Back Dating Options

During the booming stock market of the 1990s, share options were a favorite method of paying top corporate executives.  Shareholders thought they were tying executive incentives to increases in shareholder wealth.  Executives were reaping huge gains, dwarfing their cash salary, from cashing in their options.

The game was rigged.

An executive compensatory option is a right to buy a granting company’s stock in the future, usually a year or two hence, at todays market price.  If the company’s stock price increases when the option is exercised, an executive buys company stock at a price discount.  The discount can be converted into cash by selling the stock.

A 1997 study by David Yermack, an economist at New York University, found that stock options were handed out to executives just before a jump in the share price of their companies.  He marveled at executive’s perspicuity.  Another economist, Erik Lie of the University of Iowa, found that not only did stock price of a company rise immediately after the grant of executive options but that it also usually had fallen immediately before the grants.

The lid blew off the racket with a change in the disclosure requirements contained in the Sarbanes-Oxley Act of 2002.  Before the effective date of the act, August 29, 2002, companies had up to thirteen months to disclose option grants to executives.  After the effective date, companies had two days business days.  A study by Lie and Randall A Heron of Indiana University, found that eighty percent of the mysterious performance of the stock prices around option grants disappeared.

The study confirmed what many had suspected.  Companies were backdating options.  The companies would look at stock prices over the past year, find the date on which the stock had dipped to its lowest point, and declare that they had granted options to executives on that date. 

The options had immediate positive value, equal to the difference between the declare grant date and the later actual grant date.  In the vernacular of financial traders, the options were “in the money” at the time of the grant.  The exercise price exceeded the market price of the underlying stock.

Over twenty companies have formally fessed up, the latest is Microsoft, and another sixty or so have ruddy complexions.  The irony of the entire affair is that the practice of granting “in the money” options as compensation is itself legal.  What is illegal is the cover-up.

A company that grants “in the money” options as compensation had to disclose the practice in SEC filings and in their financial reports as an expense.  By back-dating the options the company could avoid disclosing to their shareholders the full amount it was paying its executives.  Moreover, the company that grants such options and the executives that receives them must pay more in taxes.  So the back-dating scam is, in reality, a tax scam and a compensation cover-up.

Companies that back-dated compensatory options submitted to the dual temptations of cheating their taxes and lying to their shareholders.  It is a sorry, sorry spectacle.  Executives, making multiple millions in compensation, strove to pick up the last nickel by stepping over the line of legality.  And they were aided by accountants and lawyers who were necessarily involved, creating the documents that sanitized the required reports of the practice. 

The back-dating practice is all but gone, done in by the new disclosure requirements in the Sarbanes-Oxley legislation.  But the stench of the practice will remain for some time.