A review of stock-option grants at a dozen large banking companies over the past decade found scant evidence of backdating, and governance experts say the growing scandal is unlikely to reach into the financial services industry.
As many as 100 companies are currently subject to backdating investigations by federal prosecutors and the Securities and Exchange Commission, and the Internal Revenue Service may be interested as well. Shareholder litigation is also starting to percolate.
Companies that find themselves enmeshed in the controversy include United Health Group Inc., CNet Networks Inc., Apple Computer Inc., Juniper Networks Inc., Cablevision Systems Corp., Electronic Arts Inc., and Microsoft Corp. Prosecutors have lodged criminal charges against executives of Brocade Communications Systems Inc., and the Federal Bureau of Investigation has even declared one executive - former Comverse Technology Inc. chief executive Jacob Alexander - a fugitive.
But as yet there has been no mention of banking or financial companies, and that does not seem likely to change.
The Corporate Library LLC in Portland, Maine, reviewed option grants over the past decade by 12 financial companies, at the request of the American Banker, and found no patterns of backdating. With over 1,300 publicly traded banking and thrift companies in the country, it's dangerous to draw too many conclusions about a survey covering 12.
"I'm not going to put my hand on my heart and say there is not backdating in the banking industry," said Paul Hodgson, a senior research associate at The Corporate Library, who conducted the study. "But I can say it doesn't look like there is any backdating for any of the named executive officers in these companies."
The study covered the nation's five largest banking companies (Citigroup Inc., Bank of America Corp., JPMorgan Chase & Co., Wachovia Corp., and Wells Fargo & Co.) as well as three large trust and processing banks (Bank of New York Co., State Street Corp., and Northern Trust Corp.) which typically award more options than their retail banking counterparts.
Three other companies (Capital One Financial Corp., Countrywide Financial Corp., and Commerce Bancorp Inc. of Cherry Hill, N.J.) were chosen because of large option rewards reaped by executives in recent years. SVB Financial Group of Santa Clara, Calif., which is located in the geographic and cultural heart of the backdating scandal, rounded out the group.
The banking companies included in this story were given a chance to comment, and most declined. Though their option-granting policies occasionally warranted further inquiry, the study concluded that "none of these translated into any real concern that stock options had been backdated for named executive officers."
Backdating involves retroactively selecting grant dates - and thus exercise prices - for option awards at market lows. If, for example, a company's shares are trading at $20 when a decision to award options is made, the corporate officer assigning the grant date looks backward for days when the shares were trading at, say, $15. The economic effect is in many ways similar to granting discounted, or in-the-money, stock options.
Depending on a company's bylaws, backdating itself may not be illegal, especially if it is approved by the board's compensation committee, subsequently disclosed, and accounted for properly. But in practice, companies get in trouble by being less than forthcoming about their practices.
It is not merely a question of running afoul of securities laws by failing to disclose - or accurately describe - backdated options. Companies generally must record income expense from in-the-money options, and recipients must declare the income for tax purposes. Therefore, attempts to hide backdating pose accounting and tax risks.
"As soon as you disclose the event and indicate it was granted at the money rather than in the money, then you create a cascade of fraudulent activity: accounting fraud, tax fraud, securities fraud, mail fraud, wire fraud," said Patrick McGurn, an executive vice president at the corporate governance firm Institutional Shareholder Services Inc. "The whole fraud family comes into play at that time."
In other words, borrowing a phrase steeped in decades of political wrongdoing, it's not the crime - it's the cover-up. The instinct to hide backdating is born from the perversion of a compensation tool developed to align the interests of a corporation's employees with those of its shareholders.
"Backdating completely divorces them. Management makes money when stockholders don't," Mr. Hodgson said. "If you are an executive at a company and you have backdated your options to a lower price, you have done exactly what a stockholder can't do."
Screening for backdating usually involves looking for irregular dating of stock-option grants and corresponding price troughs on the grant dates. That's only a first step for investigators, and it's far from proof of illegal activity.
"I have looked at some individual cases where I would want to bet that something went down, but I also wouldn't be willing to pursue the case further from a legal point of view, because the evidence is not strong enough," said Erik Lie, a professor at the University of Iowa, who has studied backdating. "You need other evidence - ideally, a whistleblower or evidence of forged documents - but the circumstantial evidence in most cases is rather weak."
Prof. Lie screened 8,000 companies and found grants that raised questions at about a quarter of them, but he found more solid evidence at around 1% of the group.
"I can't recall anybody in the banking industry at the top of my list," he said.
That's a popular conclusion. Advisen Ltd., an information firm for commercial insurers, started investigating option grants when clients underwriting liability policies for corporate directors and officers started asking some decidedly self-interested questions.
"We ran some filters against the top 1,500 public companies to see which ones would seem to be candidates, and I don't recall a single bank showing up in that group," said David Bradford, the editor-in-chief at Advisen. "It doesn't mean it hasn't happened, but they certainly don't fit the profile of the companies that are being nailed so far."
There are several distinct elements that make banking companies unlikely to backdate. Though option use is prevalent throughout the industry, in most cases it accounts for a lower percentage of total compensation than it does for executives and employees in other industries. Large banks in particular have increasingly moved to restricted stock as the preferred form of incentive compensation.
Stocks of financial companies also tend to be steady performers - or underperformers, as the case may be. Though there are some notable exceptions, troughs tend to be shallow and relatively hard to find.
"The market for banking shares is much more conservative than it is for many of the other companies involved in the scandal, which tend to be tech companies with volatile stock-price behavior," Mr. Hodgson said.
With fewer options and fewer opportunities, the incentive to backdate in the industry just is not as tempting, and these companies were not at ground zero of the option culture.
Backdating "was an airborne virus," Mr. McGurn said. "Banks were outside of the area of a disease being spread by word of mouth."
Bankers like to complain about auditors and regulators, but they may have stood the industry in good stead in relation to backdating. Internal controls - the very mention of which usually crosses bankers' lips like an expletive - apparently have a purpose.
"The audit that goes on at a bank is a much fuller audit than would go on at a high-technology company, because there are so many other issues of internal control and regulation that would have to be dealt with while you're running that audit," Mr. Hodgson said. "Whoever might be responsible for it would know that the auditors are going to be looking very closely."
The consequences of a transgression likely would be far more serious at a bank than at other companies. Though the Federal Reserve Board does not dictate rules governing stock options, it typically reviews compliance and audit programs when it examines holding companies, and it would refer any violations of securities law to the SEC.
Alan Johnson, a compensation consultant specializing in financial companies, said that banking regulators safeguarding the depository system rely on banks' documentation of loans, asset values, and financial performance - and that the malfeasance implied by backdating would cast doubt on all the company's representations.
That creates something of a double standard for the industry. Violations of trust just are not taken lightly when the violator holds other people's money.
"If it happened to a bank, you'd have to fire the management team," he said. "Apple Computer can hunker down and try to make it through."
The Corporate Library's study did find some grants that initially raised suspicions. Capital One, for instance, made a series of large "entrepreneur grants" for fiscal 1997, 1998, and 1999 that each took place in separate months. The concerns raised by the irregular pattern were not born out, however. In no case did the grant dates correspond to a low point in the stock price.
Capital One said the grant dates matched the scheduled board meetings at which they were awarded.
Countrywide's grants were less consistent than those of the other companies in the study, and governance firms have criticized the generous compensation for Angelo Mozilo, its longtime chairman and CEO. In addition to the irregular grants, there were instances, mostly in 2000 and 2001, in which grant dates did not always match expiration dates - a deviation from the other companies' practices.
"With this level of irregularity, red flags tend to sprout like weeds," the governance firm said in its report. However, "nothing about the dates and the stock price on those dates suggests backdating."
Countrywide declined to comment.
State Street's option grants were exemplary, with annual December grant dates occurring within five days of each other from 1995 to 2003, according to the study, except for a February 2002 award that occurred at the lowest closing price of the stock within 60 days of either side of the grant date. However, the study also said that the award was relatively small - only one-eighth of the options awarded that year - and unlikely to be an instance of backdating.
According to State Street, the grant was made at the compensation committee's scheduled Feb. 21 meeting, and the exercise price was at the average of the stock's high and low prices in that day's trading.
Given the substantial questions surrounding compensation and control practices at Fannie Mae and Freddie Mac, The Corporate Library conducted a "brief investigation" of them but found practices that "seem to indicate that backdating was unlikely to have occurred at either of them."
The same was true for Greater Bay Bancorp of East Palo Alto, Calif., which delayed its second-quarter earnings report to complete an internal investigation of option practices.
Though the study found few triggers for backdating investigations, it's not safe to assume that banking companies are entirely in the clear. The sheer number of publicly traded financial companies alone - close to 640 on major exchanges and more than double that number of pink sheet and bulletin board companies, according to SNL Financial LC - is a statistically persuasive argument for instances of abuse.
Labor competition is heating up. Banking companies of every size are granting options to attract and retain talent. No industry is immune from fraud. But for now, bankers can conclude that backdating is mostly somebody else's problem.
"Very possibly there are some banks that have done it, but clearly they have not done it in such a blatant way as some of the other firms," Prof. Lie said.
