Companies sometimes give their employees the right to buy shares at a fixed price for a number of years while they are with the company.
Since you will only make money if the stock prices go up, your profits increase if the price at which you are allowed to purchase the stock is very low, and the stock price subsequently rises.
The fixed price at which an employee can purchase stock is supposed to be whatever the selling price was when the option was available. However, some companies manipulated this data by creating documentation to make it look as though the option was granted on a day when the price was meager.
This practice of changing the so-called date that the option was granted to the employee is called “backdating” and is illegal.
Companies generally use stock options as an incentive to the employees. By providing large profits for its employees through stock options, a company can lure qualified individuals to come work for them and make sure that they have an incentive to stay with the company and not go to work for a competitor.
By backdating stock options, employees’ profits are even larger, providing even more incentive to work hard and stay with the company.
Many companies are currently investigating this matter by the Securities and Exchange Commission (SEC). However, backdating is difficult to identify, and it is often unclear exactly which practices are intentional and illegal and which are genuine mistakes or miscalculations.
The Sarbanes-Oxley Act, passed in 2002, requires that options be reported to the SEC within two days of the grant and makes backdating harder to do.
In the early 2000s, the Securities and Exchange Commission (SEC) investigation resulted in more than 50 resignations from senior executives and CEOs at firms across the country. The firms ranged from restaurant chains and recruiters to home builders and healthcare.
Companies including Apple, Broadcom, UnitedHealth Group, Staples, The Cheesecake Factory, KB Home, Monster, Brocade Communications Systems, and dozens of lesser-known technology firms were implicated in the scandal. The scandal related to options backdating.
The options backdating scandal can be summarized as executives falsifying documents in order to earn more money by lying to regulators, shareholders, and the IRS. The scandal dates back to 1972. That year, an accounting rule was put in place that permitted companies to avoid recording executive compensation as an expense on their income statements so long as the income was in the form of stock options granted at a rate equal to the market price on the day of the grant. The grant is often referred to as an at-the-money grant. This rule enabled companies to issue enormous compensation packages to senior executives without notifying their shareholders.
This practice gave senior executives significant stock holdings because the grant was issued at the money, but the share price had to be appreciated before the executives would profit. An amendment to the tax code in 1993 created incentives for executives and their employers to work together to break laws.
The amendment labeled executive compensation in excess of $1 million as unreasonable and not eligible to be taken as a deduction on the firm’s taxes. Performance-based compensation, however, was deductible. Since at-the-money options require a firm’s share price to appreciate in order for the executives to profit, they meet the criteria for performance-based compensation and qualify as a tax deduction.
When senior executives realized they could look backward for the date in which their firm’s stock was at its lowest trading price and then pretend that was the date they issued the stock grants, the scandal began.
By faking issue dates, executives could guarantee themselves in-the-money options and instant profits. The executives realized they could cheat the IRS twice, once for themselves, since capital gains are taxed at a lower rate than ordinary income. The executives could also cheat the IRS since the cost of the options would qualify as a corporate tax write-off. The process became so common that investigators believe 10% of the stock grants made nationwide were issued under these falsities.
A series of academic studies brought the backdating scandal to light. In 1995, a professor at New York University reviewed option-grant data that the SEC required companies to publish. The study identified a strange pattern of extremely profitable option grants which perfectly coincided with dates on which shares traded at a low.
Professors elsewhere performed two follow-up studies and suggested that the uncanny ability to time options grants could only have happened if the granters knew the prices in advance. The lid was finally blown off of the scandal when a Pulitzer Prize-winning story was published in The Wall Street Journal.
As a result, the firms restated their earnings and paid fines. Executives lost their jobs and their credibility. The SEC reported that investors lost over $10 billion due to sharing price declines and stolen compensation.
In the 2000s, new accounting provisions were enacted that required companies to report their option grants within two days of their issue. They also required that all stock options be listed as expenses. These changes were intended to reduce the likelihood of future backdating incidents.
Since the beginning of stock option backdating, corporate policies have moved toward encouraging backdating as a standard business practice. However, after public scandals emerged amid investigations into fraudulent and dishonest business practices, corporate policies moved toward avoidance of option backdating.
Before the investigations, it was a commonly held business belief that backdating was an acceptable and legal practice. In the modern business world, the Sarbanes-Oxley Act has eliminated most fraudulent options backdating by requiring companies to report all options issuances within two days of the issuing date.
Options backdating may still occur under the new reporting regulations. Still, compliant backdating under the Sarbanes-Oxley act is far less likely to be used for dishonest means due to the short time frame it allows for reporting. As a result, companies conduct internal investigations to determine if, when, and how backdating occurred. They file amended earnings statements and tax forms to show the issuance of “in the money” options in place of “at the money” options previously reported.
Although many companies have been identified as having problems with backdating, the severity of the problem and the consequences fall along a varied spectrum. Sometimes, management consciously attempts to conceal backdating by falsifying documents. On the other hand, backdating is just the result of overly informal internal procedures of delays in finalizing paperwork. Likely, most of the criminal actions that the government intended to bring were brought in 2007, under the five-year statute of limitations for securities fraud under the Sarbanes-Oxley Act.
To recover damages in a lawsuit against your company for backdating, you will have to prove fraudulent intent, which can be very hard to do. A securities attorney with experience in securities law will be able to represent you should you wish to take action against the illegal practices of your company.
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