In the mid-2000s, an investigation by the Securities and Exchange Commission resulted in the resignations of more than 50 senior executives and CEOs at firms across the industry spectrum from restaurants and recruiters to home builders and healthcare. High-profile companies including Apple Computers, United Health Group, Broadcom, Staples, Cheesecake Factory, KB Homes,, Brocade Communications Systems, Inc., Vitesse Semiconductor Corp. and dozens of lesser-known technology firms were implicated in the scandal. What was it? Options backdating. (To learn more, see Backdating Scandal Returns To The Forefront.)

Read on to find out how the scandal emerged, what brought it to and end and what you can learn from it now.

Options Backdating
The essence of the options backdating scandal can be summarized simply as executives falsifying documents in order to earn more money by deceiving regulators, shareholders and the Internal Revenue Service (IRS). The roots of the scandal date back to 1972, when an accounting rule was put in place permitting companies to avoid recording executive compensation as an expense on their income statements so long as the income was in the form of stock options that were granted at a rate equal to the market price on the day of the grant, often referred to as an at-the-money grant. This enabled companies to issue enormous compensation packages to senior executives without notifying shareholders.

Although this practice gave the senior executives significant stock holdings, since the grant was issued at-the-money, the share price had to appreciate before the executives would actually earn a profit. A 1982 amendment to the tax code created an incentive for executives and their employers to work together to break the law.

The amendment labeled executive compensation in excess of $1 million as unreasonable, and thus not eligible to be taken as a deduction on the firm's taxes. Performance-based compensation, on the other hand, was deductible. Since at-the-money options require a firm's share price to appreciate in order for the executives to profit, they meet the criteria for performance based-compensation and therefore qualify as a tax deduction.

When senior executives realized that they could look backwards for the date during which their firm's stock was at its lowest trading price and then pretend that was the date they were issued the stock grants, a scandal was born. By faking the issue date, they could guarantee themselves in-the-money options and instant profits. They could also cheat the IRS twice, once for themselves since capital gains are taxed at a lower rate than ordinary income and once for their employers since the cost of the options would qualify as a corporate tax write off. The process became so prevalent that some investigators believe 10% of the stock grants made nationwide were issued under these false pretenses.

A Scandal Comes to Light
A series of academic studies was responsible for bringing the backdating scandal to light. The first was in 1995, when a professor at New YorkUniversity reviewed option-grant data that the Securities and Exchange Commission (SEC) forced companies to publish. The study, published in 1997 identified a strange pattern of extremely profitable option grants, seemingly perfectly timed to coincide with dates on which the shares were trading at a low price. A series of two follow-up studies by professors at other universities suggested that the uncanny ability to time options grants could only have happened if the granters knew the prices in advance. A Pulitzer Prize winning story published in the Wall Street Journal finally blew the lid off of the scandal. (Learn more in Playing The Sleuth In A Stock Scandal.)

As a result, firms restated earnings, fines were paid and executives lost their jobs - and their credibility. The SEC reported that investors suffered in excess of $10 billion in losses due to share price declines and stolen compensation.

Why It Matters
Betting on stock prices when you already know the answer is dishonest. A business run without integrity is a scary proposition. From a consumer's perspective, customers rely on companies to provide goods and services. When those firms have no ethical boundaries, their wares become suspect. From a shareholder's perspective, nobody likes to be lied to when providing the financing and paying the salaries. (The Dangers Of Options Backdating provides additional insight into how this form of executive compensation can pose serious risks for investors.)

In the early 2000s, new accounting provisions were enacted that required companies to report their option grants within two days of their issue and also required that all stock options be listed as expenses. These changes reduced the likelihood of future backdating incidents.

Sadly, scandals pop up any time money is involved. Learning about how investors have been betrayed in the past is a good way to help protect yourself in the future. (Read The Biggest Stock Scams Of All Time for more insight into how the bad guys operate.)

Related Articles
  1. Investing

    What a Family Tradition Taught Me About Investing

    We share some lessons from friends and family on saving money and planning for retirement.
  2. Professionals

    4 Must Watch Films and Documentaries for Accountants

    Learn how these must-watch movies for accountants teach about the importance of ethics in a world driven by greed and financial power.
  3. Credit & Loans

    Pre-Qualified Vs. Pre-Approved - What's The Difference?

    These terms may sound the same, but they mean very different things for homebuyers.
  4. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  5. Active Trading

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  6. Insurance

    Cashing in Your Life Insurance Policy

    Tough times call for desperate measures, but is raiding your life insurance policy even worth considering?
  7. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  8. Investing Basics

    4 Iconic Financial Companies That No Longer Exist

    Learn how poor management, frauds, scandals or mergers wiped out some of the most recognizable brands in the finance industry in the United States.
  9. Options & Futures

    Understanding The Escrow Process

    Learn the 10 steps that lead up to closing the deal on your new home and taking possession.
  10. Markets

    Operating Cash Flow: Better Than Net Income?

    Differences between accrual accounting and cash flows show why net income is easier to manipulate.
  1. Can working capital be depreciated?

    Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>
  2. Do working capital funds expire?

    While working capital funds do not expire, the working capital figure does change over time. This is because it is calculated ... Read Full Answer >>
  3. How much working capital does a small business need?

    The amount of working capital a small business needs to run smoothly depends largely on the type of business, its operating ... Read Full Answer >>
  4. What does high working capital say about a company's financial prospects?

    If a company has high working capital, it has more than enough liquid funds to meet its short-term obligations. Working capital, ... Read Full Answer >>
  5. How can working capital affect a company's finances?

    Working capital, or total current assets minus total current liabilities, can affect a company's longer-term investment effectiveness ... Read Full Answer >>
  6. What can working capital be used for?

    Working capital is used to cover all of a company's short-term expenses, including inventory, payments on short-term debt ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Flier

    The slang term for a decision to invest in highly speculative investments.
  2. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  3. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  4. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  5. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  6. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
Trading Center