-Wikipedia Page: Stock Options Backdating
To view Kevin Freeman’s article on Stock Options Backdating, please CLICK HERE. This article was written by Kevin on February 7th, 2010.
Options Backdating
Backdating stock options is the practice of issuing options contracts on a later date than that which the options have listed. While options backdating is not, in and of itself, an illegal practice 1, intentional backdating that coincides with low underlying stock prices and an accounting report that claims the contracts to have been issued on those low dates as “at the money” – rather than “in the money” – contracts has resulted in the SEC’s public view that backdating can, and should, be considered fraudulent in many cases 2. While options backdating has been used to enhance or increase the value of options contracts while reaping the tax benefits of having issued “at the money” contracts, the practice is also frequently necessary in order to accommodate situations in which lengthy issuance procedures or corporate policies require more than one day to complete an approval process, thus showing an earlier issue date than that on which the contracts are actually issued.
The SEC’s opinions regarding backdating and fraud were primarily due to the various tax rules that apply when issuing “in the money” stock options vs. the much different – and more financially beneficial – tax rules that apply when issuing “at the money” stock options. Additionally, companies can use backdating to produce greater executive incomes without having to report higher expenses to their shareholders, which can lower company earnings and/or cause the company to fall short of earnings predictions and public expectations. Corporations, however, have defended the practice of stock option backdating with their legal right to issue options that are already in the money as they see fit, as well as the frequent occurrence in which a lengthy approval process is required 3.
History
In 1972, a new revision (APB 25) in accounting rules resulted in the ability of any company to avoid having to report executive incomes as an expense to their shareholders if the income resulted from an issuance of “at the money” stock options. In essence, the revision enabled companies to increase executive compensation without informing their shareholders if the compensation was in the form of stock options contracts that would only become valuable if the underlying stock price were to increase at a later time.
In 1982, a new tax code (162 M) provision declared all executive income levels over one million dollars to be “unreasonable” in order to increase taxes on all applicable salaries by removing them from their previous tax deductable status 4. To avoid having to pay higher taxes, many companies adopted a policy of issuing “at the money” stock options in lieu of additional income, with the idea that the executive or employee would benefit through the option by working to increase the value of the company without exceeding the one million dollar deductibility cap for executive income 5.
When company executives discovered that they had the ability to backdate stock option grants, thus making them both tax deductible and “in the money” on the date of actual issuance, the common practice of stock option backdating for financial gain began on a widespread level. The problem with this practice, according to the SEC, was that stock option backdating, while difficult to prove, could be considered a criminal act 6.
Implications in Corporate America
Since the advent of stock option backdating, corporate policies have moved first toward a posture of encouraging backdating as a standard business practice, but then toward a posture of avoidance as public scandals emerged and investigations into fraudulent or dishonest business practices increased despite a commonly held belief that backdating was an acceptable and legal practice. In the modern business world, the Sarbanes-Oxley Act has all but eliminated fraudulent options backdating by requiring companies to report all options issuances within 2 days of the date of issue 6.
Options backdating may still occur under the new reporting regulations, but Sarbanes-Oxley compliant backdating is far less likely to be used for dishonest reasons due to the short time frame that is allowed for reporting. As a result, numerous companies are conducting internal investigations to determine if, when, and how backdating occurred, and are filing amended earnings statements and tax forms to show the issuance of “in the money” options in place of the “at the money” options that were previously reported 7.
Myths of Backdating
While it is true that many forms of backdating are fraudulent or criminal in nature, there is a largely prevalent public opinion that all forms of backdating are the equivalent of fraud 8. This is not always the case, according to a ruling by federal judge William Alsup of the U.S. District Court for the Northern District of California. According to Alsup’s reasoning and subsequent ruling, it is improper to infer fraudulent activity based solely on the occurrence of options backdating – further facts must be present and proven before the act can be considered to be fraudulent.
Another common myth circulating through the public is that options backdating stems from executive corruption 9. While this conclusion is logical in cases of options backdating in which executives knowingly participated in the criminal actions, options backdating can be a result of normal accounting or corporate policies that are not criminal in nature 2, and is a legal practice as long as the backdated contract is appropriately reported for tax purposes.
Although public opinion and media focus tend to portray largely negative sentiments toward backdating, the legal line that separates acceptable backdating from criminal backdating has yet to be fully understood and legally defined. Many backdating supporters point to Apple CEO Steve Jobs as an example of backdating that was not considered to be a criminal action in a court of law, yet when the same behavior is exhibited by another CEO, questions of criminal activity and executive corruption still arise 10.
Further Reading
Weinstein, Bernard T. (2009) “Backdating of Stock Options (Business Economics in a Rapidly-Changing World),” Nova Science Pub Inc. ISBN 978-1607419846
Skupien, Phyllis Lipka and Reynolds, Frank (2006). “Stock-Options Backdating & Executive Compensation (Andrews Special Report),” West Group. ISBN 978-0314966278
Taylor, Jeffrey M., Creamer III, Anthony B., and Dubow, Jay A. (2007). “Understanding the stock options backdating controversy : new developments,” LC Control No. 2007931090
References
- Taub, Stephen and Cook, Dave (2007). “Backdating Not Sufficient to Prove Fraud,” http://www.cfo.com/article.cfm/9028174/c_9024377?f=TodayInFinance_Inside Retrieved 2010-01-22
- Chatman Thomsen, Linda (2006). “Speech by SEC Staff:
Options Backdating: The Enforcement Perspective,” http://www.sec.gov/news/speech/2006/spch103006lct.htm#foot1 Retrieved 2010-01-22 - Curtis, Glenn. “The Dangers Of Options Backdating,” http://www.investopedia.com/articles/optioninvestor/07/options_backdating.asp Retrieved 2010-01-22
- Rose, Nancy L. and Wolfram, Catherine (2000). “Regulating Executive Pay: Using the Tax Code to Influence CEO Compensation,” http://ideas.repec.org/p/nbr/nberwo/7842.html Retrieved 2010-01-22
- Rose, Nancy L. and Wolfram, Catherine (2000). “Has the ‘Million-Dollar Cap’ Affected CEO Pay?” http://econ-www.mit.edu/files/4326 Retrieved 2010-01-22
- 6. Gorman, Thomas O. (2009). “Part VII: SEC Enforcement Trends, 2009 — Option Backdating,” http://www.secactions.com/?p=1011 Retrieved on 2010-01-22
- Shaw, Helen (2007). “Investigation Dilemma: Sing or Keep Mum?” http://www.cfo.com/article.cfm/8626852/c_8800480 Retrieved 2010-01-22
- Schwankert, Steven (2007). “DOJ Charges Former Safenet Exec With Stock Backdating,” http://www.pcworld.com/article/135101/doj_charges_former_safenet_exec_with_stock_backdating.html Retrieved on 2010-01-22
- Bishara, Norman (2009). “Strengthening the Ties that Bind: Preventing Corruption in the Executive Suite,” http://deepblue.lib.umich.edu/handle/2027.42/63512 Retrieved on 2010-01-22
- Ribstein, Larry E. (2007). “The Reyes backdating case gets murkier,” http://www.backdatingisnotacrime.com/backdating-reference/the-reyes-backdating-case-gets-murkier.html Retrieved on 2010-01-22
External Links
Securities and Exchange Commission (SEC)
See Also
American Institute of Certified Public Accountants
Financial Accounting Standards Board
Generally Accepted Accounting Principles (USA)
International Standards of Accounting and Reporting
U.S. Securities and Exchange Commission