Options and Fraud

While cases like that of Eisner and Disney in the previous chapter may anger shareholders, we must understand that these events are not fraudulent. Boards of directors freely give executives the stock options and, therefore, create the possibility that only short-term value will be created instead of long- term value. However, in other cases, it appears that managers may purposely mislead the public in order to fraudulently enrich themselves . Consider the management actions at Xerox Corporation.

In a civil action by the SEC against Xerox, the SEC claimed that senior management directed a scheme that improperly accelerated revenue from its leasing operations from 1997 to 2000. The accounting maneuvering increased revenue by $3 billion and profits by $1.5 billion over the period. In subsequent financial restatements, Xerox shifted $6.4 billion of revenue in the period. The accounting actions violated generally accepted accounting practices and were not disclosed to shareholders or regulators. The scheme was perpetrated to help Xerox meet ever-increasing internal and analyst earnings expectations. It became common for Xerox executives to assign numerical goals to be produced through accounting gimmickry. ^[1] Indeed, the CFO/vice chairman of Xerox and the president of Xerox Europe conveyed that excluding accounting actions, the firm had essentially no growth in the 1990s. ^[2]

The artificial profits helped drive the stock price from a split-adjusted $13 at the end of 1996 to more than $60 in 1999. During this time of inflated stock prices, Xerox CEO Paul Allaire sold stock and profited by $16 million. Xerox executives, in total, sold $79 million worth of stock between 1997 and 1999. Of the total, $48 million was from exercising stock options, and the other $31 million was from stock sales. Figure 4-1 shows the relationship among the fraudulent reporting, the stock price, and the executive sales. In April 2002, Xerox admitted to the SEC that it had improperly recorded the earnings and agreed to pay a $10 million fine. Of course, this fine is paid by the firm, and it is thus a cost to the stockholders who end up getting victimized again. ^[3] The stock price fell to less than $10 per share, approximately the price ten years earlier. While the firm has lost any value created in the 1990s, the managers received millions of dollars. The SEC has expressed its intent to prosecute those managers.

Figure 4-1. Xerox stock price from January 1990 to July 2002.

Many cases like this one have occurred recently (Enron, WorldCom, Guess, Global Crossing, Sun Microsystems, Rite Aid, and Tyco, to name a few). These cases suggest that executive options and other stock incentives may not be as effective as previously thought in aligning manager and shareholder incentives.