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Don't be spooked by backdated stock options yet

Published June 13, 2006

The scandal rocking corporate America over the backdating of stock options is spooking investors, who don't like to hear about anyone skirting the rules to line their pockets.

With dozens of companies facing questions from regulators and prosecutors about how they granted options, the race is on to figure out how far this could spread. The potential fallout could rattle everything from the executive suite to the bottom line.

But investors might want to pause before panicking should they think their stocks could get caught up in this mess. Backdating might not be reason to run for the doors.

Stock options allow employees to buy shares of their company's stock in the future at a set price - and potentially reap big windfalls if share prices rise. Companies began increasingly relying on options in the late 1990s, when corporate executives touted options as an important compensation and retention tool, and as a way to align employees' and shareholders' interests.

What is becoming clear is that some executives were allowed to backdate the grant dates of their options, which guaranteed them options at below-market prices. Not only were such practices never disclosed by the companies, but they often allowed top managers to unfairly and potentially illegally profit.

All this is unnerving for investors, who are scrambling to sniff out where trouble could turn up next. Aiding them in that search are stock analysts and accounting researchers, who are rushing out reports detailing what companies to watch out for based on statistical models used to track stock-price movements and option grants.

Among them is the Center of Financial Research and Analysis. The Rockville, Md., firm found that 17 of 100 companies with the largest ratio of stock-based compensation to revenues were "at risk" for having backdated option grants from 1997 through 2002. Those companies on at least three occasions had awarded options at, or close to, 40-day lows in stock prices.

The good news is that such reports are naming potential names, and that has forced some companies to begin internal reviews of these alleged practices. The bad news is that investors sometimes can't stomach what they have to say.

But before investors engage in any knee-jerk selling, they might want to consider how backdating could affect a company's valuation and what it says about corporate stewardship.

That's the advice coming from Morningstar's director of stock analysis, Pat Dorsey, who suggests considering what kind of cash will have to be spent to review and possibly restate financial statements, fend off shareholder lawsuits or pay regulatory penalties. In his view, larger companies will have more resources to deal with these problems, which could mean they might not be as hard hit.

It is important to consider what such maneuvering tells investors about management. Dorsey suggests looking at how the management team is dealing with this issue and whether it is the same group that was running the company when the alleged option practices took place. Same goes for the board of directors.

Still, this scandal won't necessarily cause businesses to collapse and reputations to be permanently tarnished.

It has just become a big negative when evaluating a company and should drive some investors to review what assumptions they made when they bought the stock.

Rachel Beck is the national business columnist for the Associated Press. Write to her at

[Last modified June 13, 2006, 06:59:22]

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