stock options backdating

stock options backdating is the practice of retroactively setting the grant date of a stock option to an earlier point in time when the underlying share price was lower, thereby increasing the potential profit for the recipient. This practice, while not inherently illegal if properly disclosed and accounted for, became the center of widespread corporate scandal in the mid-2000s when it was revealed that many companies had systematically backdated options without complying with SEC rules or GAAP. The subsequent investigations by the Securities and Exchange Commission, the Department of Justice, and the Internal Revenue Service led to significant restatements of corporate earnings, executive resignations, and numerous civil and criminal charges. The scandal implicated hundreds of public companies across the United States, particularly in the Silicon Valley technology sector, and prompted major reforms in corporate governance and executive compensation disclosure.

Definition and mechanism

A stock option typically grants the holder the right to purchase a share of company stock at a fixed price, known as the exercise price or strike price, which is usually set at the market price on the date the option is officially granted. In backdating, corporate officials, often including members of the board of directors such as the compensation committee, would select a past date when the NASDAQ or NYSE share price was at a relative low. The documentation for the grant, including approvals from the SEC on forms like Form 4, would then be falsified to indicate that the grant occurred on that earlier, more favorable date. This mechanism effectively created an "in-the-money" option on the grant date, providing an immediate, undisclosed paper gain to the executive, which contravened the terms of most shareholder-approved stock option plans that mandated at-the-money grants.

Historical context and prevalence

The practice gained notoriety following research by University of Iowa professor Erik Lie and later work with colleague Randall Heron, whose statistical analysis of option grant patterns revealed abnormal returns following supposed grant dates, suggesting widespread backdating. Their studies, published in journals like Management Science, caught the attention of the Wall Street Journal, which launched a major investigative series in 2006. The scandal peaked in the post-dot-com bubble era and was particularly prevalent among technology firms like Apple, Broadcom, and McAfee, where volatile stock prices created greater opportunity for gain. An academic review by Harvard University and the University of Michigan estimated that over 29% of U.S. firms had engaged in some form of backdating between 1996 and 2005, with the practice often facilitated by permissive corporate culture and inadequate internal controls.

Legal and regulatory issues

Backdating raised severe legal issues primarily because it often involved violations of securities fraud laws, including the anti-fraud provisions of the Securities Exchange Act of 1934. Failure to properly disclose the practice and its costs to shareholders could constitute a breach of fiduciary duty by officers and directors. The SEC, under chairs like Christopher Cox, and the Department of Justice, through offices like the United States Attorney for the Southern District of New York, pursued numerous enforcement actions. Key legal consequences included charges for falsifying books and records under the Sarbanes-Oxley Act, mail fraud, wire fraud, and conspiracy. Furthermore, backdating triggered significant tax liabilities under the Internal Revenue Code, as "in-the-money" options were subject to different treatment under Section 409A rules, potentially leading to penalties for both the company and the executive.

Accounting implications

Under GAAP, specifically APB Opinion No. 25 and later SFAS No. 123, an "in-the-money" option granted at a discount to market value must be recorded as a compensation expense on the company's income statement. By backdating options and failing to report the true grant date, companies avoided recognizing these often substantial expenses, thereby artificially inflating reported net income and earnings per share. When discovered, companies were forced to restate years of financial results, as seen with firms like Mercury Interactive and Brocade Communications Systems. The FASB subsequently clarified and strengthened reporting standards with SFAS 123R, which mandated the expensing of all stock-based compensation, reducing the accounting incentive for such manipulation.

Notable cases and consequences

Among the most prominent cases was the prosecution of Gregrey L. Reyes, the former CEO of Brocade Communications Systems, who was convicted on securities fraud charges, though the conviction was later overturned. Apple's internal investigation, overseen by a special committee that included former U.S. Vice President Al Gore, found irregularities leading to the resignation of general counsel Nancy R. Heinen. Other significant cases involved the co-founders of McAfee, William L. Larson and Samual L. Jain, and the former chairman of UnitedHealth Group, William W. McGuire, who settled with the SEC for a record amount. Consequences extended beyond individuals to include massive shareholder lawsuits, reputational damage, and sweeping changes to corporate governance, including stricter controls by boards and increased scrutiny from institutions like the New York Stock Exchange and the Public Company Accounting Oversight Board.

Category:Corporate scandals Category:Securities fraud Category:Executive compensation