Scrutiny of executive windfalls intensifies

A widening federal investigation of stock-option trickery is part of a larger story: an unfinished effort to transform the governance of American corporations.

This week, the chairman of the US Securities and Exchange Commission (SEC) said the agency is poised to bring its first lawsuit "very soon" regarding the practice of so-called backdated options.

Think of it as a chance to buy a stock at a rock-bottom price after you already know it's gone up. It now appears that many companies offered executives this opportunity over the past decade – and broke laws in the process.

"These are not merely episodic instances," SEC Chairman Christopher Cox said Monday.

As the SEC moves toward civil lawsuits, US attorney Kevin Ryan in San Francisco announced a stock-option task force that could result in criminal cases against high-tech firms in Silicon Valley.

The probes come at a time of growing concern about skyrocketing executive pay, and about the need for stronger oversight by corporate boards of directors. Some observers say America's system of corporate governance still requires major reforms, despite new scrutiny imposed after the collapse of corporations such as Enron and WorldCom several years ago.

"CEO pay is out of control," says Nell Minow, founder of The Corporate Library in Portland, Maine, which studies corporate governance. But "the front-burner issue for me is: How effective is the board of directors?"

Not everyone agrees that poor oversight by directors is a systemic problem in corporate America. But wide agreement exists that when problems such as illegal stock-option grants crop up, the buck stops in the boardroom.

Chief executive officers, of course, run companies day to day. But it is the directors who are responsible for hiring them, setting their pay, and overseeing the design of executive pay packages – often based on the theory that manager rewards should depend on company performance.

If the system is working properly, in Ms. Minow's view, the granting of stock options would enrich executives only if their company outperformed its peers or if its shares rose significantly in price.

When options are backdated, the general result is the exact opposite. Executives get the opportunity to buy their company stock at a low point, knowing that it is now worth a lot more. They still have an incentive to make it rise further, but this is hardly the kind of "pay for performance" that compensation experts recommend.

"When you give an executive stock options, what you're trying to do is ... give executives the same incentives as shareholders," says Mary Ellen Carter, an executive-pay expert at the University of Pennsylvania's Wharton School in Philadelphia. When ordinary investors buy shares, she adds, they can't do it with hindsight.

About 60 companies, many of them in high-tech industries, are already under the SEC's legal microscope for possible illegal backdating. But the number of firms that employed the practice could be far higher.

"I don't think we know how deep this goes," says Dave Larcker, an accounting expert at California's Stanford University.

Erik Lie and Randall Heron, finance experts at the University of Iowa and Indiana University, crunched numbers that are fueling the current probes.

Often, the option to buy shares will be granted to executives "at the money," at the current share price. If the stock rises, they can make a profit by exercising that option. The new study by Lie and Heron compares the timing of options with the behavior of stock prices, and concludes that the number of bargain options given to executives could not be mere coincidence. Instead, they argue that backdating has occurred, with boards dating the grants (after the fact) for optimal prices.

"We estimate that 18.9 percent of unscheduled, at-the-money option grants to top executives during the period 1996-2005 were backdated or otherwise manipulated," the authors wrote in the study.

The practice has diminished, but not disappeared, since an SEC move in August 2002 requiring that option grants be reported within two business days.

Backdating is not explicitly against the law. But to be legal, it must be clearly reported to shareholders and properly reflected on corporate tax forms and earnings reports. In practice, Lie writes that backdated option grants are mostly illegal.

Some experts predict that the new scrutiny, coupled with pending SEC rules that will require clearer disclosure of executive pay, will go a long way toward curbing abuses of the stock option process.

But this may need to be matched by vigilance from directors and the shareholders who elect them. Surging executive pay, say critics, is in part a symptom of rubber-stamp boardroom culture.

One sign of improvement for Minow: Sixteen percent of Fortune 500 companies now require directors to be elected by a majority of votes cast at annual meetings, and the number is rising.

Many experts say that excessive pay is limited to individual firms.

"I think the typical compensation choices for companies across the spectrum are probably OK," says Dr. Larcker. CEOs have big responsibilities, he notes, and at the biggest 3,000 US firms, he says their median compensation is about $1.5 million.