Option backdating was on page one of the W$J again yesterday (here). The story was spurred by comments made by UnitedHealthâ€™s CEO, William W. McGuire, during UnitedHealthâ€™s First Quarter 2006 Results Teleconference on Tuesday. UnitedHealthâ€™s option grants to Dr. McGuire were among those cited as suspicious by a March 18 page one W$J (article here; earlier blog post here).
The Journal’s analysis raises questions about one of the most lucrative stock-option grants ever. On Oct. 13, 1999, William W. McGuire, CEO of giant insurer UnitedHealth Group Inc., got an enormous grant in three parts that — after adjustment for later stock splits — came to 14.6 million options. So far, he has exercised about 5% of them, for a profit of about $39 million. As of late February he had 13.87 million unexercised options left from the October 1999 tranche. His profit on those, if he exercised them today, would be about $717 million more.
The 1999 grant was dated the very day UnitedHealth stock hit its low for the year. Grants to Dr. McGuire in 1997 and 2000 were also dated on the day with those years’ single lowest closing price. A grant in 2001 came near the bottom of a sharp stock dip. In all, the odds of such a favorable pattern occurring by chance would be one in 200 million or greater. Odds such as those are “astronomical,” said David Yermack, an associate professor of finance at New York University, who reviewed the Journal’s methodology and has studied options-timing issues.
Dr. McGuire addressed the issue during Tuesday’s teleconference (click here for the transcript). Among other things, he recommended that that UnitedHealth:
eliminate change in control severance payments as well as non-cash perquisites, cap SERP arrangements now in place, and forego for the foreseeable future further equity-based grants or awards for our most senior and longest tenured executives for whom equity positions are well-established from prior years of service, thus already aligning their interests with those of shareholders.
It may be too little, too late. UnitedHealthâ€™s recent proxy statement notes that a derivative action relating to the alleged backdating was filed on March 29 in the United States District Court for the District of Minnesota against all but one director, as well as UnitedHealth as a nominal defendant. According to this article, another suit will be filed today which will be joined by the Minnesota Attorney General. â€œThe suit names as defendants UnitedHealth Group CEO William McGuire, COO Stephen Hemsley and several board members, alleging that shareholders were harmed by backdated option grants.â€?
Potential liability comes not from backdating itself but from improperly disclosing and accounting for the practice. For example, UnitedHealthâ€™s proxy statement provides: â€œ[t]he exercise price for all options granted under the Stock Incentive Plan is the closing sale price of our common stock on the date the option is granted.â€? This is obviously a misstatement if options were backdated and the exercise prices were set at the price on that date instead of the price on the date of grant (which was presumably higher). Additionally, accounting rules require a company that issues options with strike prices below market price on the date of grant to record a charge reflecting the difference. If a company fails to do this, its financial statements are likely inaccurate.
Issuing a proxy statement that contains a misstatement and inaccurate financial statements opens up the company, board members, and senior executives to various claims. Potential claims under federal law include violations of â€™34 Act Rule 10b-5 and Section 14(a), â€™33 Act Section 11 and 12(a)(2) (if the inaccurate financials were included or incorporated by reference in a registration statement), and Sarbanes-Oxley Sections 302 and 906 (financial report certification requirements). State law claims include breach of the duty of candor.
Whether option backdating will turn into the next big corporate scandal will of course depend on how widespread the practice has been. The March W$J article states that the SEC is looking at about a dozen companies. Additionally, there is some form of a materiality element running through all the potential claims listed above. Hence, even if a company did improperly disclose and account for option backdating, it may avoid liability if the faulty disclosure and accounting were not material (note that Analog Devices, a firm that got caught backdating last fall did not have to restate its financials, even though it failed to account for the backdating because the failure was not material). This will obviously depend in large part on the number of backdated options and the spread between the exercise price and the market value on the date of grant. The same factors will also impact potential damages which will in turn effect the willingness of plaintiffs’ firms to bring suits.