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Corporate Governance
Stock Scandal: Who's Next?

The stock options backdating scandal seems like it's growing every day. Dozens of companies have voluntarily disclosed that their stock option grants are under investigation, and the U.S. Securities and Exchange Commission said last week that it has targeted more than 80 firms so far. But that's just the "tip of the iceberg," according to former SEC Chairman Harvey Pitt.

Speaking in a live Forbes.com chat Monday afternoon, Pitt noted that there are 17,000 public companies, and the backdating scandal will probably implicate far more than 80 of them before it has run its course.

Indeed, a new study estimates that 29.2% of firms manipulated grants to top executives between 1996 and 2005. The paper, by Erik Lie at the University of Iowa and Randall A. Heron at Indiana University, found that technology companies, small firms and companies with volatile stock prices were most likely to backdate their option grants.

Watch a replay of the Forbes.com chat with Harvey Pitt.

Pitt says the business community isn't doing enough to identify and stop corporate fraud. Most companies, he says, adhere to the same ideology as his late mother. She avoided physicians for years. When she finally visited a doctor and learned she had terminal cancer, she told her son: "I was never sick a day in my life until I went to the doctor."

But her illness festered and grew, even when it wasn't diagnosed. Similarly, Pitt says, most companies refuse to acknowledge problems until the SEC forces them to.

The SEC has no problem stepping in when corporations fail to self-regulate. On Thursday, July 20, federal prosecutors announced that they had filed criminal charges against two former executives of data-storage maker Brocade Communications Systems (nasdaq: BRCD - news - people ) for backdating stock options.

The SEC filed civil and criminal securities fraud charges against Gregory L. Reyes, the former chief executive of the San Jose, Calif., firm, and Stephanie Jensen, a former vice president for human resources.

The Justice Department joined in the complaint, which alleges that Reyes and other executives manipulated the grant dates of stock options to enhance their value. While this kind of backdating isn't illegal, companies must disclose it properly and account for the associated expenses.

The case is notable in part because Reyes and Jensen did not directly benefit from the backdated options, which were used to reward other employees.

"It signifies that the SEC is taking the option backdating issue quite seriously," says Charles Elson, chair of the John L. Weinberg Center for Corporate Governance at the University of Delaware's Lerner College of Business and Economics. "Going criminal is a pretty big step."

Richard Marmaro, Reyes' attorney, said his client never profited from the options he is alleged to have backdated. "Financial gain is always the motive in securities fraud cases, and here there was none," Marmaro said in a statement. "There is not even an allegation of self-enrichment or self-dealing. Nor is there any evidence of an intent to misstate the financial statements of the company."

But Pitt says that approach may not work in court. "The defense that they're trying to raise, that they didn't profit personally, is about as irrelevant as I've ever heard," says Pitt.

While Reyes may not have padded his own bank account by granting backdated options, he could have used the tool to attract talent during the heady years of the dot-com boom, when rapidly growing information technology firms in Silicon Valley competed for highly skilled workers.

Brocade shares fell 22 cents, or 3.7%, in Friday morning trading, even though the accused executives no longer work at the company. Reyes served as CEO of Brocade from 1998 until January 2005, when the company announced it would be restating several years of financial results because of irregularities regarding stock-option grant dates. The stock price bounced back Monday.

The SEC also filed civil charges against Brocade's former chief financial officer, Antonio Canova, alleging that he learned of the backdating after he joined the firm and didn't tell Brocade's auditors and directors about it.

While these were the first charges to be brought in the rapidly growing scandal, they are unlikely to be the last. "We really just follow the facts and take them where they lead us," says Patrick Murphy, a prosecutor with the SEC's office in San Francisco, where the charges were announced Thursday. "This case was ready to be filed."

More are sure to follow. Companies like Analog Devices (nyse: ADI - news - people ), Caremark Rx (nyse: CMX - news - people ), Intuit (nasdaq: INTU - news - people ) and UnitedHealth (nyse: UNH - news - people ) have all announced federal inquiries into their options granting practices.

Others, like the Cheesecake Factory (nasdaq: CAKE - news - people ), are initiating internal investigations. Apple Computer (nasdaq: AAPL - news - people ) recently announced that an internal inquiry had discovered irregularities in options grants from 1997 through 2001, including one grant to Chief Executive Steve Jobs.