The rise and fall of options backdating: from executive windfall to executive pitfall.

Author:Stone, Timothy P.

    THE SEC's plan to require full disclosure of executive compensation generated controversy in 2006. (1) Securities and Exchange Commission Chairman Christopher Cox, when discussing the new requirements for executive pay disclosure, stated in August 2006; "With more than 20,000 comments, and counting, it is now official that no issue in the 72 years of the commission's history has generated such interest." (2)

    Options backdating was behind much of the controversy. In testimony before the United States Senate Committee on Banking, Housing, and Urban Affairs on September 6, 2006, Chairman Cox stated: "The SEC's Division of Enforcement is currently investigating over 100 companies concerning possible fraudulent reporting of stock options grants. The companies are located throughout the country, and include Fortune 500 companies as well as smaller cap issuers." (3)

    This controversy has been largely overshadowed by recent economic events, but all across the country, the investigation and prosecution of illegal options timing continues. (4)

    Many companies have settled with the SEC. For others, the consequences have been dire. Corporations have paid out millions in fines to the SEC, to settle shareholder lawsuits, or in many cases both. In the very worst cases, executives and even general counsels have faced criminal indictment. Many have been convicted or plead guilty; some have even seen the inside of a jail cell. (5)

    This article explores the controversy surrounding options backdating. It begins by discussing the basics of options backdating: what it is, how it is accomplished, and the magnitude of the problem. Next it attempts to determine how American business arrived at this point by examining the rise and fall of options backdating in light of regulation. Finally, the article explores whether we have gone far enough to correct the problem?


    This section analyzes exactly what incentive stock options are and how they are backdated. Providing this definition, it considers the magnitude of the backdating problem.

    Options grants are an important part of the compensation scheme for executives in most if not all public corporations. Most companies have used options grants to stay competitive in the hunt for executives. In addition, many companies in emerging markets have used stock options to get their companies off the ground by attracting talent that is willing to work for lower wages in exchange for executive options, a "piece of the action."

    Options enable companies to enhance compensation packages, while at the same time incentivizing executives to increase company performance. The general theory is that as a company's performance improves, the market will drive the price of its' stock higher. Mark W. Olson, Chairman of the Public Company Accounting Oversight Board in testimony before the Senate Banking Committee on, Housing, and Urban Affairs on September 6, 2006 asserted that:

    As we all know, many companies issue stock options as a form of compensation and to give employees vested interests in improving their companies' performance and share prices. Such options usually give employees the right to but shares in the future at the price of the stock on the date of the grant. The higher the share price rises relative to the exercise price, the more valuable the options are. Well managed, stock options can be a useful and appropriate tool to attract and retain employees. (6) At some point, options grants spun out of control and a new problem emerged. An Iowa finance professor's study brought to light the fraudulent practice of backdating options. In May of 2005, Erik Lie (7) published his study: "On the Timing of CEO Stock Options Awards." (8) Based on 5,977 CEO stock option awards between 1992 and 2002, (9) Professor Lie observed a difference between scheduled and unscheduled awards. He concluded "that awards are timed to occur after price decreases and before price increases." (10)

    Chairman Cox cited Professor Lie's study stating:

    A few years ago, the SEC began working with academics to decipher market data that provided the first clues something fishy was going on. One of the academics with whom the SEC worked was Erik Lie of the University of Iowa, who subsequently published a paper in 2005 that showed compelling circumstantial evidence of backdating. (11) A. Definition of Options

    Former SEC Chairman, Arthur Levitt defined an option as a "[t]ype of investment that gives the owner the right, but not the obligation, to buy or sell stock at a given price by a certain date." (12)

    In his testimony before the Senate Banking Committee in September 2006 Professor Lie addressed options granting practices for executives:

    Stock options are granted to executives at various intervals. It is common to grant options once a year, though it is also possible for executives not to be granted options in a year or to be granted options numerous times in a year. In most cases, there is no fixed schedule to these grants, meaning that they do not occur on the same date (e.g., on July 1) in consecutive years. (13) B. How are Options Timed or Backdated?

    1. Typical Options Grants.

      Lie summarized how options are granted:

      The price at which the stock can be bought is determined at the time of the grant and generally does not change. It is called the exercise price or the strike price. Most executive stock options are granted at-the-money, i.e., the exercise price is set to equal the stock price on the day of the grant. ("In-the-money" means that the exercise price is below the stock price, and "out-of-the-money" means that the exercise price is above the stock price.) (14) 2. Strategies to Inflate Value.

      Lie described three types of potential strategies that might be used to inflate the value of option grants;

      Spring-loading/Bullet-dodging: The terms "spring-loading and "bullet-dodging" refer to the practices of timing option grants to take place before expected good news or after expected bad news, respectively. They have also been referred to as "forward dating."

      Manipulation of the information flow: This refers to the practice of timing corporate announcements relative to known future option grant dates. For example, if a firm will soon announce a share repurchase plan that is expected to raise the stock price, this announcement might be postponed until after the option grant.

      Backdating: This refers to the practice of cherry-picking a date from the past when the stock price was relatively low to be the official grant date. (15)

    2. Typical Example of Backdating

      SEC chairman Cox summarized for the Senate Banking Committee, a typical example of how some companies backdated options grants:

      They granted an "in-the-money" option, that is, an option with an exercise price lower than the day's market price. They did this by misrepresenting the date of the option grant, to make it appear that the grant was made on an earlier date when the market value was lower. That, of course, is what is meant by abusive "backdating" in today' s parlance. (16) He went on to say "The purpose of disguising an in-the-money option through backdating is to allow the person who gets the option grant to realize larger potential gains--without the company having to show it as compensation on the financial statements." (17) In other words, both the company and the grantee benefit from backdating.

      1. Magnitude of the Problem

    3. How Widespread is Options Backdating?

      Professor Lie with Indiana University professor Randall A. Heron (18) studied 39,888 stock option grants to top executives dated between January 1, 1996 and December 1, 2005. (19) This number included scheduled and non-at-the money grants. (20) They estimate that 13.6% of these grants were backdated or manipulated. (21) They determined that 18.9% of unscheduled at-the-money option grants to top executives between 1996 and 2005 were backdated or otherwise manipulated. (22)

      The SEC's Director of Enforcement, Linda Chatman Thomsen, announced in an October 2006 speech that the Division of Enforcement was currently investigating over 100 matters relating to potential abuses of employee stock options. (23) She explained that the investigations are being conducted by SEC offices throughout the country and are being centrally coordinated and tracked in Washington. (24)

      She went on to say "We do not expect to bring 100 enforcement cases regarding stock options--we are focusing on the worst conduct. But we do expect to bring more cases." (25)

      Chatman added: "In addition to our investigations, there is substantial criminal interest in options matters from United States Attorneys' Offices nationwide." (26)

      The financial and social costs of options backdating are staggering. Chatman presented statistics:

      The Associated Press reported last week that the companies that have publicly disclosed backdating problems to date will collectively incur costs of more that $10.3 billion in lost share price and additional compensation expenses. (27) The AP also reported 41 senior executives have left 20 companies involved in the backdating scandal, and the total rises every week. (28) Many companies have lost an entire generation of seasoned executives who have resigned or been fired as a result of the options scandal--undoubtedly causing enormous disruption and upheavals at the affected companies. (29) 2. The Drumbeat of Investigations.

      The SEC has brought several enforcement actions against companies and individuals for fraudulent option practices. As of March 2008, seven general counsels and twenty-nine corporate executives had been charged. (30)

      This note will focus on four of the SEC's first major options cases. The Peregrine and Symbol Technologies cases were part of larger accounting fraud charges while the Brocade and Comverse actions focus solely on option practices. (31) An Analysis of the two exclusive options backdating cases and the allegations...

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