Options are scandal from ghosts of Christmas past, future

On the Money
From the December 8, 2006 print edition

The holidays have arrived. As the seasonal song says, “He’s making a list, checking it twice. Gonna find out who’s naughty and nice.”

Once again, Santa Claus is shaking his head at the financial community. If this keeps up, Santa’s annual trip will be so short, he’ll need only four reindeer.

This year, the activities that are increasing the “naughty” list have been dubbed, “The Options Scandal.” According to Forbes, as of October, more than 150 companies have been engulfed in this embarrassment and embezzlement.

Let’s examine the nature of “options” and the source of this scandal.

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specified date. An option is a binding contract with strictly defined terms and properties.

Since option contracts can be for either a sale or a purchase, the idea was originally to protect, or hedge, an investment. Additionally, many companies use employee stock option plans to compensate, retain and attract employees. These plans are contracts that give employees the right to buy the company’s shares at a fixed price within a certain period of time.They hope to profit by exercising their options in the future at a higher price than when they were granted.

If you’re a shareholder in a public company, watch for SEC filings of Form S-8 and Form 4. This may tell you the firm is using options as compensation, thereby eroding the value of the stock in general.

The two types of options are “calls” and “puts.” A call gives the holder the right to buy an asset at a certain price within a specific period of time. Buyers of calls hope that the stock will increase substantially before the option expires.

A put gives the holder the right to sell an asset at a certain price within a specific period of time. Buyers of puts hope that the price of the stock will fall before the option expires.

If you already own the asset for which you’re purchasing an option, it’s called a “covered” option. Trading in just the options alone, without owning the underlying security, is known as an uncovered or “naked” option.

The current options scandal has to do with time. An option contract is for a specific period of time from the date it was granted. Under fair and legal rules, after making a considered prediction about which way the price will move, people buy options and hope they’ve accurately predicted the future.

However, in the current cases, options were executed today for a date in the past at a price that the issuer and buyer already knew was lower than today’s worth. It’s just like betting on a football game where you already know the results.

Is this a new high-tech scheme? Hardly. It’s the oldest scheme in the books, made even more famous in the movie “The Sting” where the entire scheme was based on the practice of “past posting.”

Past posting is simply making a bet on a known outcome. This is possibly the best-known con trick of all time. A close cousin to the current scandal involving past-posting options is insider trading. Illegal insider trading would occur if the CEO of Company A learned (prior to a public announcement) that Company A will be taken over, and bought shares in Company A knowing the share price likely would rise.
One of the strangest cases occurred at Cablevision (NYSE: CVC), which announced late in September that it had granted stock options to a dead executive and then backdated the award to when he was alive.

Backdating options isn’t just a one- or two-person scam. It affects every shareholder of the firm. The deception manipulates financial statements — increasing profits, lowering taxes and affecting the overall stock price.

Options are supposed to be managed by the compensation committee of the board of directors. Recent research has discovered common board members across several companies involved in the swindle.

For example, VeriSign has other directors with ties to more than one company in the scandal, including Roger Moore of Western Digital Corp. and Gregory Reyes, the former CEO of San Jose-based Brocade Communications System Inc. Reyes became the first prominent Silicon Valley leader to face criminal charges in the options mess.

Maybe we should borrow another few lines from the holiday carol:

“He sees you when you’re sleeping. He knows when you’re awake. He knows if you’ve been bad or good. So be good for goodness sake.”

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.