Case Study on Backdating

Options Backdating

Granting stock options to key employees was a popular practice in the dot.com days. Start-up companies could offer stock options to employees in the expectations that the options would be worth a great deal if the company took off. Indeed that proved true to many people in high-text fields. However, the SEC recognized that stock options were liable to misuse, and in 1992 imposed a rule requiring companies to report executive stock options in detail.

One possible abuse of stock options involves backdating-granting an employee stock option that is dated prior to the date the company actually granted the option. By backdating an option, a company assigns a lower value to the option, which gives the holder of the option more money when he or she exercises the option. Many stockholders view this as essentially unfair; after all, stockholders can not reprice their shares to improve their returns.

In 2004, finance professor Erik Lie of the University of Iowa conducted a study in which he noted that many options grants were timed to exploit market-wide price depressions that nobody, including insiders, could predict. His conclusion was that at least some of the grants must have been backdated. The SEC subsequently conducted a year-long investigation and began to crack down on companies with questionable policies governing stock option grants. By late 2006, at least 135 companies, according to the Washington Post, were being probed by the SEC for backdating irregularities.

As a result of the increased scrutiny, a number of top-level executives at a variety of companies either resigned or were fired. A number of companies announced that they would have to issue a restatement of prior results to record charges against earnings that should have been recorded when the options were granted.

While backdating of options is not necessarily illegal, the issues relating to backdating of options involves failure to provide full disclosure to stockholders, failure to pay extra applicable taxes, and earning statements that should have reflected the modified grant dates. Any of these three issues could yield civil (and perhaps criminal) legal action.

Fortunately, accelerated reporting requirements have made unreported backdating more difficult. Section 403 of the Sarbanes-Oxley Act of 2002 now requires that directors and officers report options grants to the SEC within two business days instead of within weeks and months as allowed under prior law.

Despite the negatives of the option's backdating scandal, stock options have beneficial uses. List several appropriate uses of stock options.