A New Option Case Suggests Companies Should Manage for the Long Term

Over the last few months news about SEC enforcement has been dominated by the on-going option backdating scandals with a sprinkling of the usual financial fraud and insider trading cases.  By now, everyone had heard that the SEC has about 140 companies under investigation for backdating options and that a total of about 200 companies are conducting internal investigations into their option backdating expenses.  It is old news that a number of enforcement actions have been brought first against individuals claimed to have been involved and more recently against companies.  The real question about the scandal at this point is the standards that will be used going forward in decisions made by the SEC as to who to include in future enforcement actions. 

Now, however, a new wrinkle to the use of options has been added.  Yesterday, the SEC filed a settled administrative action against IBM Corp. over its options practices.  Big Blue was not accused, however, of backdating its options.  Rather, the crux of the actions seems to be that the company used the issuance by the SEC of its then-new guidance on options (SAB 107) as an excuse to mislead analysts about its earnings to soften the impact of missing guidance.  According to the Order For Proceedings, IBM violated the reporting provisions of the federal securities laws by filing a Form 8-K in April 2005 that “contained materially misleading information about the amount of IBM’s stock options expense and the impact it would have on IBM’s earnings per share.  The Form 8-K created the impression that IBM’s stock options expense would be greater than what IBM actually expected it to be for 1Q05 and FYO5.”  http://www.sec.gov/news/press/2007/2007-109.htm 

A review of IBM’s April 2005 Form 8-K cited in the Order For Proceedings shows precisely what the company did.  First, in the earnings call IBM told analysts that it was implementing SAB 107.  Second, the company told analysts to reset their 2004 numbers so that they would be comparable with 2005 numbers which would include the expense.  In this context, the company told analysts to include 55 cents for 2004 and 14 cents for 1Q04.  Third, IBM told the analysts to use similar adjustments for its 2005 projections.  Finally, a chart was included which listed analysts’ projections for 2004 and 2005 and made the 2004 adjustments, but not the 2005 adjustments.  Analysts were told, however, that for 1Q05, the option expense adjustment would be comparable to 1Q04 – that is, 14 cents.  At the time the SEC’s Order For Proceedings says, IBM knew that the actual number was 10 cents, not 14 cents. 

So what is the big deal?  It’s the impact.  At the time of the conference call, earnings per share projections for 1Q05 were $1.04 per share, according to the chart given analysts at the conference call, which is reproduced in the IBM 8-K.  If the option expense for 1Q05 was actually 14 cents, then the EPS number should be adjusted down to $0.90 for the quarter.  However, if the actual option expense of 10 cents had been provided, the EPS would have been adjusted downward to $0.94.  When IBM actually reported earnings per share of $0.85 in its Form 10Q for the quarter, its share price dropped 8% the next day.  That drop resulted because the company appeared to miss its projection by $0.05.  But, actually the company missed guidance by $0.09.  Since the actual difference between street expectations and reported results was almost twice as much, one would expect a more significant drop in share price — say 15%, rather than 8%.  

This sad saga appears to just be the latest difficulty with options and meeting Wall Street expectations.  In many cases where firms strive to meet those expectations, earnings get managed with improper accounting practices such as round trip transactions, channel stuffing and the like.  Here, rather than manage income, the expectations of Wall Street were managed.  IBM resolved the matter with the SEC by consenting to a Cease-and-Desist Order.  As Linda Chatman Thomsen, Director of the SEC’s Division of Enforcement, said, “Information regarding a company’s earnings is one of the most important factors that many investors consider in making an investment decision, and it is essential that the information companies provide be clear and accurate.” 

All of this suggests that perhaps management should move away from earnings guidance and meeting Wall Street expectations to a more long term of managing the business for shareholder value.