Magazine article The CPA Journal

Options Backdating

Magazine article The CPA Journal

Options Backdating

Article excerpt

Corporate Governance Remains a Challenge

Just when it seemed safe to close the book on the scandals of the pre-Sarbanes-Oxley, pre-Internet bubble era, the stock options backdating fiasco that came to light in 2006 is a reminder that the history of the period is still being written.

While the legality of stock options backdating will ultimately be decided case by case in the courts, dozens of companies are currently under investigation. Internal investigations may be initiated by a company's board of a directors through a special committee. Other investigations are externally provoked, the result of an sec notice or a U.S. Department of Justice (DOJ) subpoena. Accountants, auditors, investors, and analysts alike should understand the history of backdating, the risks companies under investigation face, how to search for indicators of backdating, and how these scandals might ultimately affect businesses and shareholders.

What Is Options Backdating?

Options backdating is the practice of using hindsight to choose a beneficial calendar date in the past for purposes of granting a stock option to an employee, officer, or director of a company. Any option granted using a date at a low point in a company's stock price would immediately be "in the money," because the strike price of an option is almost always set to be equal to the market value of the stock on the grant date. The benefit of the resulting jump in stock price would go to the holder of the option. see Exhibit 1 for an example of an options grant that may have been well timed or may have been backdated to maximize the benefit to the option holder.

Prior to the passage of the Sarbanes-Oxley Act (SOX) in July 2002, the regulations surrounding the disclosure of option grants in financial and proxy statements and the requirements for filing notice of option grants to the sec were fairly loose. While SOX now requires a company to file a Form 4 with the sec within two days of an option grant to key employees, before SOX it might have been months before notice of an option grant was filed with the sec. Along with this more lax disclosure requirement, companies may also have not had robust enough internal controls to catch those backdating without proper authority. Consider the pressure facing a large number of technology start-up companies that were competing intensely for talent and lacking the ability to compensate employees with cash. In addition, the accounting treatment for stock options under Accounting Principles Board Opinion 25 allowed most companies to avoid recording any compensation expense for commonly used stock option plans. These factors created the opportunity and incentive to provide potential hires and current employees with very generous options packages as part of their overall compensation scheme.

How Widespread Was Backdating?

Academics have performed research estimating that as many as 29% of options were backdated in the years leading up to Sarbanes-Oxley. A study by Erik lie of the University of Iowa and Randall Heron at Indiana University (see "Does Backdating Explain the Stock Price Pattern Around Executive Stock Option Grants?," Journal of Financial Economics, February 2007) formed the basis of a Pulitzer Prize-winning series of investigative articles by the Wall Street Journal in 2006.

The Center for Financial Research and Analysis (ChKA) performed a survey of the 100 companies with the greatest (as a percentage of revenues) pro forma options compensation in the preSOX period. Of those 100 companies, 17 had, on three or more occasions, option grant dates that were at or near 40-day stock price lows which were immediately followed by a significant stock increase. These option grant dates warrant attention and review to determine if options backdating occurred. Those companies in the technology and biotechnology sectors may have used options more frequently and might be at higher risk than those in other sectors. …

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