Backdating Stock Options

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. 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 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. 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.

Under APB 25, the accounting rule that was in effect until , firms did not have to expense options at all unless they were in-the-money. However, under the new FAS R, the expense is based on the fair market value on the grant date, such that even at-the-money options have to be expensed. Because backdating is typically not reflected properly in earnings, some companies that have recently admitted to backdating of options have restated earnings for past years.

Backdating is properly reflected in taxes. The exercise price affects the basis that is used for estimating both the company's compensation expense for tax purposes and any capital gain for the option recipient. Thus, an artificially low exercise price might alter the tax payments for both the company and the option recipient. However, if the options were effectively in-the-money on the decision date, they might not qualify for such tax deductions.

Unfortunately, these conditions are rarely met, making backdating of grants illegal in most cases. In fact, it can be argued that if these conditions hold, there is little reason to backdating options, because the firm can simply grant in-the-money options instead. How do we know that backdating takes place in practice? David Yermack of NYU was the first researcher to document some peculiar stock price patterns around ESO grants. In particular, he found that stock prices tend to increase shortly after the grants.

He attributed most of this pattern to grant timing, whereby executives would be granted options before predicted price increases. This pioneering study was published in the Journal of Finance in , and is definitely worth reading. In a study that I started in and disseminated in the first half of and that was published in Management Science in May available at http: Furthermore, the pre-and post-grant price pattern has intensified over time see graph below.

By the end of the s, the aggregate price pattern had become so pronounced that I thought there was more to the story than just grants being timed before corporate insiders predicted stock prices to increase. This made me think about the possibility that some of the grants had been backdated. I further found that the overall stock market performed worse than what is normal immediately before the grants and better than what is normal immediately after the grants.

Unless corporate insiders can predict short-term movements in the stock market, my results provided further evidence in support of the backdating explanation. In a second study forthcoming in the Journal of Financial Economics available at http: The graph below shows the dramatic effect of this new requirement on the lag between the grant and filing dates. To the extent that companies comply with this new regulation, backdating should be greatly curbed.

Thus, if backdating explains the stock price pattern around option grants, the price pattern should diminish following the new regulation. Indeed, we found that the stock price pattern is much weaker since the new reporting regulation took effect. Any remaining pattern is concentrated on the couple of days between the reported grant date and the filing date when backdating still might work , and for longer periods for the minority of grants that violate the two-day reporting requirements.

We interpret these findings as strong evidence that backdating explains most of the price pattern around ESO grants.


Spotlight on Stock Options Backdating


End of the Options Backdating Era

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