TOPICS > Economy

Officials Investigate CEOs in Stock Options Scandals

September 27, 2006 at 6:30 PM EST
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GWEN IFILL: Still to come: the news on the economic front; and social networks online. But first, the growing scandal surrounding stock options.

Today, the Justice Department announced that a fugitive former CEO charged with securities fraud was captured in Namibia. Jacob Alexander is the founder and former chief executive office of Comverse Technology. The government said it would seek his extradition from Africa for his role in a stock options scheme.

The NewsHour’s economics correspondent, Paul Solman, has been looking into the larger stock options story and how it all works.

PAUL SOLMAN, NewsHour Economics Correspondent: The latest tsunami of scandal to hit corporate America is more bad news from the no-rules ’90s, the decade that brought us Enron, Tyco, Qwest and the rest. Now, a new list of companies, perhaps 100 or more, many of them thought exemplary, suspected of backdating options, actually changing dates on financial documents to inflate their profits and, thus, their stock price.

Criminal charges have already been filed against Brocade Communications and Comverse. Shareholder advocate Nell Minow voices a common reaction.

NELL MINOW, Shareholder Advocate: I thought I had lost my capacity to be shocked, but I was really flabbergasted by this, by how widespread it was and by how blatant it was.

Diluted interest

PAUL SOLMAN: But before we get too far ahead of ourselves, what exactly are stock options? And what's so bad about backdating them?

To explain, we've concocted a company, NewsWear.com, a line of NewsHour clothing available exclusively on the NewsHour Web site and shipped from our offices here in Virginia.

We at NewsWear.com, like our competitors, are bidding for the next generation of star employees, and we want to give them the incentive to excel. How do we do it? We asked Donald Langevoort, a professor at Georgetown Law School.

DONALD LANGEVOORT, Georgetown University: Well, the modern way is to make the employees owners, make them want to make this company succeed, get the stock price up, because at that point it's a win-win situation. Shareholders love the price up; employees love the price up.

PAUL SOLMAN: And how do we do that?

DONALD LANGEVOORT: We give them stock, which makes them owners, just like the shareholders.

PAUL SOLMAN: Let's say we have a provisional employee we really want to keep. So how about we give you stock in the company, and you stay with us permanently?

PROVISIONAL EMPLOYEE: Are you serious? Yes, no, that sounds great.

PAUL SOLMAN: But for the current shareholders of our company, there's a problem with just ladling out stock: dilution.

DONALD LANGEVOORT: Dilution.

PAUL SOLMAN: What does delusion mean?

DONALD LANGEVOORT: Dilution means that, before the stock was given out, I owned a certain amount of the company as a shareholder. After stock is put in the hands of all these employees, I own less of the company. My interest has been diluted.

PAUL SOLMAN: The problem of dilution is the key to unlocking what became the stock market scam. To show why and make this a little more personal, let's assume that viewers like you were the shareholders of NewsWear.com, a representative sample of you in the condo complex next door watching the NewsHour, of course.

Now, if shareholders like you hold all the stock, and we turn a profit, then the profit's all yours, at least in theory. You own all the shares. But if we at NewsWear issue more stock and dole it out to employees, then you have to divvy up the ownership with them. Your stock is worth less than it was. It's diluted. And we're afraid you're going to be unhappy.

So firms like NewsWear.com gave stock options instead. And what is an option?

DONALD LANGEVOORT: An option is a right to buy something in the future at a price that's set today.

PAUL SOLMAN: So if the price goes up in the interim, the person can exercise the option by buying the stock at that price, then selling it at today's price, make the difference?

DONALD LANGEVOORT: Absolutely. And when the stock market is going up and company values are going up, employees can be very excited about that thought of getting seriously rich.

Tanked stock prices

PAUL SOLMAN: Unfortunately, there's a downside to stock options for employees, as our provisional NewsWear.com hire understood.

So how about we give you stock options at today's stock price?

PROVISIONAL EMPLOYEE: But if the stock price tanks and it never gets back up to what it is now, then it's worthless to me.

PAUL SOLMAN: He's right. Say today's stock price is $100 a share, and we grant options at $100 a share. Then, if the stock price sinks and never rises above today's price, the options won't bring him a dime. They're underwater, as they say on Wall Street.

But if we really want an employee, we could give him or her an option at below today's stock price, say $30 a share. So an option to buy at $30, which the person exercises, then sells immediately at $100, and makes the difference. Such options are called "in the money."

It's perfectly legal, but there is a catch for executives trying to maximize profits and keep you shareholders content. While options granted at today's stock price don't have to be deducted from profits, "in the money" options do. So grant a $30 option when there's $100 stock price and $70 gets pulled from profits for every option issued.

DONALD LANGEVOORT: If the stock option is granted "in the money," you do have to put on the financials that portion that represents the "in the money." That does become an expense; that does reduce the company's earnings. Companies hated that. They didn't want to take that hit.

PAUL SOLMAN: Because you investors didn't want lower profits. Talk about dilution. Some of you investors might have thought you were getting soaked.

So some executives fudged. They issued options at today's stock price. It's just that they were flexible with the meaning of the word "today." In fact, they backdated the options to a time when the stock price was lower.

DONALD LANGEVOORT: Two weeks ago, the price was lower. But if that was the price and that was the date, it wasn't "in the money." Nothing to expense. That way, we don't have to take the hit, but we do have to lie.

Beneficiaries of backdating

PAUL SOLMAN: And now comes the kicker: If executives could do this for new hires, why, they thought, couldn't they do it for themselves? They could, so they did, backdating their own stock options.

NELL MINOW: Executives. It's executives. It's appalling. They know what the outcome is going to be, and they switch around the date to benefit themselves.

PAUL SOLMAN: At Comverse, where the CEO has gone missing, the scam seems to have gotten even more audacious.

DONALD LANGEVOORT: The chief executive officer, chief financial officer were alleged to have doctored documents, created a slush fund of options for fake employees, all so they could be awarding these options to other employees and, in some cases, putting money in their own pockets.

PAUL SOLMAN: Which they allegedly did, to the tune of millions of dollars.

SINGER: What a way to run a business...

PAUL SOLMAN: Naming these slush funds for phantom employees after Andrew Lloyd Webber's haunting "Phantom of the Opera," and backdating to taste. But how could they be so bold? We asked former federal prosecutor Jacob Frenkel.

Isn't it obviously fraud if you change the date on something?

JACOB FRENKEL, Former Federal Prosecutor: That's the exact kind of case that the prosecutors are bringing. And that is something that is obvious to the average person who is going to sit in the jury box, and they're going to understand these documents were manipulated. This is fraudulent conduct.

PAUL SOLMAN: Fraudulent conduct that may seem egregious, but turns out to have been pretty run-of-the-mill. As to how many more prosecutions there will be, we can make only one promise: There's a place where they won't find anything wrong, NewsWear.com.

GWEN IFILL: And as we noted earlier, Comverse's former CEO, Jacob Alexander, was arrested in Namibia today. Paul's report was filed before Alexander's capture.