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Options backdating is one of the favorite shenanigans that executives can use to enrich themselves and employees instead of the shareholders. This is because backdating options is usually considered benign and not necessarily illegal as long as everything is disclosed to the shareholders. But before we can understand why options backdating has become so widespread especially within the technology industry, let us first examine how stock options work.

What Are Stock Options?

Stock options are rights to purchase shares of a company at a predetermined price. Traditionally, the exercise price is the same as the market price at the time of the option grant. The exercise price or strike price is the price at which the option can be used. Suppose you were granted a Microsoft stock option on January 30, 2009 which closed at $17.10/share. Your exercise price for the option will be $17.10. If the stock rises above $17.10 in the future, your option is said to be in-the-money because you can exercise it to immediately lock in a gain. So, let’s say the stock rose to $19.00 in June 2009. You can use your option to purchase a share for $17.10 instead of $19.00, therefore, locking in a gain of $1.90 or 11 percent instantly. However, if the stock continues to languish and drops below $17.10, your option is out of the money and is therefore worthless because you could buy the share at a cheaper price on the market.

As you can see, stock options can motivate the executives to increase the share price to enrich both themselves and the shareholders. Because of the vesting periods usually applied to stock options, they also help in retaining key employees. Stock options also provide a way for employees to share the profits with the shareholders.

The Problem with Options Backdating

Greed has a way of inspiring creativity. Executives began to exploit a loophole in the regulations surrounding stock option grants. Before the Sarbanes-Oxley Act of 2002 was passed, companies were allowed to report option grants two months after the actual grant date. This allowed executives to pick a two-month period where the stock price is the lowest at the beginning and the highest at the end, and grant the stock options at the lowest closing price. The result is stock options that are in-the-money from the get-go.

As I have mentioned before, this is not necessarily illegal as long as the intention to award such stock options are disclosed to shareholders upfront. Many companies, however, decided to keep this hush-hush. By doing this, they have caused two problems. One, they are not expensing the stock option grants properly thus misrepresenting financial statements to the public. Second, because they did not expense the stock option grants, they owe the Internal Revenue Service (IRS) employment taxes.

To the shareholders, the biggest lost usually comes when the options backdating scandal is exposed to the public. Shareholders will follow with civil lawsuits. IRS will sue for owed taxes. And worst of all, investors will lose confidence in the company and begin dumping shares. In the case of the most prominent case of options backdating in the tech industry, Brocade Communications had to recognize over $700 million in stock option expenses between 1999 and 2004. The stock plummeted between 2002 and 2007 and shareholders lost more than 70% of their investment.

The Temptations of Concealing Options Backdating

Locking in an immediate gain is not the only benefit from backdating options. Both the company and employee benefit from lower taxes by not reporting backdated options. Stock options that are granted at-the-money are considered to have no intrinsic value, and are therefore, performance-based compensation. (The intrinsic value of a stock option is the difference between the exercise price and the market value of the stock. So if the exercise price of an option is $8 and the market price is $10, then the intrinsic value is $10 - $8 = $2.) Since these options have no intrinsic value, the employee will not have to report them as income. But backdated options with locked-in gains have instrinsic value of greater than zero. As such, the employee must report this as income and will owe taxes. So, unreported options backdating can save executives a ton in taxes.

The Section 162(m) of the US Tax Code limits companies’ ability to deduct unreasonable compensation for executives beyond $1 million. So, creative executives began looking into stock options to avoid having to pay taxes. Since stock options are considered performance based compensation, they are inherently worthless at the time of grant. But backdated options do have intrinsic value at the time of grant. Again, by not reporting backdated options, the company owes taxes in employment taxes on backdated stock options granted to the employees. Don’t be fooled by Apple CEO, Steve Jobs’, Google CEO, Eric Schmidt’s and Yahoo! CEO, Terry Semel’s $1 salaries. Read Executive Compensation - What to Watch For.

Aside from the tax benefits above, executives also gain by misrepresenting the company as doing better than it actually is. When earnings meet or beat expectations every quarter due to under-reported expenses, investors reward the company with a higher share price. As a result, executives are granted more stock options and the cycle continues until the fraud is finally exposed.  Mercury Interactive, which flew high before it was finally known that ex-CEO Amnon Landan and other executives had been backdating options, traded in pink sheets before it was finally acquired by Hewlett Packard.

Executives’ Reaction When They Were Caught

Interestingly, executives’ first line of defense when they get caught was ignorance. They claim that the regulations and accounting rules surrounding options are so complex that no one can understand them. Legally, the prosecutor has to prove the executives’ scienter for a conviction. That is, the executives have to had known that it was illegal to backdate options to be responsible for the crime.

On the contrary, the accounting rules were clear, argued David Larcker, an accounting professor at the Stanford Graduate School of Business. He added, “They must have thought that the chances of getting caught were zero. For some of these companies, it must be hubris.” [1]

You have to wonder, “Why would the executives go through the effort of concealing options backdating if they didn’t think they were doing something wrong?”

Unfortunately, most of the cases of options backdating will remain concealed possibly forever. University of Iowa Finance Professor, Erik Lie, thinks there are two reasons for this. The first being, it’s very difficult to identify options that were backdated. Secondly, because options backdating was so rampant, the resources available to uncover all the cases are just insufficient. Most likely, the authorities will make an example out of the outstanding cases and move on. [2]

The Silver Lining

There is a bit of a good news that investors can rejoice over. With the Sarbanes-Oxley Act of 2002, companies must now report option grants within two business days instead of two months. The shortened period will effectively make options backdating very difficult. This is not to say options backdating will no longer happen. But the new rules will significantly curb options backdating. Microsoft practiced a variant called “forward dating” where the options are granted at the lowest price within 30 days after July 1st. But this is really backdating because you can’t know all the prices during the 30-day period until the 30 days have passed.

There are other tricks up the executives’ sleeves, namely spring loading and bullet dodging. Spring loading refers to the granting of options right before good news is announced to the public. Bullet dodging is the granting of options right after bad news is announced. Fortunately, these yield minor gains and probably not worth the effort.

References

1. Benjamin Pimentel, Backdating Probe Had Surprises for Investigators, MarketWatch, January 19, 2008.
2. Erik Lie, Backdating of Executive Stock Option (ESO) Grants, University of Iowa, 2006.

Side note: My recent post Executive Compensation - What to Watch For was featured on the Rich Life Carnival #30, the MoneyHacks Carnival–Frugalista Style!, the Cavalcade of Risk #70, and the Carnival of Financial Planning - January 31 2009 Edition. Be sure to check out the excellent recommendations in each carnival. Also, I highly recommend reading Jae Jun’s excellent tutorial on Analyzing Financial Statements: CROX Income Statement.