Options backdating

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Options backdating is the practice of granting an employee stock option that is dated prior to the date that the company actually granted the option. This practice raises a number of legal and accounting issues. The practice of backdating itself is not illegal, nor is granting of discounted stock options. What is illegal is the improper disclosures, both in financial records and in filings with the United States Securities and Exchange Commission (SEC).

In 1992 the SEC imposed a rule requiring companies to report executive stock options in detail. Even after the rule, some executives could legally delay reporting option grants for so long that it was virtually impossible to figure out whether any individual grant had been backdated.

Since the Enron scandal, Congress enacted Section 409A of the Internal Revenue Code to deal with such non-qualified deferred compensation. Backdated stock options would be considered discounted stock options triggering additional taxes and penalties at vesting or exercise. Most of the legal issues arising from backdating are a result of the grantor falsifying documents submitted to investors and regulators in an effort to conceal the backdating.

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[edit] Research history

In 1995, New York University finance professosr David Yermack studied data that companies were obligated to publish, under a 1992 SEC decree, in connection with the exact dates of options grants in proxy statements. Previously, dates were disclosed within often ignored filings. Yermack found a pattern that the stock prices often declined in value just prior to the time of the grant of the options, and rose thereafter. He theorized that the executives were timing the awards of the options so that the issuances would precede good news and would follow bad news. In 1997, his findings were published in the Journal of Finance.

Accounting professors David Aboody of UCLA and Ron Kasznik of Stanford followed with a study of companies that grant options at the same time every year. Aboody and Kasznik found a similar pattern. Their evidence suggests that company executives time the release of news. The findings of Aboody and Kasznik were published in the Journal of Accounting Economicsin 2000.

In 2004 Finance professor Erik Lie of the University of Iowa asserted that many options grants were timed to exploit marketwide price depressions that nobody, including insiders, could predict — leading to the conclusion that at least some of the grants must have been retroactive.

[edit] Terminology

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Please help improve this article by adding reliable references. Unsourced material may be challenged and removed. (April 2007)
  • bullet dodging - delaying an options grant until just after bad news
  • spring-loading - timing an options grant to precede good news
  • symmetric spring-loading - where members of the board who approve the grant are aware of the forthcoming good news
  • asymmetric spring-loading - where members of the board who approve the grant are unaware of the forthcoming good news

[edit] Overview of the Options Backdating Scandal

Academic researchers had long been aware of the pattern, exhibited by some companies, of share prices rising dramatically in the days following grants of stock options to senior management. However, in late 2005 and early 2006, the issue of stock options backdating gained a wider audience. Numerous financial analysts replicated and expanded upon the prior academic research, developing lists of companies whose stock price performance immediately after options grants to senior management (the purported dates of which can be ascertained by inspecting a company's Form 4 filings, generally available online at the SEC's website) was suspicious.

Backdating stock options is not necessarily illegal. Backdating becomes illegal when a company's shareholders are misled as a result of the practice. For instance, public companies generally grant stock options in accordance with a formal stock option plan approved by shareholders at an annual meeting. Many companies' stock option plans provide that stock options must be granted at an exercise price no lower than fair market value on the date of the option grant. If a company grants options on June 1 (when the stock price is $100), but backdates the options to May 15 (when the price was $80) in order to make the option grants more favorable to the grantees, the fact remains that the grants were actually made on June 1, and if the exercise price of the granted options is $80, not $100, it is below fair market value. Thus, backdating can be misleading to shareholders in the sense that it results in option grants that are more favorable than the shareholders approved in adopting the stock option plan.

The other major way that backdating can be misleading to investors relates to the method by which the company accounts for the options. Until very recently, a company that granted stock options to executives at fair market value did not have to recognize the cost of the options as a compensation expense. However, if the company granted options with an exercise price below fair market value, there would be a compensation expense that had to be recognized under applicable accounting rules. If a company backdated its stock options, but failed to recognize a compensation expense, then the company's accounting may not be correct, and its quarterly and annual financial reports to investors may be misleading.

Although many companies have been identified as having problems with backdating, the severity of the problem, and the consequences, fall along a broad spectrum. At one extreme, where it is clear that top management was guilty of conscious wrongdoing in backdating, attempted to conceal the backdating by falsifying documents, and where the backdating resulted in a substantial overstatement of the company's profitability, SEC enforcement actions and even criminal charges have resulted. Toward the other extreme, where the backdating was a result of overly informal internal procedures or even just delays in finalizing the paperwork documenting options grants, not intentional wrongdoing, there is likely to be no formal sanction -- although the company may have to restate its financial statements to bring its accounting into compliance with applicable accounting rules.

With respect to the more serious cases of backdating, it is likely that most of the criminal actions that the government intends to bring will be brought in 2007. There is a five-year statute of limitations for securities fraud, and under the Sarbanes-Oxley Act of 2002, option grants to senior management must be reported within two days of the grant date. This all but eliminated the opportunity for senior management to engage any meaningful options backdating. Therefore, any criminal prosecution is likely to be based on option grants made before Sarbanes-Oxley took effect, and the deadline facing the government for bringing those prosecutions is approaching.

As of 17 November 2006, backdating has been identified at more than 130 companies, and led to the firing or resignation of more than 50 top executives and directors of those companies. Notable companies embroiled in the scandal include Broadcom Corp., UnitedHealth Group and Comverse Technology.

Some of the more prominent corporate figures involved in the controversy currently are Steve Jobs and Michael Dell. Both Apple and Dell were under SEC investigation. On April 24, 2007, the SEC announced it would not file charges against Apple, but had filed charges against former Apple chief financial officer Fred D. Anderson and former Apple general counsel Nancy R. Heinen for their alleged roles in backdating Apple options.[1] Anderson immediately settled the charges for a payment of a civil penalty of $150,000 and disgorgement of "ill-gotten gains" of approximately $3.49 million.[2] Heinen was charged with, among other things, violating the antifraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934, lying to Apple's auditors, and violating prohibitions on circumventing internal controls, based on the options awarded to Steve Jobs (dated October 19, 2001 but allegedly granted in December 2001) and also option grants awarded to top company executives, including Heinen (dated January 17, 2001, but allegedly granted in February 2001.)[3] The SEC is seeking injunctive relief, disgorgement, and money penalties against Heinen, in addition to an order barring her from serving as an officer or director of a public company.[4] The charges against Heinen remain pending.[5]

On Friday, February 23, 2007, the Bloomberg News reported that KB Homes are now under criminal investigation.

[edit] United States income tax issues

According to the February 9, 2007 WSJ (Page A3) article IRS Urges Companies to Pay Taxes Owed By Workers Unaware of Backdated Options the government will go after taxpayers on such options but will pursue the company for rank and file employees.

[edit] Deferral of recognition into employee's gross income

According to Section 83 of the Code, employees who receive property from the employer must recognize taxable income in the year in which that property vests (i.e., in the year in which the property becomes free of restrictions and other risks of forfeiture).[6] Stock options granted which exercise price below the then current fair market value has intrinsic value equal to the difference between the market price and the strike price. Such backdating may be construed as illegally avoiding income recognition because falsely under-reporting the market price of such stocks makes them appear to have no value in excess of the strike price at the time the option is granted.

[edit] Denial of deduction under Section 162(m) of the Tax Code

The 1993 Clinton tax increase amended the Code to include Section 162(m) which presumptively makes compensation in excess of one million dollars unreasonable for public companies.[7] As the Tax Code allows a corporate deduction only for reasonable compensation to employees, Section 162(m) needed an exception for performance based compensation. According to the September 5, 2006 Joint Committee on Taxation background briefing if the CEO or other top executive gets stock option grants with exercise price equal to market price, then the options granted would be presumed to be reasonable because they would be performance based. However, if the exercise price is below the market price so that the options are in the money, then the compensation will not be performance based, as the options would have intrinsic value immediately. (See page 5 of the background briefing).

As an economic and practical matter, backdating and cherry-picking dates with the lowest market price of the underlying stock may be evidence that the options granted were not reasonable compensation, because the grant of the options would not be performance based. In such a case, tax deductions would be denied.

[edit] References

  1. ^ Press Release: SEC Charges Former Apple General Counsel for Illegal Stock Option Backdating; 2007-70; April 24, 2007
  2. ^ Press Release: SEC Charges Former Apple General Counsel for Illegal Stock Option Backdating; 2007-70; April 24, 2007
  3. ^ Press Release: SEC Charges Former Apple General Counsel for Illegal Stock Option Backdating; 2007-70; April 24, 2007
  4. ^ Press Release: SEC Charges Former Apple General Counsel for Illegal Stock Option Backdating; 2007-70; April 24, 2007
  5. ^ Press Release: SEC Charges Former Apple General Counsel for Illegal Stock Option Backdating; 2007-70; April 24, 2007
  6. ^ See 26 U.S.C. § 83.
  7. ^ See 26 U.S.C. § 162.

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