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Bitten by `backdating'

October 17, 2006

FOUR CHIEF EXECUTIVES HAVE LOST their jobs in the last eight days because of a scandal that, even by the standards of Wall Street, has proved especially hard for Main Street investors to parse. The activity in question -- backdating stock options -- is arcane and may not even be illegal. In this case, to borrow a phrase from politics, the coverup is worse than the crime.

Stock options were created to give executives and employees an incentive: The higher the company's share price, the more they got paid. In the typical options grant, the recipient receives the right to buy a block of stock one or more years later at whatever the shares are selling for today. The idea is to align the employee's interest with the shareholders'. The value of the grant goes up as the stock rises.

As millions of investors have learned in the last few years, however, stock prices do not always go up. And when they don't, stock options are worthless -- on paper and as an incentive. So companies hit on a new strategy. Instead of giving executives the right to buy future shares at today's prices, they offered them the right to buy today's shares at yesterday's prices. The beauty of this policy was that companies could pick whatever yesterday they wanted. They could take the risk out of stock options.

This practice, known as "backdating," is not illegal -- as long as each grant is properly disclosed and accounted for. What's gotten so many companies in trouble is that they backdated in secret, not in public.

Some say the companies that engaged in backdating -- many of which were technology firms -- were trying to retain workers in a fiercely competitive job market. But if the goal was to retain employees, there was no need to hide the backdating. In fact, the companies would have been better off advertising the practice ("We'll do whatever it takes to make your stock options valuable!"). More likely, the rationale for backdating was to avoid two hits to the bottom line. Unlike conventional options, which don't eat into a company's profit, backdated ones count as a charge against earnings. And for executives making more than $1 million, the expense to the company of the backdated options was not tax deductible.

More than two dozen executives have lost their jobs in this scandal in recent days, including ones at UnitedHealth Group, McAfee, CNet Networks and Monster Worldwide. The Securities and Exchange Commission is scrutinizing more than 100 companies for options grants during the high-tech boom-and-bust years from 1998 to 2002, before a change in federal law made secret backdating more difficult. Shareholders won't be made whole until the companies and executives who avoided the discipline of the market finally come clean.

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