Stock Option Backdating

The following is a paper I coauthored in December 2006 for a Seminar in Management Control Systems while completing my Masters of Science in Accounting & Taxation at the University of Hartford. Given the recent resurgence of news relating to options backdating, I thought I’d reprint the paper for those who might be interested.

Executive Summary
Stock option backdating is a complex issue. While there are legal ways to backdate stock options, as we found, few companies can properly account for backdated options. As a result, we found that many companies lose top talent, are scrutinized by regulatory bodies, and are subject to fines and penalties. The negative effects on shareholder value are significant cause for concern. Ultimately, the potential gain executives’ reap is far outweighed by the likelihood of detection. Nonetheless, stock option backdating is a prevalent practice. The statistics can be staggering: $5.9 billion in fines, more than 120 companies under investigation. In the coming pages, the history, legal issues, and effects on shareholder value will be explored.

Introduction
Stock option backdating is a popular issue in today’s business environment. With recent changes made to the accounting and reporting rules for stock options, a storied array of companies have announced illegal practices, investigations, executive resignations, and much more. Some of the companies involved come as a surprise to many: Apollo Group, Apple Computer, Home Depot, Corinthian Colleges, Electronic Arts, Gap, and more than 120 others. Infractions range from minor backdating over a short period, to a systematic backdating scheme spanning 20 years. In 1999, even Microsoft encountered problems with its options scheme. Clearly, backdating was a popular practice in executive compensation. While executives should be rewarded for success, protecting the shareholders is their primary responsibility.

When illegal backdating practices lead to negative actions, the shareholders suffer in many ways. Companies will lose top talent, individuals who are key to the company’s growth and success. Fines and penalties reduce net income, depressing earnings per share and limiting capital available for dividends. The expense of internal and external investigations serves to further depress shareholder value. In spite of the risks and legal approaches to backdating, executives are tempted to illegally backdate options. It is this curious incongruence that we set out to explore in the foregoing sections.

In early research, we found an excellent resource created by a business professor in the Midwest. His discussion included, among other items, legal ways to backdate stock options. Logically, we began to wonder why so many companies were illegally backdating options when the risk is so high. Further investigation has revealed the complexities involved with a legal backdating program. Because of these complexities, many companies are unable to keep all paperwork in line. As we will explore in the coming pages, stock option backdating is anything but a straightforward issue.

Background
American stock options are a type of derivative contract that gives the holder the right to buy or company stock at a set price (strike price) during a specified period.¹ Once the purchase or sale occurs, the option has been exercised. Employee stock options are offered as compensation in two different ways. Stock options may be offered on a regular schedule, as part of a normal executive compensation package, or unscheduled, as a performance- or inventive-based reward. It is with the later of these two forms that the majority of options backdating fraud occurs. Corporate executives are tempted to alter the issuance date to one with a lower stock price, building in a greater intrinsic value. Unfortunately, for most companies engaged in this practice, as well as their shareholders, fraudulent accounting is needed which leads to fines, penalties, and even financial restatements. As of October 30, 2006, Glass, Lewis & Company estimates that companies have taken charges totaling more than five billion dollars in fines and restatements.²

The penetration of stock option backdating is significant. According to Eric Lie, professor and researcher at the University of Iowa Tippie College of Business, 23% of unscheduled options granted between 1996 and August 2002 were manipulated.³ New legislation that went into effect in August of 2002 cut that percentage roughly in half, Professor Lie reports. Nonetheless, backdating is still being discovered at companies large and small. For example, on December 6, 2006, Home Depot announced that “an internal investigation found that it routinely backdated stock options for 20 years starting in 1981 and as a result it understated compensation expense by $200 million.”⁴ In addition to the widespread initiation of internal investigations, stock option backdating has been discovered by external parties through complex stock-price analysis. One of the earliest researchers of stock options, New York University Professor David Yermack, first noticed what he described as “peculiar” stock price patterns before and after stock option grants.⁵ His pioneering research has been put to use by shareholder advocates such as Glass, Lewis & Company in their efforts to identify potential shareholder fraud. Even still, it seems that much is yet to be uncovered. This is an unfortunate situation for shareholders, one that will be addressed in a forthcoming section. Luckily for shareholders and creditors alike, legislative and regulatory bodies have not sat idly by as the extent of backdating has been uncovered.

As previously mentioned, August 2002 marked the enactment of new reporting requirements for stock options, accompanied by an estimated halving of grant manipulation. Starting in August of 2002, companies were required to report option grants within two days of their issuance. This afforded greater transparency to the process, as shareholders and analysts could better correlate option grants with positive or negative changes in stock price. The practice of spring-loading (issuing grants before positive announcements) and bullet-dodging (issuing grants after negative announcements) was curbed significantly by the change. Still, critics felt that stock options were still too loosely controlled and accounted for. Prior to fiscal years beginning June 15, 2005, employee stock options were not expensed at the time of their issuance; instead, the cost of the grant was disclosed in a footnote to the financial statements. The grant expense was not recognized until the grant was exercised. As a result, the company could spread its grant expense over a longer period. Rather than recognizing a large expense when many grants are issued, the company is more likely to recognize the expense piecemeal, since it is unlikely every employee issued a grant option would exercise it at the same time. The update to financial accounting standards, embodied in the revision to FAS 123, supersedes a rule in effect since 1973. Under the old rule, APB 25, options were only expensed if the strike price was less than the market price of the security.⁶ For most companies, starting with fiscal year 2006, option grants will now have an income statement effect. FAS 123R has also been embraced by the Securities and Exchange Commission (SEC) in Staff Accounting Bulletin 107, method of option expensing.⁷ Since adopting this position in March of 2005, the SEC has begun investigating more than 120 companies. Reasons range from improper accounting records to forged or inaccurate documentation to improper tax treatment of options. As of December 7, 2006, the SEC had concluded its investigation of only one of the more than 120 companies without punitive action.⁸ The bulk of the companies have active SEC investigations, many have announced restatements, while many have also been fined by the SEC, Justice Department, and Internal Revenue Service. As it turns out, inflated intrinsic values were not the only motivation behind backdating.

The New York Times reported on October 30, 2006 that in addition to greater built-in gains for grant recipients, backdating has been a vehicle for tax evasion.⁹ The article focuses on two companies, Symbol Technologies and Mercury Interactive. At these two companies, grant dates were not backdated. Instead, exercise dates were backdated to days with lower share prices. By reducing the reported gain, the recipient decreases the tax liability associated with exercising the option. Additionally, companies may take improper tax deductions in preparing corporate returns, resulting in future reporting issues. In Mr. Dash’s New York Times article, he also discusses occurrences of backdating options to days with higher closing prices. Since stock can be cashed out to pay the cost of converting options and pay related taxes, higher prices on exercise dates necessitate fewer shares to cover associated costs.¹⁰ At Symbol Technologies, the SEC suspects top executives avoided paying “hundreds of thousands in income taxes.” Take the case of Symbol’s former CFO, Ken Jaeggi. In June 2000, Mr. Jaeggi signed a document stating he exercised 101,250 options on the day in May when the stock was at its second-lowest close. The SEC found that the options were actually exercised and paid for until June 30. This deception let Mr. Jaeggi underreport his gain to the IRS by $1.46 million. As a result, he avoided paying more than $596,000 in income taxes. Because the documents signed in June 2000 were falsified, Mr. Jaeggi was forced to resign and awaits trial along with other former Symbol executives. A similar situation unfolded at Mercury Interactive, a California-based software testing company. In an update to its annual report, the company reported that certain top executives “reported ‘a date that differed from the date at which the exercise actually happened’…[reducing] the executives’ taxable income significantly and [exposing] the company to possible penalties for failure to pay withholding taxes.”¹¹ This statement from Mercury Interactive sums up a large part of the problem with options backdating: penalties.

Beyond simple outrage at the size of executive compensation, shareholders should be concerned about backdating for one basic reason: shareholder value. While there are legal methods for backdating option grants, as will be discussed in the foregoing section, few companies succeed. As a result, companies are subject to investigations, fines, penalties, loss of key executives, and financial restatements. Bad press also tends to follow announcements of backdating. Every one of these issues reduces shareholder value in one way or another. Furthermore, penalties and restatements may be substantial enough to cause problems with creditors. Debt covenants, often tied to financial ratios or measures, may be violated when option expenses and fines are properly entered into the accounting records. As unsecured parties without priority, shareholders are left holding the bag when creditors decide their investment is no longer safe with a particular company. Where else can the company make up for lost borrowing power but in a reduction in shareholders’ equity?

Legal Issues
Backdating stock options does not necessarily have pros and cons. By backdating stock options, you are only hurting the stockholder, entity, and the integrity of the United States investment system. As noted in previous paragraphs, stock option backdating is illegal, but there are ways in which backdating stock options can be legal. In order for backdating stock options to be legal, many things must occur including no forging of original documents, backdating is communicated to shareholders, backdating is properly reflected in earnings, and backdating is properly reflected in taxes.¹²

First and foremost, in order for an option to be considered properly backdated, the ESO cannot be forged. The date can only be backdated on the option, if it is a discount option. A discount option is an option in which the board of directors decides the executive can grant an option within any of the past thirty days. Also, note spring-loading, which is exercising a stock option right before an earnings release or good news from the entity, is considered backdating. Therefore, a discounted option can be considered forged if it is spring-loaded.

Secondly, backdating of stock options must be effectively communicated to the shareholders both within the 10-Qs and 10-K, as well as during quarterly and annual shareholder meetings. The reason for this is that shareholders are the ones effectively affected by the backdating of the options as they are the ones who pay the inflated price of the executives’ earnings.¹³ By ensuring that this is communicated to the shareholders, the backdating is in fact reviewed by external auditors and included in the 10-K for review by the SEC.

Lastly, the backdating must be properly reflected in both earnings and taxes. Under APB 25, entities did not have to expense stock options unless they were in-the-money. In-the-money essentially means the stock options were exercised for a profit. Since 2005, though, the new FAS 123R states that even at-the-money (options exercised for no profit) need to be expensed.¹⁴ In our opinion, this rule was created, as many executives were not exercising stock options because they did not result in a profit and therefore would not expense them, but in actuality, they should be expensed. In addition, since the expense of the stock option affects earnings in the fiscal year of the grant, the entity must use the fair value of the stock at the grant date. Since many options were backdated, though, earnings in prior years were not changed to effectively update the actual expense related to the backdating of the option. This, therefore, overstated earnings and affected shareholders by creating a ripple effect throughout Wall Street.

Also to note, taxes need to be properly reflected in order for backdating of stock options to be legal. Capital gains and compensation expense are being understated when backdating of options occurs. “Thus tax payments for both the company and option recipient are being misstated.”¹⁵ According to Section 162(M) of the Internal Revenue Code, at-the-money options are considered performance-based compensation and deductible.¹⁶

Based upon the above circumstances, it is nearly impossible to backdate options legally without notifying the public. Executives try to get the best of both worlds and backdate options to receive larger capital gains while still inflating company performance.

According to the text, stock option plans are an example of agency costs inherent with incentive compensation. The text states that with stock options plans, it is necessary for the agency to inflate the executive’s regular salary in case the company does not perform well. In this case, if the company does not perform well, the executive therefore has a regular salary to compensate for the options being worth less.

Agency theory points out that everyone does what is in their own self-interest, explaining why executives backdate stock options. It even further illustrates why backdating is done illegally. By not telling the shareholders that backdating of stock options took place, the shareholders feel they are being treated properly. Thus, according to agency theory, since the executive is fulfilling his financial need and carrying out his duty to achieve shareholder value, the executive feels no wrong is done.

Conclusion
It is obvious to any person involved in the business world the negative effect backdating of stock options has on a business, individuals, and the investment community. Backdating stock options is essentially a fraudulent act that should not be separated from other forms of misrepresented financial statements.

Based on our research, we believe that even if the company does report the backdating properly and if no fraudulent activity takes place, backdating still serves no purpose. The company could have simply granted in-the-money options, according to the University of Iowa research. If the company grants in-the-money options, the executive is compensated properly, the shareholders are informed, and financial results are not mixed. So, in essence, the reason executives backdate options is to get the best of both worlds: inflated financial results and more compensation.

We have come to the conclusion that in order for stock options not to be backdated, the SEC needs to set new and more stringent accounting pronouncements. Possibly there needs to be a new set standard of when the options can be granted for particular industries. The problem with this control is that the SEC cannot state timeframes when options can be granted because each business is different and some will benefit if certain timeframes are implemented; similarly, some would not. There are possible ways to prevent backdating, such as the SEC notification now required every time stock options are granted, notification to external auditors, or possibly increased Sarbanes-Oxley controls related to executive compensation. All in all, we feel that the SEC has uncovered another act of fraudulent reporting and they have only uncovered the tip of the iceberg in incidents of backdating. Yes, executives will stop backdating stock options now that there is SEC involvement, but they will find another way to fudge financial results and increase their performance pay.