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How Options Backdating Can Hurt

In a financial scandal that shows no signs of abating, well more than 150 public companies are now being scrutinized for the questionable, but not illegal, practice of backdating stock options granted to executives — and many of the executives involved have been forced out of their high-paying jobs, with the possibility of more to go, as well as the possibility of a federal clampdown and tighter rules forced on companies.

So far, only one of the companies surveyed in this year's HTT Executive Compensation survey, Bed Bath & Beyond, has admitted backdating options following an internal investigation, and said it faces an $8 million charge against third-quarter profits. Further, the retailer said the federal Securities and Exchange Commission said it will conduct an "informal inquiry" into the company's practices.

The "why" behind the practice of backdating options becomes crystal clear with just a casual glance at the way executives are paid. For the five highest-paid executives in this year's canvass, options made up more than 80% of their total compensation package. The poster child for the options-festooned executive corps in this year's HTT survey is Target's Robert Ulrich, who took home $34.9 million in options, 81% of his total compensation package. Put another way, the options he pocketed were worth more than 22 times as much as his relatively meager cash salary of $1.6 million.

But even that looks like chump change stacked up against the $1.6 billion value of the options held at year's end by United Health Group ceo William McGuire, who was forced out of his job.

So just what is backdating? Options grant an executive the right to purchase stock at some time in the future — usually more than a year out — at the stock's price on a specific date. The idea is that when you buy the stock this year at last year's price, you might, say, be buying $100 worth of stock for just $75. Backdating is a lot like a bookie moving the goalposts once the football game is over, changing the result of the game and limiting his payout. In this case, the date of the grant is manipulated, shifted to a time when the stock was at a low point, guaranteeing the executive can stuff his piggy bank full.

The trick is, it's not really illegal — just wrong. No laws are broken, just accounting rules. But if a company doesn't make it clear up front and right away that backdating is taking place, the question of fraud can be raised. For example, the former ceo of computer peripheral manufacturer Brocade, now out of a job over the backdating issue, is being sued by shareholders for stock fraud.

Further, tax penalties might apply, and past earnings might have to be restated. And it can get even worse for shareholders. Once the news came out about United Health Care's problems, the company's stock lost almost a third of its value.

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