- The Washington Times - Monday, July 3, 2006

SAN FRANCISCO — Silicon Valley’s long-running obsession with stock options is turning into a sordid affair.

With each passing week, more companies in high-tech’s heartland have become entangled in internal or government inquiries examining whether a few insiders rigged employee stock options to ensure larger windfalls without properly disclosing or accounting for the manipulation.

The fallout threatens scores of companies with hefty bills to cover delinquent taxes, regulatory fines and shareholder lawsuits purporting financial deception. Criminal charges could be filed if federal prosecutors find evidence of deliberate fraud.

“I don’t think the stock market realizes how big this problem really is,” said Randall Heron, an Indiana University associate professor of finance whose research into deceptive option awards helped focus attention on the issue.

“If people were willing to push the envelope in this area of accounting, it’s possible these investigations are going to dig up other skeletons in the accounting closet,” he said.

The preliminary investigations already have triggered the firings of several top executives and raised the prospect that some companies exaggerated their past profits.

Silicon Valley icon Apple Computer Inc. provided another scent of stock option chicanery last week when it revealed that an internal investigation had uncovered “irregularities” that occurred between 1997 and 2001. The troublesome awards included millions of options given to the Cupertino, Calif.-based company’s renowned chief executive officer, Steve Jobs, who subsequently surrendered the awards in 2003.

So far, stock option probes have been disclosed by at least 57 companies, including 25 based in Silicon Valley or other parts of the San Francisco Bay area. Based on his research with University of Iowa professor Erik Lie, Mr. Heron predicts both numbers will quadruple by year’s end.

Most of the questions over stock options center on the timing of the awards and how they were recorded on the company’s books.

Under a practice known as “backdating,” insiders looked back in time for a low point in their company’s stock price so the exercise, or “strike,” price of the options could be set at that ebb.

Because stock options become more valuable as the market price rises above the exercise price, backdating to a low point fattens the recipient’s profit.

If companies backdated their options without accounting for the retroactive move, it could cause them to overstate their profits and underpay their taxes. The lack of proper disclosure about the practice also exposes companies to accusations of neglect and malfeasance.

Backdating was relatively easy to do until 2002, when Congress imposed tougher securities regulations to avoid the kind of duplicity that helped Enron Corp., WorldCom Inc., Tyco International Ltd. and HealthSouth Corp. mislead investors.

Until the 2002 reforms, companies conceivably could have waited more than a year to disclose the stock options granted to top executives. Now, the awards must be disclosed within two days, dramatically narrowing the window of opportunity for cherry-picking a ripe price for the option.

Silicon Valley has been especially caught up in the brewing stock option storm largely because of an entrepreneurial culture that embraced the rewards as a way for a large number of employees to strike it rich if they were willing to accept slightly smaller paychecks for a few years.

The compensation concept helped launch a legion of cash-strapped startups and turned stock options into a Silicon Valley staple that later spread to other parts of corporate America. Stock option mania intensified in the dot-com boom, when companies scrambled to come up with even more creative techniques to recruit and retain talented employees.

Mr. Heron thinks the intense competition for workers contributed to the backdating phenomenon in Silicon Valley. “With all those people moving around from job to job, companies began to realize they had to do something special,” he said. “It could be they didn’t think they were doing anything wrong because they knew others were doing it, too.”

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