November 13, 2006
Stock Option Backdating
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Jack Horgan - Contributing Editor

by Jack Horgan - Contributing Editor
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An employee stock option gives its owner the right to purchase a specified number of shares at a fixed price at some specified time in the future. Both the option holder and granter hope and expect the price of the stock will rise over time. This is seen by both sides as an incentive to attract new and retain existing employees. Often there are terms and conditions placed on the exercise of stock options. The most common is vesting. The employee is required to continue to work at the company for a specified period of time to attain full ownership of the stock option. There is usually a maximum period of time during which the options must be exercised.

Stock options have been heavily used particularly by startup high-tech firms to lure talented and experienced person from more established companies who typical offer higher wages, better benefits and more job security. Many people who joined startups in the earlier stages became wealthy through the exercise of these stock options. This even includes relative low wage earners like secretaries.

Executive compensation has also shifted from salary and cash bonuses to stock based compensation after a change in IRS rules in 1993 that limited executive wage expense to $1 million. The rational was that this shift would better align executive compensation with the interest of shareholders, i.e. higher stock price. Executives benefited because the tax rate on capital gains is typically lower than for ordinary income. Corporations benefited because generally they incurred no expense for this form of compensation. This is a classic win-win situation.

Many firms have engaged in practices that sough to maximize the value of stock options for employees, particularly C level executives, by minimizing the option grant price. The easiest method to accomplish this is to backdate the options relative to the actual date of grant to a date where the stock price was lower. A second practice called “spring loading” is to grant stock options just before the announcement of good news (record earnings, merger, acquisition, …) which presumably will boost the stock price. Similarly “bullet dodging”, the delaying of stock option grants until after the announcement of bad news, accomplishes the same thing.

These practices are not illegal if there are no forged documents and they are properly reflected in statement of earnings and in taxes. Under the old rules (APB Opinion No. 25 Accounting for Stock Issued to Employees) stock options did not have to be shown as a corporate expense if the exercise price was equal to the market price on the grant day. Officers and directors didn't have to disclose their receipt of stock option grants until after the end of the fiscal year in which the transaction took place.

How often did these practices occur? David Yermack of NYU published a study in the Journal of Finance in 1997 showing that stock prices tended to increase shortly after executives were granted options. He theorized that this was due to timing grants before predictably prices increases. Erik Lie of the University of Iowa Business School published an article in the May 2005 issue of Management Science that showed stock prices also tended to decrease before grants. His study was entitled “On the timing of CEO stock option awards” and covered a sample of nearly 6,000 CEO options grants between 1992 and 2002. Furthermore, he found that the aggregate price pattern had intensified over time. He began to suspect backdating of option grants. He 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. He concluded that “Unless corporate insiders can predict short-term movements in the stock market, my results provided further evidence in support of the backdating explanation.”

Everyone recognizes that stock options have a real value to the employee. Granted that this is true, shouldn't there be a corresponding expense to the employer in much the same way employee wages and health benefits are recognized expenses? Since no one knows at what the price the employee will ultimately sell the stock, there is the question of what this stock based compensation expense should be. The Black-Scholes option-pricing model is the most common model used. This model was developed by Fischer Black and Myron Scholes in the early 1970s. This model calculates the present value of a stock option at the grant date, based upon specific information about the terms of the option and assumptions about future stock price performance. The value of an option reflects the estimate of the price that someone would pay in the market today for the option. It is the point at which an investor would be indifferent between receiving the option or the amount of cash equal to its value. The method is considered a probability model because it assumes that the underlying stock behaves in such a way that possible future prices can be modeled by a probability distribution. Those representing the interests of high-tech startup firms argue that any method based on stock performance of publicly traded companies fails to take into account the inherent risk of startups.

After the highly visible collapses of Enron, WorldCom and Tyco International, there was considerable outrage over executive greed, lack of internal and external controls and so forth. The public demanded protection against unscrupulous executives and rubberstamp board of directors. The business community argued that this was case of a few bad apples and that the proposals being offered to combat abuses were excessive, unnecessary and terrible costly particularly for smaller firms.

Backdating of stock options was not a major factor in the most egregious corporate scandals. However, since stock options were the major form of compensation for the individuals involved, there was considerable motivation to keep the stock price high by any means. In a January 2005 editorial entitled the Future of Stock Options, I described the arguments pro and con for the expensing of stock options and the actions of the SEC and FASB in this area.

As part of the reaction to these corporate scandals the US Congress passed the Sarbanes-Oxley Act of 2002. The goals were to improve quality and transparency in financial reporting and independent audits and accounting services for public companies, to create a Public Company Accounting Oversight Board, to enhance the standard setting process for accounting practices, to strengthen the independence of firms that audit public companies, to increase corporate responsibility and the usefulness of corporate financial disclosure, to protect the objectivity and independence of securities analysts, to improve Securities and Exchange Commission resources and oversight, and for other purposes. Unfortunately the act translates into a tome of regulations and reporting requirements that many firms particularly smaller ones find onerous. There is considerable expense in developing and maintaining the systems and procedures necessary to comply with the act.

The Securities Exchange Commission (SEC) has also issued regulations. In particular beginning in August 2002 companies are required to disclose their stock-option awards in Form 4 filings within two days of options grants. In 2003, the SEC took another important step that has helped increase the transparency of public company options plans. The Commission approved changes to the listing standards of the New York Stock Exchange and the Nasdaq Stock Market that for the first time required shareholder approval of almost all equity compensation plans. Companies have to publicly disclose the material terms of their stock option plans in order to obtain shareholder approval.

In the area of stock options new regulations also prevent firms from lending money to executives to exercise their options and stock option grants must be reported within two business days.

The Financial Accounting Standard Board (FASB) has issued and revised Statement 123R, Accounting for Stock-Based Compensation. This Statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award-the requisite service period (usually the vesting period).
A nonpublic entity, likewise, will measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of those instruments, except in certain circumstances. Specifically, if it is not possible to reasonably estimate the fair value of equity share options and similar instruments because it is not practicable to estimate the expected volatility of the entity's share price, a nonpublic entity is required to measure its awards of equity share options and similar instruments based on a value calculated using the historical volatility of an appropriate industry sector index instead of the expected volatility of its share price.

A public entity will initially measure the cost of employee services received in exchange for an award of liability instruments based on its current fair value; the fair value of that award will be remeasured subsequently at each reporting date through the settlement date. Changes in fair value during the requisite service period will be recognized as compensation cost over that period. A nonpublic entity may elect to measure its liability awards at their intrinsic value through the date of settlement.

The grant-date fair value of employee share options and similar instruments will be estimated using option-pricing models adjusted for the unique characteristics of those instruments (unless observable market prices for the same or similar instruments are available). If an equity award is modified after the grant date, incremental compensation cost will be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification.
You have probably seen references to FASB 123R in quarterly financial releases. Since many firms did not previously report stock-based compensation expenses as part of GAAP (General Accepted Accounting Principles) releases, there is a likely unfavorable year-over-year comparison. However, most firms also report non-GAAP results which excluded stock-based compensation expenses among other things.

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-- Jack Horgan, Contributing Editor.


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