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, Monster.com, 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.)

Conclusion
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.)

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