The Four Sins of Stock Option Backdating

I have a weak spot in my heart for my former students–especially if they were also my tennis or cycling buddies.  Chris, of the cycling variety, recently sent me this email message:

…So, today I was reading some posts on the Greg Reyes trial/verdict (he was the CEO of Brocade …  I must confess that I’ve heard all the fuss, but don’t really understand it (and haven’t followed it very closely) … was wondering what you make of it all.

Chris, I’m not going to remark about the specifics of the Brocade case, and would rather give you a broad outline of the general issues underlying illegitimate stock option backdating.  The following simple example is representative of the types of transactions that have been questioned:

The board of directors of BD Company met on December 1, 20×1, on which date the market price of BD was $50 per share.  The board authorized the granting of one at-the-money option to BD’s CEO, to vest over two years. The CEO instructed the vice president of human resources to backdate the option to November 1, on which date the market price of BD was $40 per share.

The stock option backdating scandal involved four kinds of ripoffs, which I’ll describe more fully below:

1. Shareholders ripoffs–By selecting a date in the past on which the stock price is lower than the current stock price, options are deceptively granted in the money.  In my simple example, the effect is to transfer more value to executives than the board of directors intended.  In some cases, the board may actually participate in the backdating scheme.
    
2. Accounting fraud–Options that were effectively granted in the money (because the real grant date is not the backdated one–it’s the date the board authorized the award) are accounted for as if they were granted at the money.  Under APB 25 (recently superseded, but in effect during the halcyon days of scandal), expense is measured at the intrinsic value of options at their grant date. (I’m oversimplifying here, but am being specific enough to make the point.) In my simple example, recording zero expense overstates net income by $10, which is the intrinsic value of the option. Often, the accounting fraud has not had a material impact on earnings, except that it was an essential to misstate earnings in order to cover-up the shareholder ripoff (See #1, above).
   
3. Tax fraud–In addition to backdating grant dates, there is strong evidence of executives backdating their exercise of options to a date on which the stock price was low. In so doing, they could reduce the amount of payroll taxes they owed, and reduce the amount of profits they realized on exercise from being taxed at ordinary rates.  If they could then manage to hold the stock for at least a year, they would eventually pay taxes on the rest of their profits at the lower capital gains rate. 
4. Inadequate SEC regulations created a loophole the size of Arthur Andersen–Under SEC rules (promulgated under Section 16a of the Securities and Exchange Act of 1934), executives have to report (i.e., publicly announce) their personal acquisitions of financial instruments issued by their company, and also derivatives underlying those financial instruments.  Until Congress forced them to tighten the loophole (one of the many good things accomplished by SOX), executives had as much as 40 days to report the transactions.  In effect, that gave executives a window of more than a month from which to cherry-pick the lowest share price for option backdating purposes.  A funny thing happened when the report due date was shortened to two days: backdating disappeared. 

That last point, above, doesn’t get a lot of press, but it rankles me the most.  I had criticized the SEC for years about the 40-day window–not because I was aware of the backdating frauds, but because I didn’t see why investors had to wait so long to receive important information about executives trading in their own shares.  Of all the wonderful things Arthur Levitt tried to accomplish as SEC chair, I don’t know why this one wasn’t on his radar screen.  After all, it was during his watch that the SEC first floated the idea of accelerating the due dates of annual reports.  (Dear Mr. Levitt, if you perchance should read this, I would consider it an honor to publish your response.) 

Based on the number of SEC investigations and the academic research that exposed this repulsive scandal, there must be hundreds of executives who betrayed the trust of their shareholders with the some criminal indifference that possessed Enron’s top guys.  Also similar to Enron, there are likely just as many dupes and facilitating lawyers, accountants, board members, etc. as there were executives who profited directly.  For those Pollyannas amongst you who thought that Sarbanes-Oxley was an overreaction to the crimes committed by a few, I hope the stock option backdating scandal has transported you closer to my world.

So, Chris, you owe me one … or maybe I owed you one.  It doesn’t matter.