Backdating: Is It Corporate Theft?

April 24, 2007 — -- Bob Chapman is an investor and shareholder activist, who relishes his reputation as a "tough guy" on Wall Street. Chapman's critics might call him a bully because of his sharp, abrasive style, but there's no denying that he draws much-needed attention to controversial issues.

Chapman's most recent frustration stems from the latest scandal to hit Wall Street: the often illegal practice of backdating stock options so company executives earn greater profits than they deserve.

'Subtle Theft'

On the subject of backdating, Chapman's stance is clear. "It truly is as bad, in my mind, as if the board of directors or the beneficiaries of the backdated options went into the treasury, opened up a safe, took money out and handed it to somebody, and told the board of directors it was OK," he told ABC News. "I think it is a subtle yet egregious form of theft."

Essentially, options backdating means granting an employee an option to buy stocks in the company at an artificially low price dated before the company actually granted that option.

The low price ensures a handsome profit when the stocks are then sold at a higher price. The practice is tantamount to handing cash over to the grantee at the expense of the shareholder.

Investors believe the practice is unfair. Regulators say if the backdating is concealed, it is also illegal. "We'd all be millionaires if we could choose the lottery numbers after the drawing," said Tim England, assistant director at the Securities and Exchange Commission. "That's fraud, and that's rigging the game."

The Investigation

England and his fellow investigators at the SEC are taking a hard look at well over 100 companies they suspect of fraudulently backdating their stocks -- and the number seems to keep growing. "The range of companies that are being investigated by us," England told ABC's "Nightline," "include Fortune 500 companies, as well as smaller mid-to-smaller cap companies that span sectors and industries and time periods."

The FBI has also launched criminal investigations. Several executives, including the former CEO of Take Two Interactive, as well as the former top lawyer of Monster Worldwide, have already pleaded guilty.

"I think we will see, over the coming months, a number of other cases against executives and senior executives for fraudulent backdating," said England.

Against the Odds

The irony of this practice is that it was uncovered by an obscure professor of finance at the University of Iowa.

In what turned out to be groundbreaking research that led to the still-unfolding scandal, Erik Lie, a native of Norway, crunched the numbers in thousands of cases. He discovered that the stocks of many companies jumped after awarding options, and the odds against such market moves were astronomical.

"If I were to convert my statistics into odds," said Lie, "I am certain that I would at least come up with odds that were at least one in a billion. There is some kind of manipulation taking place here, clearly."

Lie's number-crunching of 8,000 companies indicated the manipulation was more widespread than anyone, including the SEC, ever imagined.

Twenty-nine percent of the firms Lie looked at showed some kind of manipulation of the stock prices. That number "amounts to more than 2,000 firms," Lie said. "I was shocked."

A Rotten Apple?

Lie passed his findings on to federal authorities and now some of America's best known companies are under investigation.

One of the executives of Apple, the popular computer company, has agreed to pay $3.5 million in civil fines and penalties, and claims he warned Apple CEO Steve Jobs about backdating problems. Apple has confirmed that Jobs himself was awarded backdated options that carried a false date in October 2001.

According to Apple's own 10-K report filed with the SEC, the award was "improperly recorded as occurring at a special board meeting," when in fact "such a board meeting did not occur."

"What they did was create a virtual meeting, an imaginary meeting," said Nell Minnow, editor of The Corporate Library and a longtime advocate of corporate ethics. "I think the board has done a shameful job, at first, in approving this retroactively and, then, investigating it. I think they have done a very poor job."

Apple appointed a review committee that included former Vice President Al Gore, a member of Apple's board, which cleared Jobs himself of any wrongdoing.

Minow doesn't buy the Apple board's explanation. "Somebody needs to explain to Al Gore, who was on that committee, what an 'inconvenient truth' is," Minow said.

In a January interview with ABC News, Jobs defended his board and his company. "All of the investigations cleared all the current management, and we've shared everything with the SEC every step of the way," Jobs said. "And we're back on file with the SEC with our financials, and our auditors have blessed everything, so I think we're just fine."

'It's Just Money'

On Wall Street, regulators now believe backdating probably peaked around 2002, before a new federal law made the practice far more difficult. Now investigators are combing through old e-mails and other documents for evidence.

"Some people think that they can write things in e-mails and keep them private when, in fact, we have great resources to be able to track e-mails from years and years and years ago," SEC enforcement official Tim England explained. "They can be a terrific source of evidence for us, along with other documents and computer data that we can evaluate."

At the bottom of it all, the underlying motive for backdating is as ancient as greed. "Money. It's just money," said Minnow. "It's about gaming the system for every last penny, even more than you're supposed to."

As for Bob Chapman, the Wall Street investor, he's also hoping to profit from this scandal, which has provided him with a new opportunity: He chastises company directors to dismiss corrupt management, hoping that the value of his own investment grows.

"Well, I'm in it to make a buck, and if it happens to put away a criminal at the same time, that's icing on a very nice cake," said Chapman.

He vows to continue to hound certain corporate CEOs in his sharp, abrasive manner, a tactic that might be worthwhile for Chapman and for the executives he upbraids.

Listening to Chapman and taking corrective action may prove less painful than a visit from federal agents.