Backdating problems

Most shareholder approved option plans prohibit in-the-money option grants (and thus, backdating to create in-the-money grants) by requiring that option exercise prices must be no less than the fair market value of the stock on the date when the grant decision is made. For example, because backdating is used to choose a grant date with a lower price than on the actual decision date, the options are effectively in-the-money on the decision date, and the reported earnings should be reduced for the fiscal year of the grant.

(Under APB 25, the accounting rule that was in effect until 2005, firms did not have to expense options at all unless they were in-the-money.

backdating problems-22

Furthermore, the pre-and post-grant price pattern has intensified over time (see graph below).

By the end of the 1990s, the aggregate price pattern had become so pronounced that I thought there was more to the story than just grants being timed before corporate insiders predicted stock prices to increase.

Unfortunately, these conditions are rarely met, making backdating of grants illegal in most cases.

(In fact, it can be argued that if these conditions hold, there is little reason to backdating options, because the firm can simply grant in-the-money options instead.)David Yermack of NYU was the first researcher to document some peculiar stock price patterns around ESO grants.

In those cases, the courts may look at surrounding circumstances to determine approximately when the contract went into effect.

In addition to dated documents, courts may also look at the behavior of the parties, finding the contract to be effective when the parties proceeded as though they were under the terms of the contract.

The Wall Street Journal (see discussion of article below) pointed out a CEO option grant dated October 1998.

The number of shares subject to option was 250,000 and the exercise price was (the trough in the stock price graph below.) Given a year-end price of , the intrinsic value of the options at the end of the year was (-) x 250,000 = ,750,000.

Unless corporate insiders can predict short-term movements in the stock market, my results provided further evidence in support of the backdating explanation.

Tags: , ,