Tech's Backdating Blues

The sector's heavy reliance on options likely means a higher number of future irregularities.
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The options-backdating scandal hasn't exactly been good news for the beleaguered tech sector.

But things could get worse -- potentially, a lot worse.

In coming weeks and months, the number of companies accused of backdating options for their executives or allowing them to game the system in other, similar ways will likely continue to grow, analysts say. And because the tech industry has been one of the most prolific users of the compensation scheme, it wouldn't be surprising if the bulk of those are tech firms.

"I worry every day that one of the names I own will come out and say 'We have an issue,' " says a portfolio manager who asked to remain anonymous. "This is already a big cloud. A portfolio manager would have to be kidding you if he said he wasn't worried about this."

Further revelations will, of course, be especially bad for those companies named. But the steady trickle of disclosures so far has already weighed on the sector as a whole, and will likely continue to do so. "This is a breach of trust to shareholders," says Charles Elson, chairman of the Weinberg Center for Corporate Governance at the University of Delaware. "It's bad news all the way around."

The scandal centers on how certain companies priced options granted to their executives. Employee stock options typically carry a strike price equivalent to the market price of the stock on the day they are granted.

But about a dozen companies so far have been identified as having suspiciously granted options on what turned out to be their stock's near-term or 52-week low. The accusation is that the companies set the strike price for the options long after they were actually granted, i.e., when the stock's movement was known. The value of an option is determined by the difference between the market price of the stock and the exercise price of the option, meaning the lower the exercise price, the greater the payout.

Depending on a particular corporate options plan, backdating isn't necessarily illegal. But regulators are investigating whether the companies involved clearly communicated what was going on to shareholders. Because accounting rules treat options priced at market value differently from those priced below it, regulators are also looking into whether companies misstated their earnings or taxes as a result of the backdated options.

Erik Lie, an associate professor of finance at the University of Iowa, helped to expose the backdating scheme with a research paper published last year. Lie's research indicates that backdating was fairly widespread -- not just the work of a few bad actors.

"There are still more companies that have very strong patterns

indicating that backdating was going on that have not come out yet," says Lie, though he declined to name any particularly suspicious companies. "It's a big thing, but I don't think we'll see the whole thing ... ever."

Lie and other analysts believe the scandal could metastasize. Most of the scrutiny so far has focused on options grants before 2002 because until then, companies could report options grants weeks or months after the fact. But even though the Sarbanes-Oxley Act requires more timely disclosure of grants, Lie estimates that about 20% of companies haven't done that, meaning that there could be other questionable grants of more recent vintage.

Then there's the age-old issue of when companies report material news. Some research has indicated that companies have timed the release of good and bad news around options grants so as to depress their stocks before the grant and boost it afterward.

The revelations thus far are "probably the tip of the iceberg," says Paul Hodgson, senior research associate at The Corporate Library, an investor research firm and watchdog group.

That's not a good thing for tech. Although some non-technology companies, such as


(UNH) - Get Report

, have been accused of backdating options, the scandal to date has had a decidedly tech flavor.

Just last week, for instance, chipmaker


(ALTR) - Get Report

, chip-equipment manufacturer


(KLAC) - Get Report

, tech-news-and-reviews online publisher

CNET Networks

(CNET) - Get Report

and integrated-circuits maker

Analog Devices

(ADI) - Get Report

have disclosed that their stock-granting practices are the subject of regulatory inquiries.

That tech has borne the brunt of the scandal thus far isn't really surprising.

Stock options are a big part of the culture of Silicon Valley, and tech companies have been far more dependent on them than companies in most other sectors. The tech sector fought tooth and nail against a recent accounting rule requiring companies to recognize options costs in their income statements, often using specious arguments to do so.

More recently, many companies -- particularly in tech -- have been accused of suspiciously playing with the assumptions they use to calculate the value of options, allegedly to reduce their recorded options expense.

"It's certainly possible that those people would have played the same game with backdating," says Lynn Turner, former chief accountant at the

Securities and Exchange Commission

and the managing director of research at Glass Lewis, a proxy advisory firm.

Companies hit by the backdating scandal so far have seen their stocks singed. Shares of

RSA Security


, for instance, are off nearly 10% since the company announced it was being investigated. Shares of KLAC are down about 12% since its own revelation.

But investors say the revelations to date -- and the fear that there will be more to come -- are weighing on the entire technology sector. How much is hard to say, given the sector's many areas of concern: rising interest rates, inflation, and worries about slowing growth.

"Anything that erodes the credibility of the marketplace -- which this clearly does -- adds to the discount rate," says Ken Broad, a portfolio manager at Delaware Investments. "This is one more negative that absolutely has to weigh, in general, on investors' minds, and particularly in the technology sector."

The scandal is already playing a role in the anonymous portfolio manager's investment decisions. The investor sold off






after they revealed that they were being investigated. And the investor is trying to steer clear of other companies that could potentially have problems, particularly those flagged in research reports.

"Some of this is once bitten, twice shy," says the portfolio manager, adding that it's hard to know how long to take that stance. Right now, "this stuff seems to keep coming out of the woodwork."