The options backdating scandal continues to haunt the markets today as KB Homes CEO Bruce Karatz resigned as head of the company amid an internal options investigation. A preliminary report found that the home construction company had incorrectly reported around $50 million in options grants, which the CEO agreed to repay. Several other members of the company were also found guilty, which prompted the board to fire HR head Gary Ray and encourage the resignation of VP and chief legal officer Richard Hirst. The board found that Mr. Karatz and Mr. Ray had selectively chosen grant dates under the company's stock option plan for personal gain.

According to an 8K filed by the company today:

"On November 12, 2006, the Company announced that a subcommittee of the Audit and Compliance Committee of the Board of Directors and its independent legal counsel conducting an investigation into the Company’s past stock option practices have concluded that the Company used incorrect measurement dates for financial reporting purposes for annual stock option grants during the period from 1998 to 2005. The Company expects that the incremental non-cash compensation expense arising from these errors is not likely to exceed an aggregate of $50 million, spread over the vesting periods of the options in question. The errors may also require an increased tax provision. The Company is evaluating, with its independent auditors, whether a restatement of certain previously-filed financial statements will be required. The Company has cooperated and will continue to cooperate with the inquiry of the SEC and other government agencies." (Read More)

This latest investigation has again pushed the bounds of these investigation to companies outside of the tech sector, which was hit especially hard. Although the number of investigations has slowed as of recent, there continues to be many new instances while older cases are just beginning to be settled by the SEC. So far, only a handful of executives have faced criminal charges.

Mentioned Companies
KB Home (NYSE:KBH)

We all know that the Democrats recently took control of the House and Senate, but what does this mean for executive compensation? Currently these kinds of issues are handled by the House Committee on Financial Services, which oversaw the development and implementation of laws like Sarbanes-Oxley. Prior to the elections, the chairman of this committee was Republican Michael Oxley from Ohio; however, it is likely that he will be replaced by Democrat Barney Frank from Massachusetts. Barney Frank has pledged to push legislation that will give shareholders much more control over executive compensation. One of the aspects discussed the most is the social implications of corporate profit-sharing; some believe that the stagnated middle-class could benefit from money that would otherwise be lining the pockets of upper-class executives. Essentially, they seek to close the growing income gap between executives and employees, which has grown even greater according to recent reports that executive compensation was growing at 20% per year while employee salaries remained nearly even. So far these ideas have not gained much political traction; however, this could change as the Democrats have taken control of the House and Senate and more media attention has been drawn to executive compensation.

Enron has become one of the greatest examples of fraud in corporate America - when a company with a $60 billion market cap disappears overnight, it draws some attention! But what really happened at Enron, and what can we learn from it? Well, here's the story: In early 2001, the high-flying energy company was the darling of Wall Street, trading at over $80 a share with analysts at their feet strongly recommending the stock. A few months later the stock began to slowly drop; however, so did the rest of the market, so few analysts voiced any concerns. Many just assumed that it was trading alongside the rest of its sector. Little did people know that executives were dumping millions worth of stock while trying to keep their financial statements in order for just a few more months...

The first sign of trouble came in August 2001, when Enron's CEO Jeffrey Skilling unexpectedly resigned. Shortly after, the company's chairman and previous CEO Ken Lay took over. However, by the end of the month the stock was trading at just $35 per share - less than half of its early 2001 highs. But the real news didn't hit until two months later when the company stunned Wall Street with a $638 million loss along with a $1.2 billion write-down in its book value. This turned out to be far less than the actual losses, which came as a result of losses suddenly realized on a series of partnerships setup by CFO Andrew Fastow. It turns out that Enron had guaranteed the partnerships' debt, making its true liabilities much higher than what was shown on Enron's financial statements. It was this fact that ultimately caused both investors and customers to flee, leading to the company's bankruptcy.

As if this weren't enough, investors and employees soon discovered that senior executives had received over $750 million in salaries, bonuses, and stock options for good performance in the same year before the company declared bankruptcy! It turns out that executives were bailing out of the stock while the partnership losses remained hidden. Soon after, even more conflicts of interest on Wall Street were revealed: It turns out that Enron's accounting firm, Arthur Anderson, turned a blind eye because they wanted to keep the lucrative contract they had with the company. Meanwhile, analysts continued touting the stock in order to help the investment banking side of their firms get more business from Enron in future offerings.

Luckily, financial statements and securities laws have come a long way since this scandal first started; however, there is still much work that needs to be done. With the new executive compensation disclosure requirements (recently approved by the SEC) and web portals like ExecutiveDisclosure, investors will have tools at their disposal to find problems and conflicts of interest before they become full-blown scandals like Enron or WorldCom.

Dana Corp. (NYSE:DCN, OTC:DCNAQ) announced today that it had reached an agreement to provide CEO Mike Burns with $6.75 million in cash and stock if he can meet certain financial goals in the next two years as the company struggles to emerge from bankruptcy. Other company executives are also entitled to over $4.75 million under the newly approved agreement. This news comes after the CEO fought for retention bonuses of $4 million (plus his base salary) if he was able to successfully bring the company out of bankruptcy or sell it off, while fighting to give other CEOs $4.3 million in similar bonuses. However, a judge said that the plan violated a law aimed at preventing executives from taking large bonuses while workers suffer cuts in pay or benefits. Under the new agreement, the bonuses are tied to specific performance objectives that are more stringent than simply bringing the company out of bankruptcy. If the bonuses are not met, then the executives may only receive their base salaries. Mr. Burns had been making as much as $11.7 million in 2004 before receiving a sharp pay cut to $2.2 million when the company declared bankruptcy. A hearing on the latest plan is scheduled for November 21, where creditors, shareholders, unions, retirees, and others will have their input. This is likely to draw some opposition, as it has in the past, because Dana has been long trying to trim health-care benefits for retirees.

Bonus data is out today on executives working on Wall Street and the results are surprising. Compensation at major brokerage houses increased nearly 30% (after a record year last year) to its highest levels ever. This increase is due in part to a surge in M&A activity along with a strong IPO market and continued economic growth in the world's markets. These factors led to record profits reported by the Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns. Private equity and hedge funds also managed to do well with a widened salary range for managing directors of $700,000 to $7 million compared to a range of $1.5 million to $2.5 million just one year ago. There are indications that private equity and hedge funds are making riskier bets with record amounts of cash being poured into the funds, resulting in over $2.9 trillion in takeovers and a surge in loans, according to reports by Bloomberg and Private Equity Intelligence. Whether this activity continues or not remains to be seen; however, there are few signs now to indicate any slowdown in M&A activity by hedge funds and private equity.

Sanjay Kumar, the ex-CEO of CA Incorporated (NYSE:CA), was sentenced today to 12 years in prison and ordered to pay an $8 million fine for his role in the company's $2.2 billion accounting fraud. The primary concern was over the so-called "35-day month" scheme, which consisted of the company keeping its books open past the end of the quarter to realize additional revenue and meet Wall Street expectations. One person, testifying for immunity, also revealed that the company had regularly backdated contracts to manipulate sales - even going so far as to say that within the company, they referred to the practice as "the CA way".

The verdict comes after many years in the court system, tied up after the government agreed to a deferred prosecution agreement in 2004. The agreement soon went sour, however, after the fed discovered the company's executives were destroying evidence and lying to investigators. This led to additional obstruction of justice charges imposed on Kumar and other executives facing conviction. Investigators noted that they were very suprised at the number of senior executives who participated in the scheme or tried to cover it up. As one law enforcement official put it, "nearly every executive listed in the company's 2000 annual report ended up pleading guilty to something in the case".

Mentioned Executives
Sanjay Kumar

After three trials over the course of nearly a decade, U.S. Federal Prosecutors were finally able to put Walter Forbes behind bars after he masterminded one of the largest cases of stock fraud in history back in 1998. A jury found the 63 year old ex-chairman of Cendant guilty of conspiracy and two accounts of submitting false documents to the Securities and Exchange Commission, where he overstated his company's earnings by $250 million. He was acquitted, however, on a forth account of securities fraud. Forbes is currently free on a $1.5 million bond, but will be sentenced on January 17th, facing up to 25 years in prison.

The U.S. Securities and Exchange Commission filed civil charges yesterday against the former CFO and CEO of Delphi along with 11 others, charging them with altering the company's financials between 2000 and 2004. The SEC said that Dawes has agreed to pay around $687,000 to settle with the SEC, while six others took similar deals. The rest of the defendants are fighting the charges.

The problems began last year, when an internal investigation by Delphi's audit committee revealed a series of accounting problems. These problems included improper accounting for $237 million worth of warranty claims to GM as well as several million dollars of debt that could not be found on the company's balance sheet. These accounting misstatements led to an inflated net income number and an artificially higher value (due to less debt appearing on the balance sheet). Typically such misstatements are used to reach financial targets to achieve bonuses or other executive perks. In a press release, current CEO Robert Miller said, "We have cooperated fully with the commission's investigation and will continue to do so. We are pleased to put the SEC investigation behind us and consider this settlement an important step in our transformation process."

Regulation 162(m) is a part of the IRS tax code that restricts tax deductibility of the five highest-paid executives in a public company to $1 million. Bill Clinton was the one who instituted this change in the tax code that was intended to curb executive compensation; however, it had some major flaw - it didn't apply to "performance-based" compensation. This caused the entire plan to backfire as the government and shareholders lost billions more while executives made out with more than ever before.

How did companies get around the regulation? Instead of paying executives the majority of their salary in standard compensation, companies began expensing stock options, LTIPs (long-term incentive plans), perks, and other bonuses that were based on low "performance-based" standards. They passed this by shareholders by tying down these performance metrics to many intangible factors that the company could inflate, such as customer satisfaction, diversity, and customer service. Moreover, they were released in obscure 8K filings with the SEC that normal investors rarely check. And to put the nail in the coffin, neither the SEC nor the IRS evaluate or check over these metrics - so it is impossible to tell if the company is being truthful. Sometimes targets aren't even defined, and in some cases can be as vague as tying compensation to "individual achievement of personal commitments"!

As a result of Reg 162(m), the government has lost out on roughly $20 billion in tax revenues while investors were stuck with extensive share dilution as executive compensation levels skyrocketed yet again to their highest levels ever. In 1980 the average executive earned only 40x what a normal worker would; now, executives make approximately 400x as much as a normal worker! Finally, in September, The Senate Finance Committee acknowledged the fact that they made a mistake, and is now evaluating other possible solutions. Whether or not they will come up with something effective remains to be seen; however, it is becoming increasingly important for investors to watch executive compensation levels.