Bigger Than Enron? There's a New Corporate Scandal Brewing

Although much recent attention has been given to the spying of former Hewlett-Packard (HP) Chair Patricia Dunn on H-P board members and high tech journalists, a far greater scandal has been brewing that has flown largely under the public's radar. It's not as tawdry as the Hewlett-Packard scandal, and it does not have the cheekiness of the antics of Enron bad boys Andrew Fastow and Jeffrey Skilling, but it's depth and breadth are unsurpassed by anything that happened at Enron or HP. What is the problem so pervasive that it is overtaking these corporate nosedives? It's stock option backdating, and according to the "Wall Street Journal" in its "scandal scorecard," the number of companies now facing federal investigation is at least 130: the number reporting internal probes: 153; the number of executives or directors resigning or being fired: at least 42, including 10 CEOs; the number criminally charged: 5; and the amount of misstated profits from misdated options: $5.3 billion from more than 60 companies. No small potatoes here.

This dirty little secret has been gracing the pages of the "Wall Street Journal" and other business media, but gone largely unnoticed by the general media. Yet this scandal has rocked some of the most successful companies in the American vernacular: Apple, Home Depot, UnitedHealth Group, and a stunning number of Silicon Valley companies, where backdating one's stock options was a "no brainer."

The current investigation by the Securities and Exchange Commission (SEC) has become so large that it is now relying on internal investigations by companies to determine just which companies to pursue on federal indictments. What is this scandal all about? In a nutshell, this story centers on the practice of corporate executives improperly affording themselves undeserved wealth through the process of backdating stock options to dates when a company's stock price is low, giving the grant recipient an instant paper profit. Stock options, part of the typical corporate executive's pay pack, allow the executive to buy company stock at a fixed price on a certain, pre-determined date, allowing the executive to profit if the stock rises in value from the date of purchase. How to win at this game? Pick the date with the lowest stock price. How can the executive know that date? Only through backdating, an illegal practice that now has some 70 companies scrambling to restate or reduce their profits because of said illegal practice.

This problem first came to the attention of the federal government more than 3 years ago, when Stephen Cutler, then an enforcement officer at the SEC read an account suggesting that executives has issued options just prior to the release of news so favorable that it caused a significant rise in the company's stock price. Today, the problems are so large that the SEC, Federal Bureau of Investigation (FBI), the US Postal Service, and 9 US attorney offices have largely come to rely on corporate self-policing, stepping in when they feel internal probes are skirting serious issues, such as in the case of Affiliated Computer Services, Inc. (ACS). At ACS, the odds of the chosen dates for option granting were determined to be 300 billion to 1 against being randomly selected.

Backdating options are clearly illegal if not reported to shareholders, causing serious accounting and tax problems for companies and their executives. The SEC, which is leading the federal investigation, has more than 150 lawyers and accountants working on the scandal, despite the number of companies conducting their own internal examinations and turning the results over to federal authorities. The situation in Silicon Valley is so serious that the US Attorney's Office for the Northern District of California formed a special force of prosecutors and FBI agents. According to Lynn Turner, a former chief accountant at the SEC, "The sheer magnitude of the numbers of companies, executives, and corporate boards that have disclosed options-related investigations in mind-boggling...." Add to that the millions of dollars being spent in the corporate sector by more than 100 companies, and you have a corporate scandal many times larger than anything cooked up by Enron or HP.

The scandal is now so large that the SEC must let the fox watch the hen house, relying on self-reporting of a practice that has become so common in corporate America as to overwhelm federal investigative resources. Clearly some companies will escape prosecution altogether, while many will be let off the hook for their good effort for restating financials and self-correcting internally. The sheer number of companies conducting such internal investigations, to the tune of several million dollars in legal fees, is unprecendented. Yet, it is clearly not enough and raises questions of fairness for those who choose not to conduct internal reviews, instead taking the gamble such practices will not be discovered. Although the SEC now has put in place measures to evaluate the outside investigators, this is a problem now so widespread that nothing like its magnitude has been seen since the 1970s when the overseas bribery scandal rocked the financial pages of newspapers everywhere.

Stock option backdating may not have the audacity of the Enron scandal or the intrigue of the HP debacle, but it has a serious impact on the earnings of many, many US corporations and the ability of the top 1 percent of wage earners to profit at the expense of us all. Isn't that a scandal you should know about?