At cocktail parties in Silicon Valley and on Yatchs in Sausalito,

two new phrases have been added to sophisticates'

vocabulary: Back-dating and Spring-loading.

These are terms that describe two widespread methods

of cheating shareholders and enriching greedy executives.

Especially those of the high tech companies, which rely on

stock options extensively to allegedly "align the interest of

the executive with the share holders".

How much cheating is out there? Plenty!

Well, lets take one real life example:

An executive at a major high tech company received a

grant of ESOs to purchase 2,900,000 shares of common

stock in March 2004 at $41.70. The lowest closing price of

2004 was $41.65. (How did he miss the bottom?)

Twenty seven days lafter the alleged grant date, the

company announces record earnings and a 2/1 stock split.

Of course the stock jumped up to 56 after the announcement.

The gain from $41.70 to $56 in twenty seven days is the

largest gain in any 30 days for over five years.This is a case

of back-dating and spring-loading all rolled into one.

Mr. Lucky then sells 2 millions shares two trading days

after the announcement. He received the shares from

exercising other options with lower exercise prices. His

sales are at $55.25. He sells another 1.5 million in July

2004 at 60.

It cost the company $50,000,000 to have an extra "alignment

of interests" for four months on that one grant alone. Since

he sold 3.5 million shares in April and July, his alignment is

less than before the grant in March.

Nice bit of work. My compliments to the compensation

committee for taking care of Mr. Lucky (not the shareholders).

Of course themove from $41.70 to $60 made Mr. Lucky about

$130,000,000 on other options that he was holding.

SEC Section 16 b was designed by Congress to prohibit short

swing insider trading by executives. Section 16 b makes the

$50,000,000 returnable to the Company. But the SEC was

pursuaded to treat grants of ESOs as exempt from 16 b if

certain factors were in place (i.e. if the Rule 16b-3(d)(3) is

interpreted in a certain manner), thereby taking the grant

out of the scope of 16 b.

In other words the SEC accomodated the back-daters and

spring-loaders. Whether the SEC were aware that they were

set up or were complicit in the scheme is grist for another

article.

The suggested consequence of the SEC exemption is that

executives can legally back-date and spring-load a grant

and sell stock that they owned previously after the stock is

higher shortly after the news. And they think they can do so

without concern of a 16 b recovery because of SEC Rule

16 b-3(d)(3).

Isn't that absurd.

There are even some at the SEC who think that this example

of insider trading is just fine. One is a SEC Commissioner.

Of course in todays modern world of double-think what can

you expect.

Disguised re-loading

Another way they cheat is the following:

Suppose an executive is highly sought after and is offered

as a signing bonus a package of options worth $110,000,000

in "Fair Value" as calculated by the FASB and the SEC

recommended calculation methods.

That would be the largest bonus for any employee ever given.

Well it happened in Silicon Valley.

Guess what, the stock immediately went down and after 6

months the stock was 55% of the value on the day of the

grant (whenever the grant was realy made), making the

bonus package worth perhaps 40% of its value 6 months

earlier.

So what did the company do for fear that Mr. Hot Shot

executive would retire or be less "aligned with the

company interests".

They graced him another million options.

After 9 more months, the stock is only down 30%

compared to when Mr. Hot Shot joined. So they give

him another 2 million options for a bonus for his great

performance. Then he gets another 800,000 options five

months later. Sooner or later the stock wil go up and since

more options are being granted to Mr. Hot Shot at lower

and lower prices, he will eventually have a winner.

Within 1 1/2 years after the initial bonus package,

Mr. Hot Shot received ESOs worth a "Fair Value" of a mere

$29.5 million in addition to the first $110,000,000 value

initially. That $139,500,000 would not have to be

expensed and never taken out of earnings.

So the stock eventually went back up.

So what does the Compensation Committee do? They grant

him millions of more options. And he starts laying his stock

options out as the stock goes up, knowing that he is

decreasing his alignment.

However, he knows that the Compensation Committee will

re-load him with move options,thereby increasing his take

at the expense of the shareholders.

In this scenario, the back-dating spring-loader, Mr. Lucky,

from the first part of this article is our very same Mr. Big

Shot.

As of this writing Mr. Big Shot/ Mr. Lucky has managed to

receive $450,00,000 net before taxes as liquidated

"received compensation" from the exercise of his options

and sale of stock over five years. He also holds

unexercised ESOs worth another $240-280,000,000.00 as

a result of his services to the company.

Want to quess his name and the nature of his game?

He's been around a long long time, have sympathy for

him. He's a man of means and taste.

John Olagues

The author, JOHN OLAGUES, is a former member of the Chicago Board Options Exchange and the Pacific Stock Exchange for over ten years. He offers a unique view of employee stock options from a trader’s standpoint rather than from the standpoint of an accountant, compensation planner or academic. To contact JOHN OLAGUES email olagues@hotmail.com and  see www.optionsforemployees.com.