the practice say, is that when stocks crashed, companies in scores of cases quietly let executives off the hook by forgiving the loans, even as other shareholders were battered. Ann Yerger, research director at the Council of Institutional Investors, a shareholder advocacy group, calls it "stealth pay." In some instances, executives may have surrendered some other valuable perk in return for wiping out the debt. But in many cases, the terms of the loans themselves made them forgivable at little penalty. Often, as with Belluzzo, the only thing executives gave up in exchange were worthless stock options. Moreover, the loans sometimes weren't reported at the time they were made; when they were disclosed, in proxy statements, the details were frequently sketchy.

"This was an addiction that corporations for years felt they had to supply in order to keep executives," says Judith Fischer, managing director of Executive Compensation Advisory Services, a firm based in Alexandria, Va., that designs corporate compensation strategies. "And they got into even more trouble by not disclosing fully to shareholders how much the addiction was costing them. This became corporate America's secret vice."

It was an expensive habit. Companies of all stripes made and forgave insider loans during the boom years, from highflying Internet wonders like Priceline.com to staid blue chips like Home Depot. Some executives, including Belluzzo, got insider loans from more than one company. Others used them not to buy stock in their own companies but for more adventurous efforts at wealth creation: At high-tech contract manufacturer Flextronics, for instance, a group of executives used insider loans to speculate on technology startups.

All told, loans to insiders in recent years may have reached more than $5 billion. Hundreds of millions of dollars in loans, perhaps as much as $1 billion, have been or will be forgiven, based on Securities and Exchange Commission records and estimates by corporate compensation experts. This suggests that companies will be eating losses from insider loans for years to come. But the more damaging legacy may be that the practice--by helping fuel the explosion in CEO pay that is at the heart of much of today's outcry over corporate behavior--will contribute to the perception that management has all too often lined its pockets at investors' expense, and to the public's distrust of how American companies are run.

Congress has already reacted. The Sarbanes-Oxley Act, which was signed into law in July, bans insider loans for stock, insurance, or anything else. But corporate lobbyists are even now pressing lawmakers to water down the law, and many corporate compensation experts are hard at work dreaming up new executive pay schemes to replace insider loans.

How did the system get so out of whack? Insider lending added thrust to the long surge in executive pay that has pushed the average major-company CEO's compensation from 45 times that of the average worker in the early 1970s to about 500 times worker pay today. Insider loans started cropping up several decades ago, with a clear but limited business purpose: Companies in high-cost housing areas wanted to help newly hired executives relocate. Forgiving such loans was rare. Stock-purchase loan programs came into use during the late 1980s bull market, although disclosure was spotty. American Express is one company that made these programs widely available to managers when it spun off Shearson Lehman Bros. in 1987, just before that year's epic crash. Borrowers watched in horror as their Shearson shares dropped by two-thirds, leaving the managers with huge liabilities. "It backfired terribly," says attorney Michael Sirkin, a veteran compensation attorney based in New York.

Meanwhile, the colossal fortunes amassed by the likes of junk bond king Michael Milken--he was paid a reported $550 million in 1987 alone--and corporate raiders like Carl Icahn and Ronald Perelman during the 1980s had an intriguing effect on many chief executives: They felt underpaid. The solution was jumbo-size grants of stock or options. For instance, Coca-Cola CEO Roberto Goizueta, in packages backed and partly designed by the great shareholder champion Warren Buffett, received stock grants in the early 1990s that were worth more than $1 billion. Since Coke's market capitalization increased nearly fourfold to $93 billion in roughly the same period, Buffett and most other Coke shareholders had no problem with Goizueta's eye-popping pay.

The Internet boom changed the scale of CEO pay again, and insider loans became a key facet. Two big pluses were that executives didn't have to pay tax on them and companies could sidestep the $1 million limit on salary deductions. (Forgiven loans were taxable, but companies often picked up executives' tax bills on those too.) For some companies, loan-related payouts dwarfed other forms of annual executive compensation--salary, bonus, pension, perks. Fischer recalls questioning the insider-lending spree at a January 2001 compensation conference: "I said, 'This is all crazy,' and everyone asked, 'Who invited her?' The party was still going on, and nobody wanted to think about the consequences." Indeed, during the long run-up in executive pay, the Dow Jones industrial average climbed from 760 in 1980 to more than 11,700 in early 2000. As long as stocks kept rising, it was easy to argue that insider loans, options, and other means of boosting executive compensation were justified.

For rising stars like Belluzzo, the climate of the late 1990s presented marvelous opportunities. Belluzzo, who became one of Silicon Valley's hot properties by guiding Hewlett-Packard's flagship printer division to some of its most profitable years during the mid-1990s, became CEO of Silicon Graphics Inc. in early 1998. As an incentive for taking the job, SGI loaned Belluzzo $3.4 million, enabling him to exercise options he had at HP and to reap a $600,000 gain. Belluzzo repaid that loan. In August 1999, with SGI's stock price virtually unchanged, Belluzzo quit to run Microsoft's consumer operations. In its eagerness to land him, Microsoft awarded him a $4.2 million signing bonus. A year later, shortly before Belluzzo was promoted to president and chief operating officer, the company extended the $15 million loan, which it finally disclosed in September. The loan was collateralized by his Microsoft options.

Belluzzo, now 48, resigned from Microsoft in August after losing a power struggle. He didn't leave empty-handed. In addition to the pardon of his $15 million loan, granted in exchange for most of his worthless options, Belluzzo retained hundreds of thousands of other options. They too are worthless now, since Microsoft stock, recently at $44, trades below their strike price. Whatever happens with those options, Microsoft paid Belluzzo more than $21 million in cash, the bulk of it from the forgiven loan. He was at the company for 35 months. In that time, Microsoft's market cap fell by more than $200 billion.

Belluzzo declined to comment. A Microsoft spokesperson says Belluzzo's deal was dictated by competitive forces, and adds, "We felt his compensation was appropriate for an executive of his caliber at the time." Today, Belluzzo is CEO of data-storage firm Quantum; in addition to a $600,000 salary, Quantum awarded him a $1 million relocation bonus and 2 million options (he received no insider loans; the practice had been banned by the time he was hired). A Quantum spokesperson declined further comment on Belluzzo's compensation package.

If the rationale for making insider loans was to lure hotshots, the stated reason for forgiving the loans was often to keep them onboard when the going got rough. In mid-1999, Daniel Schulman, then 41, was named Priceline. com's president. He came from AT&T, where he ran the consumer markets division. Priceline was on a meteoric rise at the time; its stock closed at $107.50 the day Schulman took over. Schulman eventually wound up with 7 million Priceline options and borrowed $9 million, promising to repay the loan from the profits on the options. It's unclear how Schulman used the money. In any case, there's no evidence that anyone at Priceline doubted that the options backing the loans would only grow in value. But by December 2000, Priceline was on the verge of collapse and its stock was in the single digits. The company's board forgave $4.5 million of Schulman's loan, plus $5 million lent to two other executives, "to maintain senior management continuity in order to facilitate the company's turnaround plan," according to Priceline's proxy.

Six months later, having failed to reverse Priceline's slide, Schulman was forced out. Terms of his agreement called for the company to absolve him of repaying the other half of his loan. Thus, after less than two years of running a company with dismal results, Schulman walked away with $9 million from the forgiven loan, plus salary and other payments worth $1.8 million. His loan terms required that he surrender only stock options that were then worthless in exchange for having his debt wiped out. Priceline declined to discuss forgiving the loan. Contacted at Virgin Mobile USA, a startup phone service where he is currently CEO, Schulman also declined to comment.

Even when loans did work to keep managers on the job, the results often don't appear to have justified the cost. In June, Maxtor, a troubled data-storage firm, forgave a $5 million loan to CEO Michael Cannon, plus a total of $4.3 million in loans to 10 of his managers. The loans had been handed out in 1999 in return for the managers' agreement to stay for at least three years. But during that period, the high-priced team at Maxtor didn't stem the company's bleeding--its three-year net loss totaled $824 million. And its stock price slid from $5 per share to $2.40 today. Maxtor declined to comment.

As the stock market continued to boom, insider loans spread quickly beyond the Young Turks of high-tech. In December 2000, Home Depot named Robert Nardelli, then 52, president and CEO and gave him a $10 million loan as a "long-term employment incentive," the company's proxy says. The loan is automatically forgiven at the rate of 20 percent a year. Many analysts predicted that Nardelli, a General Electric veteran, would deliver GE-like growth, and Home Depot's stock price at first did go up, hitting $53 per share in May 2001. Today it's at about $24 per share, down from $40 when Nardelli arrived. Toymaker Mattel gave CEO Barad loans totaling $7.2 million, in part to keep her from selling off company shares as they vested. When she was forced out in 2000, Mattel forgave the loans. SEC records show that the company went on to award her successor, Robert Eckert, a $5.5 million loan that will be forgiven if he stays at Mattel until next May. Douglas Leatherdale, 65, who retired as chairman of the St. Paul Companies last year after 29 years of service, still owes the firm $3.8 million lent to him for stock purchases.

Not all insider loans went toward company stock--or even, for that matter, to insiders (defined as executive officers). Hundreds of companies, from BellSouth to Outback Steakhouse, made loans to pay premiums on multimillion-dollar life insurance packages known as split-dollar policies. (AOL Time Warner, Business 2.0's corporate parent, also made such loans.) These arrangements can be bonanzas: They can be cashed out during an executive's lifetime, and only the premiums have to be reimbursed to the company. Investment gains the policies generate over the years can and often do go to the executives, tax-free, after they leave the company. In mid-2000, Fred Langhammer, CEO of Estee Lauder, got a $26.6 million policy that the company will fund over five years, SEC filings show (it isn't clear what the policy, including any gains, is worth today). In April, Qwest gave its president, Afshin Mohebbi, a $4 million insurance loan after forgiving an earlier $600,000 interest-free loan made for an unspecified purpose.

Planet Hollywood doled out options to celebrities like Bruce Willis and Sylvester Stallone, whose only corporate role was to frequent and promote the restaurants. The company initially did well, prompting some of the stars to want to cash their shares in. To head that off, the company lent its celebrity friends $5 million, thereby avoiding potentially negative press about its stars bailing out. In late 1999, after Planet Hollywood's business crashed, it filed for bankruptcy and apparently wrote off the loans, according to a recent bankruptcy court examiner's report.

While public companies were obligated to report all insider loans of more than $60,000, the timing and extent of those disclosures varied widely. The result: Many such revelations came well after the loans were made, as in Microsoft's case, or were fuzzy on important details. Michael McNamara, chief operating officer at Flextronics, borrowed $8.7 million from the electronics manufacturer between November 1998 and May 2002, at interest rates as low as 2.48 percent. The loans were disclosed in proxy statements, but no specifics about the collateral behind the loans or the reason they were given was ever spelled out. During a conference call last July in response to analysts' questions about the matter, a company official said Flextronics had made various loans for mortgages and tax payments but didn't address the McNamara loans specifically. Flextronics also disclosed that it had used insider loans to gamble on shares of tech stocks, including duds like Calico Commerce and Agile Software. Now, Flextronics CFO Bob Dykes says McNamara used the money to buy a house, and would have sold shares to raise the funds but couldn't because the company was in the midst of a stock offering that prevented him from doing so. Dykes defends the loans issued for speculating in tech stocks. "There were no conflicts," he says. "We were very careful." Dykes owes $2.6 million to the company himself.

Flextronics recently said it expects the loans to be repaid. There are ways to wriggle out, however. Last August, when Sonicblue CEO Kenneth Potashner asked three board members to repay $600,000 in loans for stock purchases, the board fired him, Potashner has publicly asserted. A Sonicblue spokesman confirmed that Potashner was "terminated" but denied Potashner's account of the reason for his dismissal and declined to discuss the matter further. Potashner couldn't be reached for comment.

In rare instances, it was the decision to borrow that took a bit of arm-twisting. In 1998, Comdisco hosted about 140 of its managers at a retreat in Palm Springs, Calif. On a Friday night, after golf and a boozy dinner, Comdisco CEO Nicholas Pontikes offered the group an opportunity to load up on company stock with five-year loans secured by nothing but the stock itself, according to allegations in federal court filings in Chicago. He allegedly gave them 48 hours to decide. On the following Monday morning, a Comdisco press release hailed a $109 million investment by 106 managers as a "personal vote of confidence in the future of the company." One of the biggest borrowers, Thomas Flohr, Comdisco's European division head, took a $3.3 million stake.

Today, Comdisco is in bankruptcy, its stock is nearly worthless, and Flohr has filed suit against it and Pontikes in federal court, alleging fraud. (Comdisco, which guaranteed the loans made by Bank One for 100 percent of the stock's value at the time, has in turn alleged that Bank One violated federal margin rules in an attempt to void its guarantee.) Comdisco and Pontikes deny any wrongdoing. But dozens of current and former managers, some of whom say they face personal bankruptcy as a result of the debt they incurred, are taking legal action in bankruptcy court to undo the deal. "Comdisco," says a person familiar with their situation, "took advantage of the loyalty of these individuals."

Greater loyalty to shareholders seemed to be a major benefit of loans to insiders, until lately. Shareholder activists had harped at managers for years to own more stock in the public companies they ran; loans earmarked for the purchase of company stock were a way to achieve that. In a 1998 offering of AMC Entertainment stock at $15 per share, the theater chain's chief executive, Peter Brown, borrowed $5.6 million to buy 375,000 shares, more than doubling his stake. AMC, which similarly lent a second executive $3.7 million, explained in its prospectus that the transactions would "more closely align their financial interest with other common stockholders."

But for most of the past three years, AMC's stock has traded well below $15. Last June, AMC's board forgave both loans and paid related taxes, taking a $19.2 million charge. Today, AMC faces a shareholder suit challenging the arrangement in state court in Kansas City, Mo. Brown, 44, got to keep the shares, now worth about $2.5 million. He declined to comment. Charles J. Egan Jr., who sits on the AMC board's compensation committee, which approved giving and forgiving the loans, says the original idea for them came from Goldman Sachs, lead underwriter of the offering. Goldman representatives felt it would make the offering more attractive to investors, Egan says, but he declines to comment on the company's subsequent largesse, citing the shareholder lawsuit. A Goldman spokesman declined to comment.

Where will insider lending ultimately rate in the hierarchy of boom-time excess? Clearly, in dollar and moral terms, it's not up there with the alleged fraud at Enron and other center-stage scandals. But many critics still say it played a substantial supporting role. The executives who got insider loans "are the most solvent people on earth," says Nell Minow, the Corporate Library's editor and a noted shareholder activist. "They can get a loan at any bank in the country." Forgiving a loan used to buy shares that later cratered "completely undermines the idea of owning stock," she says. "Owning stock isn't supposed to be risk-free for a bunch of favored executives."

Plenty of executives understood that, of course. There are ready models for how companies can reshape compensation policies, avoid the excesses of insider lending and similar gambits, and still attract and retain top talent. Intel, for example, says it has never made loans to execs, a reflection of the egalitarian culture nurtured by the likes of co-founder and chairman Andy Grove. "Providing loans to executive officers would have been out of step with our values," says Intel spokesman Tom Beermann. Those values are themselves a selling point with prospective managers, Beermann says. Procter & Gamble likewise has never made loans to executives, says spokeswoman Linda Ulrey. At least 75 percent of its executives' pay is tied to financial results, not just stock performance. "Whether it's the CEO or a brand-new employee, we pay at the median level based on a review of companies we compete against for talent," Ulrey says.

Linking compensation to basic corporate values and reviewing pay frequently in relation to competitors, as Intel and P&G have done, should be a fundamental pillar of all corporate compensation policies, some experts say. Other guidelines for sensible and effective pay strategies include always having a backup candidate for top jobs, so companies don't feel pressured to pay whatever it takes to land the first choice. Moreover, the true cost of all potential aspects of a pay package, under all scenarios, should be carefully calculated in advance, so that if and when termination comes, companies won't be faced with paying unexpected windfalls. "No one ever does the math to see what it all adds up to," says compensation consultant Claude Johnston. Most important, corporate board members and compensation committees must do their jobs. "CEO overcompensation is just a bad idea," says business theorist Geoffrey Moore. "Boards have got to stand up and say, 'No dice.'"

Moore believes that many companies and their boards have gotten that message. Still, corporate lobbyists have been working the hallways in Congress and at the SEC, trying to persuade regulators and lawmakers to create exemptions to the Sarbanes-Oxley Act's ban on insider loans. SEC chairman Harvey Pitt has said he'll resist those efforts. Meanwhile, many compensation experts say their clients are beating the bushes for new pay techniques to substitute for insider lending. "Companies will be just as creative about getting around Sarbanes as they are at getting around everything," says Bob Damon, managing director at recruiter Spencer Stuart. Adds attorney Roger Stern, co-head of compensation and benefits at Wilson Sonsini Goodrich & Rosati, a top tech industry law firm, "It's a boon for our business, no doubt about it."

That may not be a comforting thought, given that the fallout from the insider loans already out there is far from over. Under the new law, insider loans made before the ban can still be forgiven. Fischer, the compensation expert, says we've only seen the leading edge of the loan forgiveness wave. She may be right. In late September, Microsoft disclosed that it had made another loan to an executive two years ago. This one went to senior vice president Richard Emerson. It isn't as big as the $15 million loan to Belluzzo. Emerson's loan is for $13 million. He is still with Microsoft, so the company hasn't had to write the loan off. But Emerson's loan is secured by stock options. And they're underwater.

Ralph King (rking@business2.com) is a senior writer at Business 2.0.