More than just a few rotten apples as Jobs is drawn into latest US corporate scandal

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The Independent Online

It is the scandal Wall Street can no longer dismiss as "a few bad apples". In what amounts to systematic corruption, dozens of American companies stand accused of manipulating share options to inflate executive pay artificially, and then lying to shareholders about it.

As many as 2,000 companies may be involved. So far, 85 have publicly admitted they are under investigation. Directors from nine companies have quit in disgrace. Six executives from two firms are facing criminal charges. Angry shareholders are lining up their lawsuits.

And now we have the extraordinary possibility that shares in Apple Computer might be thrown off Nasdaq, and that Steve Jobs, the iPod maker's visionary leader, could be questioned by the Securities and Exchange Commission, the Wall Street regulator.

The scale of the scandal is breathtaking and the anger felt among shareholders is palpable. Tobias Levkovich, chief equity strategist at Citigroup, said the affair will radicalise shareholders. Already we are in an age in which activist investors and hedge funds appear on shareholder registers to agitate for change; they may find more willing support from traditional shareholders.

Mr Levkovich said: "From talking to shareholders, I think there is a growing willingness to go along with activist investors and this options issue is making life less hospitable for corporate managements. The whole thing is offensive and an affront. Share options are meant to align the interests of directors and shareholders, but now we find that some companies have perverted and corrupted this capitalist tool so as to reward directors irrespective of the share price."

Companies, particularly loss-making Silicon Valley firms during the boom, have always loved share options as it gives directors incentives without having to find any cash to pay them. Shareholders often think they are okay, too, because they like directors who are focused on getting the share price up.

Share options give an executive the right to buy company shares at a fixed price - typically the price on the day they were granted - for several years into the future. The greater the share price rise before they are exercised, the greater the profit.

But getting a company's share price up is hard work for directors. A much easier way to increase the profit on options is to pretend they were granted at a lower price than they really were. With disclosure rules lax before the Sarbanes-Oxley reforms of 2002, and plenty of time allowed before the grant had to be revealed to shareholders, there was ample temptation to wait and to pick the date at which the share price was at its lowest.

The backdating of options is not explicitly illegal but it is not allowed under most company's stated options plans. The SEC and federal prosecutors have begun to lay charges against executives they claim misled their shareholders and who they allege have faked internal documents to cover their tracks. The former chief executive and two other executives at Brocade Communications Systems, an IT infrastructure company, are charged with doling out backdated options to hundreds of employees. And last week, the former boss and two other executives at Comverse Technology, a telecoms software group, were charged with criminal fraud.

There will certainly be other charges. There is also likely to be chaos across the technology sector as companies sort out the accounting and tax mess that their deceptions have caused. Because stock options are now accounted for as an expense, companies who secretly backdated grants will have been overstating their profits in recent years and may have to pay higher taxes in future years.

Mercury Interactive, the first tech company to admit options backdating, took nine months to finalise accurate accounts, during which time its shares had to be suspended. And last Friday, Apple said it might be forced to delist from Nasdaq. It missed the deadline for filing its latest quarterly results, which will have to include significant changes to the old figures and possible reductions to future earnings guidance. The company has a period of grace but will have to meet Nasdaq within the next couple of months.

Mr Jobs received an option to purchase 10 million shares, dated on the stock's lowest point in January 2000. News of the investigation into that and other executive grants sent Apple shares lower as investors feared the legendary chief executive, who founded the company 30 years ago, might be forced to quit, although there has been no indication of wrongdoing on his part. He faces questions, too, over another of his companies, Pixar, the film animation studio he sold to Disney last year. Two senior Pixar executives received options grants at low points for the share price.

New companies are admitting they have been drawn into the regulatory investigation at a rate of almost one a day but the scandal has taken a long time to unfold.

In many ways, the tale of its discovery is a classic detective story. It was maverick academics who first smelt something fishy and pursued their hunch, in the face of an establishment that dismissed them or was slow to respond. Only in recent months have they finally been hailed as heroes.

In 1997, David Yermack, now a professor of finance at New York University, planted the first germs of suspicion by noting the lucky timing of the average executive options grant, which appeared to come just before a strong rally in a company's share price.

And as options grants became a more central plank of executive pay during the years, these coincidences became more frequent and striking. By the time Erik Lie, associate professor at the University of Iowa, compiled statistics on the subject in 2003, he could come up with only one conclusion.

"The odds of executives being able to predict a rally in the share price over the next few days after a grant were simply astronomical. I thought it was clear they were cherry-picking dates from the past."

But Mr Lie struggled to find a publisher for the work. At this point, not a single company had been accused of backdating options, and the editors thought it unlikely that this was what was happening.

It was only in 2004 that the SEC stumbled across backdating at Mercury, and Mr Lie sent his research to the regulator. The SEC has since worked with him and other academics in its search for new companies where there are suspicions of fraud.

His latest studies continue to provide astonishing new evidence of systematic corruption. At 2,000 of the 8,000 companies examined, there were significant grounds for believing that options dates were chosen after the fact to maximise executive profit. And the introduction of Sarbanes-Oxley rules did not stamp out the practice. Although companies are required to disclose options within two days of granting them, many have simply not complied with the rules and filed the information late. Even since 2002, one in eight grants still has the whiff of suspicion over them, Mr Lie says.

"I believe that only a minority of firms that have engaged in backdating of option grants will be caught. In other words, we will never see the full iceberg," he said.