Stock Option Backdating: What’s the Big Deal?

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The list of companies involved in stock option backdating and related investigations continues to grow. The Wall Street Journal currently lists more than 120 companies under scrutiny, including the likes of UnitedHealth, Broadcom, Apple, and Home Depot. These companies are either under investigation by the Securities and Exchange Commission (SEC) or the Justice Department, or they have issued restated financial statements.

Is anyone surprised anymore when a company ends up on this list? This seems to be the scandal that never goes away, and people aren’t too shocked when a new company is added to the list. The crux of the scandal is the timing of stock options. But calling it “backdating” makes the problem sound far more innocuous than it really is.

As we know, stock options are a popular corporate incentive, generally meant to give executives a vested interest in the company’s stock performance. Options are issued, giving the employee the “option” to purchase shares of the company’s stock at a specified price. This exercise price is usually equal to the market price of the stock on the date the options are granted, meaning that the options are “at the money.”

Obviously, the value of this benefit would be greater if the exercise price were lower. With a lower exercise price, the holder is able to make a greater profit when the stock is sold on the open market.

Backdating of stock options is, therefore, attractive because a date with a particularly low stock price can be selected. With a lower exercise price, this makes the options “in the money” when granted and therefore the executive is already in a profitable position.

So if it’s just a matter of selecting a grant date that gives an executive the highest level of compensation, why not be upfront about it and follow the proper rules?

Therein lies the problem.

Backdating Isn’t Always Illegal
Believe it or not, the backdating of stock options can be legal, provided that the company follows certain rules. The most basic requirements to make the practice legal are that there cannot be any forged documents, and the fact that options were backdated must be disclosed to shareholders.

Additionally, backdated stock options must be properly reflected in a company’s earnings. Because options are backdated to a date with a lower stock price, this effectively makes the options “in the money” on the grant date. This must be properly expensed on the company’s financial statements.

The tax impact of these “in the money” options must also be properly reported. The exercise price of options affects the basis used to calculate compensation expense and capital gains for the recipient. Also, whether or not options are “at the money” or “in the money” may change the tax deductibility of the options.

Companies have gone wrong because they simply haven’t followed these steps. It would appear that this was done in an attempt to avoid disclosure to shareholders. Why? Because shareholders might balk at executives being given “in the money” options? Because they may object to even more compensation at the highest levels?

At the end of the day, though, the “why” doesn’t really matter. Shareholders have been deceived and it is wrong. Executives and boards work for the shareholders, and they deserve full disclosure.

The Heart of the Issue
If stock option backdating can be done legally, why are companies getting in trouble for this practice? It’s likely the deceptive nature of this practice and the subsequent cover-ups that make law enforcement uncomfortable. If a company’s executives are on the up-and-up, the deception (and maybe even fraud) wouldn’t occur.

So why not just grant stock options that are “in the money” from the start and not play around with the grant dates? Companies can grant options at pre-selected prices if they choose, rather than the market price at the grant date. They could give the executives options that are already priced below the market price of the stock, disclose it to the stockholders and authorities, and all would be well.

It is this gaming of the system that bothers so many. Prior to new reporting rules in 2002, companies had many months to report the granting of stock options. Some used this delay to watch the prices go up and down.

If there was an advantageous dip in the stock price, that date might have been used as the grant date. And without access to all the pertinent documentation, shareholders might be none the wiser.

Federal regulators are so overloaded with investigations, that they are starting to rely on the suspect companies to hire investigators. Outside law firms are to conduct the investigations and hand over their findings to the SEC or federal prosecutors, who decide if the matters should be pursued. Plenty of companies have conducted internal investigations that have resulted in the restatement of earnings, the firing of executives, and other disciplinary action.

Yet self-policing of this issue creates some interesting results. In some ways, companies could be writing their own death sentences by initiating the investigations that law enforcement will eventually use against them.

Companies who engage law firms to do aggressive investigation face the likelihood of law enforcement action for wrongdoing. At the same time, companies with more egregious offenses may escape scrutiny if internal investigations are not so thorough (whether on purpose or not). Would this be equitable justice?

Resolving Backdating Problems
The problem of backdating was largely resolved in 2002, when a new rule required companies to report stock option grants to the SEC within a matter of days. Almost as soon as they are granted, the public is notified. This means that there isn’t time to watch the stock market go up and down and pick and advantageous date.

Yet the problem is not going away quickly. Because there are so many potential cases for law enforcement to investigate, federal officials have made it clear that they will pursue the worst cases. These will be the ones involving the largest dollars, the most blatant self-enrichment by top executives, and the worst acts meant to deceive auditors and shareholders.

Companies involved in stock option backdating face investigations, possible harm to their reputations, and potentially decreased investor confidence. They are busy restating financial statements, which is likely to affect current stock prices. Companies are spending millions and millions of dollars on investigations and legal defense. Executives are being forced to give up their profits from the backdated stock options.

In addition to criminal investigations and penalties, companies and executives will likely have to face civil actions by shareholders. There is no doubt that stock option backdating can have an impact on the stock market, as it may have affected earnings for several years, which can have a significant cumulative impact. In the worst cases, there could be significant long term harm to the companies and the market value.

There is more to come in the stock option backdating scandal. Be assured that each week we will hear of new companies that are under investigation, either internally or by law enforcement authorities. It will be interesting to see when and where this all ends, but we may not know for several years.

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