Published in The Observer Oct. 8, 2006
Americans are ever more reliant on the stock market to pay for retirement, education, health care. In turn, the market relies on companies to honestly report profits and expenses.
Over the last decade, many companies didn't. They concealed from shareholders the cost of options grants to senior executives. Through a practice known as backdating - cherry-picking a stock's low point from the past - they enriched executives at shareholders' expense.
The Observer inspected options grants by 50 of the largest public companies in the Carolinas. There was no clear evidence of backdating at firms based in Charlotte. But the practices of a Greenville, S.C., company raise questions.
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Robert McLain is a fortunate man.
In summer 1995, McLain, a marketing executive, joined ScanSource Inc., a distributor of electronic devices such as bar code scanners. That year, and again the following year, ScanSource granted McLain options to buy its stock, entitling him to profit if the price increased.
Remarkably, both grants were reported as made on days when the company's stock closed at its lowest price of the year, the best possible timing for an options grant.
Other ScanSource senior executives benefited from similar timing. In fact, an Observer analysis of grants made since 1995 by 50 of the largest companies in the Carolinas found ScanSource had an unmatched record of granting options at the most lucrative moments for its executives.
The Greenville, S.C., company granted options on 18 dates. Seven times, the stock price was at its lowest point for at least a month on either side. Twice more, the price was at the second-lowest point. In all but two cases, the price dipped before the grant, then climbed.
Experts say such good fortune is unlikely. Similar patterns at other companies have led to accusations that those companies or their executives fabricated the timing, selecting dates with low stock prices to make their options more valuable. The practice is known as backdating.
"There is a lot of smoke here, " said Nejat Seyhun, a University of Michigan finance professor and backdating expert who analyzed ScanSource's grants at the Observer's request. "To prove backdating, you need all the corporate documents. But it would be very, very unusual that this could arise due to chance."
A ScanSource spokesman said the company had no comment. McLain and other executives did not respond to a letter detailing the Observer's findings, nor did they return phone calls.
The Securities and Exchange Commission, which regulates options grants, said it does not comment on specific companies.
Backdating, a new entry in the catalog of corporate scandals, has exploded onto the scene. A recent study estimated more than 2,000 companies falsified grant dates in the late 1990s and early years of this century, enriching executives at the expense of shareholders. Some experts estimate the cost to shareholders at several billion dollars.
Backdating is not illegal by itself. Companies can pay executives as they wish. But concealing the date of a grant almost always means the company also concealed the extra expense, which means it probably reported inflated profits. That is illegal.
More than 100 U.S. companies are under investigation for civil and criminal violations associated with backdating. Some executives have been arrested And a growing number of companies face shareholder lawsuits, including Matthews-based Family Dollar Corp.
Most of the scrutiny has focused on tech companies, which granted large numbers of options. ScanSource shared some of the common characteristics. It was a new company, without a lot of money to pay executives; it had a relatively volatile stock price, so the date of grants mattered; and it was a small company, not closely watched by analysts or institutional investors.
When McLain was hired in 1995, the company was three years old. The board of directors granted him 10,000 options and dated the grant as of June 5, according to the company's filings with the SEC. Options granted to executives confer the right to buy shares in the future, typically at the price on the day of the grant.
ScanSource stock closed that day at $8.50, matching its low for the year. The option was priced at $8.63, the average of the high and low trading prices that day. The relatively low share price made the grant more lucrative.
Since then, ScanSource has said in securities filings that McLain did not join the company until July. By the first weekday in July, the stock price had climbed 13 percent. If McLain had received options when the company said he was hired, the potential profit would have been reduced by about $10,000.
McLain exercised the 1995 grant in March 2002, after several years of strong growth in the stock price. He sold the resulting shares for a profit of $562,500, more than twice his total pay that year. He made an additional $336,450 from a 1996 options grant.
Corporate America's new game
Options became popular because Congress and Corporate America played a figurative game of whack-a-mole. In 1993, Congress changed the corporate tax code in a way that discouraged companies from paying salaries above $1 million. The pressure sent companies rushing in a new direction: They started granting options, which the tax code did not count as salary.
ScanSource was founded in 1992 by two experienced technology salesmen, Steven Owings and Michael Baur. They noticed a growing demand for scanners and other electronic tools for managing inventory. They decided to distribute the devices.
It was a good plan. In 2005, ScanSource, with more than 800 employees and posted revenues of $1.47 billion, cracked Fortune's list of America's 1,000 largest publicly traded companies.
Shareholders have done well. The annualized return is about 27 percent on shares purchased when the company first sold stock in March 1994.
They might have done even better. ScanSource has granted almost 5 million options, adjusting for stock splits. The company's SEC filings estimate that over the last three years, the grants reduced profits by a total of $6 million, or 6 percent. Each time an option is exercised, a new share is created, spreading future profits more thinly.
More than half the options went to senior executives. Baur, first as president, then as chief executive, received 20 percent. Owings, first as chief executive, then as chairman, got 17 percent.
The average large company grants all of its senior executives combined less than 20 percent of options, according to the Corporate Library, a compensation watchdog based in Portland, Maine.
Since December 1995, two men controlled the allocation of ScanSource grants: James Foody, a Greenville business consultant, and Steven Fischer, a New York bank executive. The two sat on the board of directors with Baur and Owings. But Foody and Fischer, the only independent directors, sat alone on the compensation committee. They were paid to represent the shareholders.
Foody and Fischer did not respond to letters or calls for comment.
Corporate governance experts say options should be granted on a fixed date, announced in advance and reported immediately. This precludes manipulation.
The board granted options on a wide variety of dates in eight different months, never announced in advance, and often reported weeks after the fact.
Until 2002, there was no rule against delayed reporting. Executives had 45 days to file a report with the Securities and Exchange Commission. They could easily report a grant made yesterday, and list a date a month earlier.
In fact, executives who said they had waited longer also reported more lucrative grant dates, according to a study by Michigan's Seyhun and a colleague, M.P. Narayanan. In other words, what looked like waiting was sometimes backdating.
On Jan. 10, 2000, ScanSource executives reported grants of 62,500 options. The stock closed that day at $40, but the filings said the grants were made on Dec. 6, 1999, when the stock closed at $33.62.
There is no evidence the grants were backdated, but the difference between the two dates was worth nearly $400,000 to the executives.
In 2002, regulators tightened the filing deadline to two days. But 24 percent of all filings over the next two years violated the rule, studies show. The SEC, which had threatened penalties, fined few companies.
ScanSource has made grants on five dates since the change. Twice, the filings violated the rule.
On Jan. 21, 2004, senior executives reported grants of 61,900 options. The stock closed that day at $54.34, but the filings said the grants were made on Jan. 2, when the stock closed at $46.12.
This time, the difference was worth more than $500,000. Regulators took no action. Asked why, a spokesman for the SEC said the commission did not comment on individual cases.
Directors didn't fare as well
Fischer and Foody also received options each year. These grants were always made on the day after the company's annual meeting. Corporate governance experts recommend such a regular schedule.
The directors did not share the good fortune of the executives. Their scheduled grants came at lackluster moments. Since 1999, ScanSource stock declined by an average of 3 percent in the 20 days of stock market activity following a grant to directors.
By contrast, the irregular grants to executives came at beneficial times. Since 1999, the stock climbed by an average of 7 percent in the 20 trading days after the executives received a grant. The odds of such a successful pattern for executives occurring by chance are about 160,000 to one, according to an analysis by Seyhun.
The period of 20 trading days, roughly one month, is often used in analyzing backdating. It approximates the range of days from which an executive might have selected the day with the lowest share price.
It is not clear why the company had different policies for grants to executives and directors.
How the suspicions arose
Imagine: A gambler walks up to a roulette wheel and picks a number. The ball lands on it. He picks a new number. The ball follows. If it keeps happening, you might want to examine the wheel. You might want to consider the possibility that the person is not actually gambling.
That's how backdating was discovered. Studies showed too many executives were getting lucky. A 2006 study found that 29 percent of public companies had falsified a grant date at least once in the last decade. It also said that 19 percent of all unscheduled grants had been backdated.
Analysts, reporters and regulators started identifying specific companies, and the resulting scandal pushed regulators to finally impose options reporting rules that make backdating all but impossible.
The new rules issued this summer require instant and complete reporting of each grant.
ScanSource now seems to be making options grants on a fixed schedule. In 2005 and again this year, the company made all of its grants on Jan. 5, and the grants were reported within two days.
Companies now rush to reward executives in new ways. In 2002, options accounted for 76 percent of long-term compensation, according to Mercer, a human resources consultancy. By 2005, it was 52 percent and falling.
"We're advising companies, stop fooling around for the sake of a few dollars on an options grant, " said Steven Hall, a New York consultant who helps companies decide how to compensate their executives.
"So that's stuff in the past, " he said, "but the question is, What is there that's ugly that's going on now?"