Stock Option Backdating: Ethical and Accounting Challenges Rick Fezell, Ernst & Young Kirk Hanson, Markkula Center for Applied Ethics, SCU

What is a STOCK OPTION? A stock option gives an employee the right to buy shares in the future at the market price on the date a grant is approved. If the stock rises, exercise, sell and make a profit. Grant date – June 30 >> $10.00/share market price 1,000 options granted, vesting over 4 years All exercised at the end of Year 4 >> employee pays $10,000. Sold on the same day, $25.00/share >> employee receives $25,000 Gain >> $15,000

What is BACKDATING? Backdating is selecting a date prior to the actual grant when the stock price was lower, thus increasing the award's value. Grant date – June 30 >> $10.00/share market price “Backdated” grant date – May 19 >> $6.00/share 1,000 options granted, vesting over 4 years All exercised at the end of Year 4 >> employee pays $6,000. Sold on the same day, $25.00/share >> employee receives $25,000 Gain >> $19,000

Types of Stock Option Backdating 1. Paperwork missing from corporate files 2. Grant date unclear due to unanimous consent 3. Company policy to give lowest or average price during a period 4. Backdating to attract a new employee with in the money options; to sweeten a deal 5. Backdating to enrich value for all employees 6. Backdating to enrich value for management 7. Creating false paperwork to justify options

How Was Backdating Detected? Academics, analysts and news organizations. The WSJ won a Pulitzer Prize for its investigative reporting, which began in March 2006 – The Perfect Payday Academics, analysts and news organizations. The WSJ won a Pulitzer Prize for its investigative reporting, which began in March 2006 – The Perfect Payday Affiliated Computer Services CEO - all six of his stock- option grants from 1995 to 2002 were dated just before a rise in the stock price, often at the bottom of a steep drop. Just lucky? A Wall Street Journal analysis suggested the odds of this happening by chance are extraordinarily remote -- around one in 300 billion. The odds of winning the multistate Powerball lottery with a $1 ticket are one in 146 million. Affiliated Computer Services CEO - all six of his stock- option grants from 1995 to 2002 were dated just before a rise in the stock price, often at the bottom of a steep drop. Just lucky? A Wall Street Journal analysis suggested the odds of this happening by chance are extraordinarily remote -- around one in 300 billion. The odds of winning the multistate Powerball lottery with a $1 ticket are one in 146 million. Maybe insider trading? No, the SEC eventually came to "an increasing realization that the companies were in fact lying about the timing of the grants." Maybe insider trading? No, the SEC eventually came to "an increasing realization that the companies were in fact lying about the timing of the grants."

V-Charts – “The pictures were telling us a story” - WSJ

Who was doing it? 140 Companies under Federal investigation; 70 executives lost jobs and 10 face federal or state criminal charges. Numerous SEC investigations. KLA-Tencor – Settled with 3 city/state pension plans for $65 million KLA-Tencor – Settled with 3 city/state pension plans for $65 million Brocade – Settled with the SEC for $7M and CEO Greg Reyes convicted and sentenced to 21 months in prison Brocade – Settled with the SEC for $7M and CEO Greg Reyes convicted and sentenced to 21 months in prison Monster Worldwide – Deferred prosecution for terminally ill former CEO Monster Worldwide – Deferred prosecution for terminally ill former CEO

Apple, Inc. “Although the investigation found that CEO Steve Jobs was aware or recommended the selection of some favorable grant dates, he did not receive or financially benefit from these grants or appreciate the accounting implications. The Special Committee also found that the investigation had raised serious concerns regarding the actions of two former officers in connection with the accounting, recording and reporting of stock option grants.” – 2006 Annual Report

Why Was it Done? Intense competition for employee talent Intense competition for employee talent Non-cash – nobody cares and nobody gets hurt Non-cash – nobody cares and nobody gets hurt Everyone else does it Everyone else does it

Who should be punished? CEO who directed it be done CEO who directed it be done CFO who knew it was being done CFO who knew it was being done General Counsel who knew it was being done General Counsel who knew it was being done VP Human Resources who processed the paperwork VP Human Resources who processed the paperwork Individuals who benefited from the backdated options Individuals who benefited from the backdated options

What punishment is appropriate? Who should be fired? CEO, CFO, Gen Counsel, VP HR, Compensation manager who processed it? Who should be fired? CEO, CFO, Gen Counsel, VP HR, Compensation manager who processed it? Legal Penalties: None – victimless crime; just fine the company for back taxes and penalties? Legal Penalties: None – victimless crime; just fine the company for back taxes and penalties? Personal fines for individual who ordered it done? Personal fines for individual who ordered it done? Jail for individual who ordered it done? Jail for individual who ordered it done? Personal fines or jail for person who did backdating paperwork? Personal fines or jail for person who did backdating paperwork? Personal fines or jail for “gatekeepers” who knew it was being done (CFO, GC, HR etc)? Personal fines or jail for “gatekeepers” who knew it was being done (CFO, GC, HR etc)?

What should we learn from the backdating scandal? “Bubble” periods are ethically risky “Bubble” periods are ethically risky Correct accounting is always worth the time Correct accounting is always worth the time Tax manipulation and fraud -- is fraud Tax manipulation and fraud -- is fraud Falsifying documents is particularly dangerous – Obstruction of justice is worse than the act itself Falsifying documents is particularly dangerous – Obstruction of justice is worse than the act itself “Gatekeepers” are expected to stand up for what is right “Gatekeepers” are expected to stand up for what is right CEOs and others can go to jail for fraud CEOs and others can go to jail for fraud Other………… Other…………