The Dangers Of Options Backdating

By Glenn Curtis AAA

Do you ever wish that you could turn back the hands of time? Some executives have, well, at least when it comes to their stock options.

In order to lock in a profit on day one of an options grant, some executives simply backdate (set the date to an earlier time than the actual grant date) the exercise price of the options to a date when the stock was trading at a lower level. This can often result in instantaneous profits! In this article, we'll explore what options backdating is and what it means for companies and their investors.

See: Employee Stock Options

Is This Really Legal?
Most businesses or executives avoid options backdating; executives who receive stock options as part of their compensation, are given an exercise price that is equivalent to the closing stock price on the date the options grant is issued. This means they must wait for the stock to appreciate before making any money. (For more insight, see Should Employees Be Compensated With Stock Options?)

Although it may appear shady, public companies can typically issue and price stock option grants as they see fit, but this will all depend on the terms and conditions of their stock option granting program.

However, when granting options, the details of the grant must be disclosed, meaning that a company must clearly inform the investment community of the date that the option was granted and the exercise price. The facts cannot be made unclear or confusing. In addition, the company must also properly account for the expense of the options grant in their financials. If the company sets the prices of the options grant well below the market price, they will instantaneously generate an expense, which counts against income. The backdating concern occurs when the company does not disclose the facts behind the dating of the option. (To learn more, read The "True" Cost Of Stock Options, The Controversy Over Option Expensing and A New Approach To Equity Compensation.)

In short, it is this failure to disclose - rather than the backdating process itself - that is the crux of the options backdating scandal.

Who's to Blame?
To be clear, the majority of public companies handle their employee stock options programs in the traditional manner. That is, they grant their executives stock options with an exercise price (or price at which the employee can purchase the common stock at a later date) equivalent to the market price at the time of the option grant. They also fully disclose this compensation to investors, and deduct the cost of issuing the options from their earnings as they are required to do under the Sarbanes-Oxley Act of 2002.

But, there are also some companies out there that have bent the rules by both hiding the backdating from investors, and also failing to book the grant(s) as an expense against earnings. On the surface - at least compared to some of the other shenanigans executives have been accused of in the past - the options backdating scandal seems relatively innocuous. But ultimately, it can prove to be quite costly to shareholders. (To learn more, see How The Sarbanes-Oxley Era Affected IPOs.)

Cost to Shareholders
The biggest problem for most public companies will be the bad press they receive after an accusation (of backdating) is levied, and the resulting drop in investor confidence. While not quantifiable in terms of dollars and cents, in some cases, the damage to the company's reputation could be irreparable.

Another potential ticking time bomb, is that many of the companies that are caught bending the rules will probably be required to restate their historical financials to reflect the costs associated with previous options grants. In some cases, the amounts may be trivial. In others, the costs may be in the tens or even hundreds of millions of dollars.

In a worst-case scenario, bad press and restatements may be the least of a company's worries. In this litigious society, shareholders will almost certainly file a class-action lawsuit against the company for filing false earnings reports. In the worst cases of options backdating abuse, the stock exchange on which the offending company's stock trades and/or regulatory bodies such as the Securities and Exchange Commission (SEC) or National Association of Securities Dealers can levy substantial fines against the company for perpetrating fraud. (For more information, see The Pioneers Of Financial Fraud.)

The executives of companies involved in backdating scandals may also face a host of other penalties from a range of governmental bodies. Among the agencies that could be knocking on the door are the Justice Department (for lying to investors, which is a crime), and the IRS for filing false tax returns.

Clearly, for those who own shares in companies that don't play by the rules, options backdating poses serious risks. If the company is punished for its actions, its value is likely to drop substantially, putting a major dent in shareholders' portfolios.

A Real-Life Example
A perfect example of what can happen to companies that don't play by the rules can be found in a review of Brocade Communications. The well-known data storage company allegedly manipulated its stock options grants to ensure profits for its senior executives and then failed to inform investors, or to account for the options expense(s) properly. As a result, the company has been forced to recognize a stock-based expense increase of $723 million between 1999 and 2004. In other words, it had to restate earnings. It has also been the subject of a civil and a criminal complaint.

The total cost to shareholders, in this case, has been staggering. Although the company continues to defend itself against the charges, its stock has dropped by more than 70% between 2002 and 2007.

How Big Is the Problem?
According to a 2005 study by Erik Lie at the University of Iowa, more than 2,000 companies used options backdating in some form to reward their senior executives between 1996 and 2002.

In addition to Brocade, several other high profile companies have become embroiled in the backdating scandal as well. For example, in early November 2006, UnitedHealth reported that it would have to restate earnings for the last 11 years, and that the total amount of restatement (related to improperly booked options expenses) could approach, or even exceed, $300 million.

Will It Continue?
While reports of past indiscretions are likely to continue to surface, the good news is that companies will be less likely to mislead investors in the future. This is thanks to Sarbanes-Oxley. Prior to 2002, when the legislation was adopted, an executive didn't have to disclose their stock option grants until the end of the fiscal year in which the transaction or grant took place. However, since Sarbanes-Oxley, grants must be filed electronically within two business days of an issue or grant. This means that corporations will have less time to backdate their grants or pull any other behind-the-scenes trickery. It also provides investors with timely access to (grant) pricing information.

Beyond Sarbanes-Oxley, the SEC approved changes to the listing standards of the NYSE and the Nasdaq in 2003 that require shareholder approval for compensation plans. It also approved requirements that mandate that companies outline the specifics of their compensation plans to their shareholders.

The Bottom Line
Although more culprits in the options backdating scandal are likely to emerge, because standards such as Sarbanes-Oxley have been instituted, the assumption is that it will be more difficult for public companies and/or their executives to hide the details of equity compensation plans in the future. (To read more on this topic, check out The Benefits And Value Of Stock Options.)

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