Shareholder activists and academics have long speculated that some corporate executives were timing their option grants to occur before the release of good news that would spur market gains, a practice sometimes referred to as "spring loading." One indication that many of these anomalies are more likely based on backdating is the fact that the number of such statistically improbable gains fell sharply after the Sarbanes-Oxley Act (SOX) went into effect. One SOX provision implemented by the SEC reduced the reporting period for many executive transactions including option grants from 45 days after the end of the fiscal year to two days after the transaction.

Accounting and tax rules stipulate that an option with an exercise price below the market value of the stock on the (actual) grant date constitutes a discount-priced option. If a company's grants are determined to have been discounted without proper disclosure and accounting, the firm could face significant tax penalties and may have to file a restatement. Most stock incentive plans provide that the option price is set at the stock's fair market value on the grant date, so determining a grant and then setting the exercise price at an earlier date would violate the terms of the plan. One of the investor lawsuits against UnitedHealth characterized the practice as the "equivalent of picking the lottery numbers after they have been announced on the evening news."

Earlier Investor Doubts
Most of the companies being probed are small companies that have relied heavily on options. In many cases, it appears that shareholders had concerns about company option programs prior to the recent regulatory scrutiny, as evidenced by above-average shareholder opposition to specific option plans. In 2004, shareholders expressed greater opposition to management-sponsored equity incentive proposals at several of the companies that are under investigation, according to data compiled by ISS' Governance Research Service.

At CNET Networks, which announced May 24 that the SEC had begun an investigation into the company's option practices, 44.5 percent of votes cast opposed the firm's 2004 option plan, despite the fact that CNET's dilution level was less than at industry peers. This negative vote was significantly higher than the average 24.6 percent opposition to option plan proposals at S&P 1,500 firms in 2004.

In 2004, 41.9 percent of votes cast opposed an equity plan at Renal Care Group, which recently received subpoenas from prosecutors about its option granting practices. Boston Communications, identified by The Wall Street Journal as a company where statistical analysis of options grants showed suspicious patterns, also received above-average opposition to its 2004 option proposal with a 34.3 percent negative vote.

At F5 Networks, 46 percent of votes opposed the company's 2005 option plan, which exceeded the 25.5 percent average shareholder opposition that year. On May 18, the company announced it had received a grand jury subpoena for documents related to option grants since 1995.

Companies with questionable option grants may have other accounting problems, according to two finance professors whose research helped spark the recent media and regulatory scrutiny of option grants. Erik Lie, a finance professor at University of Iowa, and Randall Heron, a finance professor at Indiana University, said investors should look more closely at the other accounting practices of those firms.

"This sends a signal that management is willing to fudge numbers for their own benefit and they might be willing to play other accounting tricks," Heron told Bloomberg News.

Lie estimates that at much as 10 percent of all stock options granted in the decade before August 2002 were backdated. For more background on option backdating, see Lie's faculty Web site here.

Investor Lawsuits
In the lawsuit against UnitedHealth directors, a group of pension funds allege the board allowed UHG chairman and CEO William McGuire to "dictate his own compensation through the secret manipulation of the company's stock option plans" for almost a decade. Public pension funds from Ohio, Connecticut, Minnesota, Louisiana, Florida, and Mississippi have joined that lawsuit, which is pending in federal court in Minnesota.

"We claim that UnitedHealth's CEO and other executives secretly bled the company with the board's blessing," Connecticut Attorney General Richard Blumenthal said in a May 31 press release. "Connecticut demands an immediate halt to this illegal, immoral practice and return of ill-gotten gains to the company, as well as damages for stockholders."

The lawsuit, which includes both class action and derivative claims, contends that UnitedHealth's directors "completely abdicated their fiduciary responsibilities" to shareholders, leading the company to overstate its earnings and issue misleading financial statements since at least 1997.

The Ohio and Connecticut pension funds are represented by the law firm of Grant & Eisenhofer, while Bernstein Litowitz Berger & Grossmann represents the St. Paul Teachers' Retirement Fund Association, the Public Employees' Retirement System of Mississippi, the Jacksonville (Florida) Police & Fire Pension Fund, the Louisiana Sheriffs' Pension & Relief Fund, and the Louisiana Municipal Police Employees' Retirement System.

Other companies recently sued by investors include Juniper Networks, KLA-Tencor, American Tower, Nyfix, Computer Sciences, and Affiliated Computer Services. Last year, investors sued Tyson Foods, Cisco Systems, Brocade Communications, and Mercury Interactive over their option granting practices. More shareholder lawsuits are likely, as additional companies disclose probes into option grants. Sepracor and Quest Software are among the latest companies to announce option inquiries.

On June 5, Merrill Lynch released a research report concluding that 40 companies in the S&P 500 may have timed their option grants from 1999 through 2002. This list includes Dillard's, Sherwin Williams, Northrop Grumman, and other firms outside the technology and health-care industries, where much of the scrutiny by regulators and investors has been focused. The Merrill analysts compiled their list after finding that those firms had better-than-average stock performance in the 20 days after option grants.

Shareholder Response
In addition to filing lawsuits, investors have taken the issue directly to the SEC. In a June 7 letter, AFL-CIO Secretary Treasurer Richard Trumka urged the commission to amend its proposed rulemaking on executive compensation disclosure "to address stock option grant procedures and controls." As Trumka noted, "The most troubling aspect of stock option backdating is that boards apparently relinquished responsibility for setting option grant dates to executives" which Trumka said could open the door to self-dealing.

Several shareholder activists have indicated that they are following this issue closely and said they expect to file resolutions to address option grants.