Analysts try to pinpoint next options subpoena

Merrill Lynch's Joseph Osha, Institutional Investor's No. 2 chip analyst last year, knew he had to get ahead of the stock-options scandal and find out which companies would be investigated next.

Teamed with semiconductor-equipment analyst Brett Hodess and six others, Osha first examined the 19 components of the Philadelphia Semiconductor Index. Vitesse Semiconductor, already under investigation by the Securities and Exchange Commission (SEC), and KLA-Tencor, which received a subpoena two days later, were near the top of the list.

"We knew we had to get on top of this," says Osha, who is based in San Francisco. "Investors don't want to be around these companies while all of this is playing out."

With about 60 companies facing investigations by the government or their boards of directors into whether they backed-dated options, research teams at Merrill Lynch, Citigroup and Cowen are assembling task forces to try to pinpoint which will be next to receive a government subpoena or be investigated by their own boards of directors.

Options controversial

Stock options already are controversial among technology analysts, who disagree about how, or whether, to count them as costs.

The Financial Accounting Standards Board, which writes accounting rules for U.S. companies, voted in December 2004 to require options grants to be expensed, a rule that went into effect in 2005. Backdating options to coincide with a low stock price creates a built-in profit for executives who receive them.

"The analysts have been subject to criticism about pricing the options, or not counting them at all," said James Cox, a law professor at Duke University in Durham, N.C. "They may be trying to show their worth here. They're trying to figure out whether the markets have overreacted and to do that, they've got to dig even further."

Two days after their initial report about the semiconductor-index components, the Merrill analysts published a study on a total of 47 chip and chip-equipment companies they follow. The reaction among investors spurred Merrill to do even more.

"People were going bananas," Osha said. "We were surprised at how big this thing got."

His bosses expanded the project to examine every company in the Standard & Poor's 500 index. That study, released June 5, found that 40 companies may have backdated their option grants. They identified Linear Technology and Computer Sciences as possible targets for investigation, both of which received requests from the SEC shortly afterward.

Jim Friedland, an analyst with Cowen in San Francisco, called together his two associates a few weeks ago to analyze for a proxy statements and other government filings to determine whether companies may have improperly back-dated stock-option grants over a seven-year period.

The eight-company analysis, which included Amazon.com and eBay, didn't turn up any suspect behavior. Yet Friedland said he is glad they did it.

"Anytime any kind of accounting or SEC issue comes into play, the stock will take a big hit," says Friedland, who has been an analyst for 12 years. "Chances are, it's fine, but I can't take a chance."

Scandal seen as holdover

Some analysts view the stock-option scandal as a holdover from the Internet boom, when executives played fast and loose with the numbers and investors and analysts alike turned a blind eye because it seemed everyone was getting rich.

Companies are less likely to get away with such shenanigans now, said David Wu, an analyst with Global Crown Capital in San Francisco who follows semiconductor companies including Altera.

"People aren't making the kind of money they used to and people are more careful about these sorts of things," Wu said. "Otherwise Jack Grubman would still be on Wall Street."

Grubman, a former Citigroup telecommunications analyst, was barred from Wall Street and fined $15 million for fraudulent research. His behavior in part led New York Attorney General Eliot Spitzer to win a $1.4 billion financial-services-industry settlement over conflicts of interest at investment banks.

Banks no longer tie research-analyst compensation to investment-banking performance or revenue.