What the options saga means to investors
A prominent securities lawyer explains how, and why, the controversy over executive option grants could hurt you.
NEW YORK (CNNMoney.com) - With the controversy over stock options growing more heated by the day, investors are wondering how many more companies will face scrutiny from government regulators and prosecutors.
Questions over executive stock options have sparked federal investigations of more than a dozen companies, many of them technology firms. A number of executives have been fired, others have resigned, and some firms are looking at restating financial results going back several years.
The SEC and prosecutors are investigating whether companies "back-dated" stock options for some employees, or retroactively changed the date an options grant was effective, to a date that led to a bigger windfall for those who held the options.
In his 30-plus years as a litigator, Bruce Vanyo, a lawyer and co-chair of the securities litigation practice at Katten Muchin Rosenman LLP, has defended Boeing, Silicon Graphics, Dell, Sun, Krispy Kreme and other firms in high-profile lawsuits.
Stock options give executives and employees the right to buy shares at a certain price, and if the stock rises after the options are granted, profits can be fat.
Vanyo said that while options-back dating stopped in 2002, its effects could be far-reaching. He discussed the impact of the controversy from his office in Los Angeles.
CNNMoney.com: How did the controversy get started?
Vanyo: "It all started with an article written by a professor last year who speculated that this was not coincidence and there might be something wrong here. That's what kicked it all off, but nobody ran with it for awhile.
"The first instance of anything coming up was with Mercury Interactive (a software maker that overhauled its executive ranks last year and said it would restate results due to option grants). Since then ... everyone who is affected by this is quickly doing the math. That's why I wouldn't be surprised to see the number of companies (involved) double or even triple."
Q: How severe could the fallout be?
A: "The key is if the accounting treatment (of options grants) was incorrect. The practice of back-dating has long ceased; no one has been doing it since the early 2000s. The way it's a problem is twofold. If (the grants were) accounted for improperly, the companies involved will be required to restate. That'll be a major expense to the company and a major disruption. They won't be able to file current financials until the auditors get through with the process.
"The second aspect is that typically options are granted to key managers. If those managers (are still running the company) today, that creates problems. As a result you've seen a lot of resignations, people going on administrative leave and people being fired. And these are key people. That's disruptive.
"Current shareholders are taking a beating for practices that are years old and do not, in any way, reflect the current practices of the company."
Q: Why was the practice so prevalent?
A: "Back in the 1990s and in particular the late 90s because of the big bull market, the way to incentivize your key managers was to give them options and say, 'Produce, and if you produce, you'll get a big gain.' There's nothing wrong with that. The practice itself was deemed to be very healthy and consistent with the desires of investors.
"But there have been two significant changes since then. With 2002 and (the passage of) Sarbanes Oxley, a change was made with respect to how much time a company has to report the granting of options. The SEC changed that to require that within two days of granting an option you had to notify the SEC, which makes it hard to back date.
"The other change was how for accounting purposes you treat the granting of options. Prior to last year there was not a requirement that you had to expense options. But after Sarbanes-Oxley, lots of companies adopted the practice of expensing options; now it's mandated. You have to value options at the date you grant them."
Q: What kind of impact will this have on the tech sector?
A: "I'm sure there are lots of folks thinking, if this happened to 20-plus companies, what's to say it won't happen to 50-plus companies? That's causing a lot of short-selling and a drop in market price (for companies affected).
"This is going to be a cloud that hangs over the tech industry for quite a while. And it's not just tech companies; it's high-growth companies in general."
Q: What about the other companies involved?
A: "It'll be a dislocation and it will be an expense. (Companies affected) will have to pay auditors fees and legal fees. But it really depends on the size of the company. The bigger problem is that it disrupts their operations for awhile. One or two entities have been delisted because they couldn't file financials. I think there are a lot of high-level executives that are losing a lot of sleep over this."
Q: Will anything positive come out of this for investors?
A: It's not about current fundamentals; it's about old financials being restated. If someone really believes that a company has strong fundamentals, this could even be a time to buy. You run some risk that disruption could be so large that it impairs a company for a substantial period of time, but that's a pretty small risk for a company that's strong."
(The article Vanyo was referring to was by Erik Lie, associate professor of finance at the University of Iowa, who published a study in the journal Management Science in May 2005 noting that the granting of options to executives at several companies preceded big run-ups in the stock price.)
Options controversy hits techs hard: More here.