One Last Backdating Whipping Boy?

One beneficiary of the subprime hurricane has been the legion of corporate backdating miscreants, whose travails have been blown off the front pages. Or perhaps we should say the beneficiary has been the legal system – since, with the media's attention elsewhere, it has been liberated to treat these cases with the skepticism they deserve.

Two hundred civil lawsuits remain, and the trial bar is stuck on the wicket of showing any harm to shareholders. Sayeth the National Law Journal: "Of those made public, few settlements have reached proportions that lawyers anticipated at the start of the backdating scandal."

What about criminal cases? All eyes now are turned to Henry Nicholas III, former CEO and cofounder of the chip company Broadcom.

His decision to build his company in Orange County has proved a shortsighted one. The U.S attorney for Orange County has only a few backdating cases to investigate, whereas his counterpart in Silicon Valley has hundreds and is developing sensible rules about which (if any) are worth pursuing. Apple's Steve Jobs, for one, appears to be emerging unscathed.

No less ill-advised, Mr. Nicholas in several ways has made himself a figure to excite a jury and the media. With his NBA-sized physique, he's one of techdom's most conspicuous billionaires, an eccentric genius and widely known (thanks to this newspaper) for having been accused in a disgruntled employee's lawsuit of patronizing prostitutes and drug dealers.

All this would make a convenient distraction for a prosecutor in a case where otherwise the facts are these: Mr. Nicholas did not benefit from any backdated stock options. He was Broadcom's largest shareholder, thus had no natural or unnatural interest in overpaying employees with backdated stock options. What's more, Ernst & Young, the company's outside auditor, appears to have blessed the accounting in full knowledge that option grant dates had been assigned retrospectively to make sure employee options had the intended value.

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Yet an indictment may loom now that the U.S. attorney has reached a plea bargain with former Broadcom executive Nancy Tullos. Her account, as portrayed in a separate SEC complaint, suggests that management knew exactly what it was doing and why – exercising positive control over the price of options used to attract, keep and reward its employees. Mr. Nicholas had a business philosophy. He was stingy with cash salaries, imposing a top limit of $110,000, but used hefty option grants to keep workers toiling away at all hours in the highly competitive chip business.

Take the hiring of engineer Mehrdad Nayebi, recruited in June 1999 with a promise of 120,000 options priced at the May 25 closing price. He was livid when he later discovered his start date had been listed as May 29, when the stock price was $7 higher. He demanded the company fulfill its promise – which Ms. Tullos did, through backdating.

Inevitably, Mr. Nicholas's prosecutors would play up the fact that Broadcom took the biggest restatement of any company involved in the scandal – $2.2 billion – to meet a now-defunct accounting rule that required only "in the money" options to be charged against profits. Such a big charge is partly a reflection of Broadcom's high stock volatility during the bubble years – volatility being a key variable in assigning a dollar value to an options grant.

Anyway, so what? This was not real cash. The vast majority of these options were canceled or expired unexercised, thus had no cost for shareholders. Had it been otherwise, even so the required charge would have been a poor and uninformative approximation of the true cost of option issuance to shareholders, and would likely have been ignored as such by the markets.

In an unusual development, Mr. Nicholas's lawyers reportedly have been to Washington to brief Alice Fisher, chief of the criminal division at the Justice Department. With hundreds of companies involved in backdating, her agency won't be seeking to put hundreds of executives in jail. His lawyers presumably were trying to explain why Mr. Nicholas shouldn't be one.

Steve Jobs, as we say, lives at a luckier latitude. All these cases have been somewhat tainted by the media's consistent misstating and overstating of the nature of the wrong here – myths from which some prosecutors still apparently have not disentangled themselves. That's why it would indeed be useful for the Justice Department honchos to develop national standards for prosecuting what is a national phenomenon.

If Mr. Nicholas were to be charged now merely because of location and notoriety, it would not represent the finest hour in recent backdating jurisprudence.