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Option backdating and its implications define

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Backdating is the practice of marking a document with a date that precedes the actual date. What is the benefit of backdating ESO grants? ESOs are usually granted at-the-money, i.

What it is:

Because the option value is higher if the exercise price is lower, executives prefer to be granted options when the stock price is at its lowest. Backdating allows executives to choose a past date when the market price was particularly low, thereby inflating the value of the options. An example illustrates the potential benefit of backdating to the recipient. In comparison, had the options been granted at the year-end price when the decision to grant to options actually might have been made, the year-end intrinsic value would have been zero.

Is backdating of ESO grants illegal? Backdating of ESO grants is not necessarily illegal if the Option backdating and its implications define conditions hold: No documents have been forged. Backdating is clearly communicated to the company's shareholders. After all, it is the shareholders who effectively pay the inflated compensation that typically results from backdating ESOs. Backdating does not violate shareholder-approved option plans.

Backdating is properly reflected in earnings.

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 untilfirms did not have to expense options at all unless they were in-the-money. However, under the new FAS R, the expense is based on the fair market value on the grant date, such that even at-the-money options have to be expensed.

"Option backdating and its implications define" backdating is typically not reflected properly in earnings, some companies that have recently admitted to backdating of options have restated earnings for past years.

Backdating is properly reflected Option backdating and its implications define taxes. The exercise price affects the basis that is used for estimating both the company's compensation expense for tax purposes and any capital gain for the option recipient. Thus, an artificially low exercise price might alter the tax payments for both the company and the option recipient. However, if the options were effectively in-the-money on the decision date, they might not qualify for such tax deductions.

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.

How do we know that backdating takes place in practice? In particular, he found that stock prices tend to increase shortly after the grants. He attributed most of this pattern to grant timing, whereby executives would be granted options before predicted price increases. This pioneering study was published in the Journal of Finance inand is definitely worth reading. In a study that I started in and disseminated in the first half of and that was published in Management Science in May available at http: Furthermore, the pre-and post-grant price pattern has intensified over time see graph below.

By the end of the s, 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. This made me think about the possibility that some of the grants had been backdated. I further found that the overall stock market performed worse than what is normal immediately before the grants and better than what is normal immediately after the grants.

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

In a second study forthcoming in the Journal of Financial Economics available at http: The graph below shows the dramatic effect of this new requirement on the lag between the grant and filing dates. To the extent that Option backdating and its implications define comply with this new regulation, backdating should be greatly curbed. Thus, if backdating explains the stock price pattern around option grants, the price pattern should diminish following the new regulation.

Indeed, we found that the stock price pattern is much weaker since the new reporting regulation took effect.

This Article begins by examining...

Any remaining pattern is concentrated on the couple of days between the Option backdating and its implications define grant date and the filing date when backdating still might workand for longer periods for the minority of grants that violate the two-day reporting requirements. We interpret these findings as strong evidence that backdating explains most of the price pattern around ESO grants.

There is also some relatively early anecdotal evidence of backdating. A particularly interesting example is that of Micrel Inc.

For several years, Micrel allowed its employees to choose the lowest price for the stock within 30 days of receiving the options.

What is the benefit of...

Remy Welling, a senior auditor at the IRS, was asked to sign the deal in late Instead, she decided to risk criminal prosecution by blowing the whistle.

A NY Times article describes this case in greater detail the article is available hereand so does a article in Tax Notes Magazine available here. In a CNBC interview, Remy Welling said that "this particular -- well, it's called a "Option backdating and its implications define" look-back plan, is even widespread in Silicon Valley and maybe throughout the country.

What about spring loading and bullet dodging? The terms "spring loading" and "bullet dodging" refer to the practices of timing option Option backdating and its implications define to take place before expected good news or after expected bad news, respectively. This is what Professor Yermack hypothesized in his article discussed above, though he never used these terms. Option backdating and its implications define collective evidence suggests that these practices play a minor role in explaining the aggregate stock returns around grants.

For example, if spring-loading and bullet dodging played a major role, we should observe pronounced price decreases before grants and increases after grants irrespective of whether they are filed on time, but we don't. Thus, it appears that either a spring loading and bullet dodging are not widespread or b these practices typically fail to lock in substantial gains for the option recipients.

A couple of related notes: Positive news announcements after grants is consistent with both spring-loading and backdating. Thus, such news announcements do not necessarily imply spring-loading. However, this term has been used imprecisely in the media.

For example, Microsoft's practice before of using the lowest market price during the 30 days after July 1 which was when the grant was issued as the exercise price has been referred to as forward dating. However, this is just a variation of backdating, because the exercise price cannot be set until the 30 days have passed, at which point one can look back to see what the lowest price was.

What happens to companies that are caught backdating? An internal investigation uncovered 49 cases in which the reported date of a Mercury stock-option grant differed from the date on which the option appears to have been actually granted. Because the company was unable to restate the earning to account for the option backdating in a timely manner and delayed other filings of earnings with the SEC, its shares were delisted in the beginning of In a follow-up story, I supplied the WSJ with data that allowed it to identify six companies as possible backdaters available here.

The publication of this article on March 18, triggered several events among the identified companies: In addition, federal prosecutors have begun a criminal investigation of stock-option-granting practices, and a class action lawsuit has commenced in the United States District Court for the Southern District of New York on behalf of Comverse stockholders.

A shareholder suit supported by the Minnesota attorney general alleges that shareholders were harmed by backdated option grants. Tomasetta and two other top executives on administrative leave and might restate three years of financial results. A WSJ article published on May 5, available here summarized some of these events and discussed some of the effects on shareholders' value.

The reduced market capitalization presumably reflects direct effects such as those listed above and indirect effects such as disruption in operations and consequences of a tarnished reputation. How many ESO grants have been backdated? This fraction was roughly halved as a result of the new two-day reporting requirement that took effect in August However, among the minority of grants that are filed late i.

While a non-trivial fraction of the grants that are filed on time are also backdated, the benefit of backdating is greatly reduced in such cases.

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