Backdating Employee Stock Options: Such circumstantial evidence suggested that companies withhold good news or publish bad news prior to long-term employee stock option awards to reduce stock prices. In solving this financial puzzle, Lie touched off a firestorm with immediate and far-reaching public-policy implications.
In one of the first cases involving stock option grant manipulation, the U. Although researchers may have been puzzled by this phenomenon, jurists are not. The article concludes by presenting the potential financial implications of backdating for investors. Brocade Communications Systems, Inc. Because of accounting treatment differences between in-the-money and at-the-money option grants, backdating resulted in materially understated employee compensation expenses and overstated operating income and company performance.
Brocade executives were charged with concealing millions of dollars in employee compensation expense from investors. The criminal complaint also charged Reyes and Jensen with securities fraud. These include violations tied to books and records, internal controls, misrepresentations to auditors, and SOX certification provisions.
The IRS filed charges of aiding and abetting personal income tax evasion related to stock options from to On September 7, , U. Especially troubling for regulators, auditors, and investors were the criminal and civil complaints alleging that Brocade executives repeatedly postdated employment offer letters and falsified compensation committee minutes to conceal the in-the-money grants. While no laws or regulations prohibit the grant of properly authorized in-the-money employee stock options, these grants must be accurately recorded for financial reporting and tax purposes.
Employee Stock Option Accounting Financial accounting and reporting standards clearly define the appropriate accounting treatment when employees receive stock-based compensation. Examples of stock-based employee compensation plans include stock purchase plans, stock options, restricted stock, and stock appreciation rights. Since , accounting principles for awards of stock-based compensation to employees have required a fair-value method of accounting for employee stock options under SFAS R.
Under the fair-value method, compensation cost is measured at the grant date based on award value and is recognized over the service period, which is usually the vesting period. Most options-backdating problems, however, occurred before , when companies were encouraged, but not required, to record employee option grants as compensation expenses. Thus, compensation expense corresponds to the total dollar amount by which employee stock options are in-the-money at the time of the stock price measurement date.
Because at-the-money stock options have no intrinsic value when measurement and grant dates are identical, there is no employee compensation cost to be recognized under APB Opinion Furthermore, APB Opinion 25 requires compensation-cost recognition for other stock-based compensation plans, such as those with variable exercise prices or those that allow changes in the number of options granted. He states that, under paragraph 10 b of APB Opinion 25, the measurement date for determining the compensation cost of a stock option is the first date on which both of the following are known: The number of options that an individual is entitled to receive; and The option strike price or stock purchase price.
Even if documents related to an employee-option award are dated earlier, the measurement date cannot occur until the terms of the award and its recipients are fully determined.
In most instances, determining the measurement date is not difficult because corporate governance provisions, stock option plans, and applicable laws specify the required granting actions that would confirm the stock option grant and establish the measurement date.
Some backdating companies used incorrect stock-option measurement dates because all required granting actions were not complete. In some cases, companies awarded stock options after obtaining oral authorization from their board of directors or compensation committee, and finalized documents later.
Other backdating companies delegated options-awarding authority to a manager who obtained appropriate approvals later. To be valid, the delegation of option-granting authority to managers requires specific mention in the option plan approved by the shareholders. Otherwise, the required granting actions would not be met and the measurement date would not be established until all documents were finalized.
Under accounting guidelines, stock option terms are considered unknown and subject to change until those empowered to make grants have determined, with finality, the terms and recipients of those awards.
If, however, facts, circumstances, and patterns of conduct suggest that the terms and recipients of a stock option award were known with finality before the completion of all required granting actions, it may be appropriate to conclude that a measurement date occurred before the completion of these actions.
In summary, the facts, circumstances, and pattern of conduct must make it clear that the company considered the terms and recipients of the awards to be fixed and unchangeable on that earlier date.
SOX—Related Problems Caused by Backdating Backdating occurs when an employee stock-option grant reflects a grant measurement date earlier than the true grant measurement date. Such misrepresentation allows the option recipient to take advantage of a lower stock price, which translates into greater profit when the option is exercised. While accounting rules allow companies wide discretion in the granting of in-the-money, at-the-money, or out-of-the-money employee stock options, backdating practices frequently conflict with employee stock-option grant procedures.
Specifically, many shareholder-approved option plans permit only at-the-money grants. Therefore, the compensation committee typically lacks the authority to properly authorize an in-the-money grant.
In such cases, backdating can invalidate an option award. From an accounting perspective, backdating practices that involve the concealed award of in-the-money stock options result in misleading financial statements because employee-compensation expenses are hidden. If the amount is material, accounting principles require that any in-the-money stock options granted to employees be recorded as an employee-compensation expense. Failure to do so results in an understatement of compensation expenses and an overstatement of net income.
SOX addresses financial accounting problems and reporting issues exposed by corporate scandals such as Enron and WorldCom. Penalties under SOX sections , , , , and are intended to deter corporate fraud. They have reviewed the report. Based on their knowledge, the report is truthful and does not omit material information. Based on their knowledge, the financial statements fairly present, in all material respects, the financial position, results of operations, and cash flows.
All material weaknesses in internal controls have been disclosed to the audit committee and the independent auditors. All known instances of fraud, material or not, that involve internal controls personnel have also been disclosed. Significant changes to internal controls subsequent to the most recent evaluation have been disclosed, including any corrective action.
The CEO and the CFO are responsible for disclosure controls and procedures, and have reviewed those procedures within the 90 days preceding the report filing date. These certifications were required as early as , prior to the change in option accounting rules. Any executive intentionally violating the certification process is subject to severe criminal penalties. Moreover, under section , if a company must restate its financial reports due to material noncompliance with financial reporting requirements, the CEO and the CFO must personally reimburse the company for any bonus or incentive-based or equity-based compensation received 12 months following issuance of the financial statements.
The CEO and the CFO must also disgorge any profits realized from selling company securities during that month period. Sections and create severe penalties for those who disrupt any official investigation of potential SOX violations. Prior to the passage of SOX in July , white-collar criminals seldom received stiff jail sentences. Under SOX, executives involved with options-backdating are personally liable for certification of false corporate financial statements.
Exposure for Investors Investors should expect backdating problems to be expensive for affected companies. As noted above, penalties may be imposed under SOX section for false certifications. Investors should also expect higher fees for accounting and legal work related to correcting accounting mistakes and restating financial statements.
Companies involved in options-backdating scandals may be subject to class-action lawsuits alleging that financial statements were materially misstated in violation of federal securities laws.
Indirect costs from correcting accounting problems and financial restatements will also be significant. Recent studies find a negative stock-price reaction and an increased cost of capital for companies disclosing poor controls over financial reporting.
Such companies are also more likely to experience costly auditor resignations. Therefore, resolving accounting and legal problems tied to options backdating promises to be a costly drain on management and corporate resources.
When options backdating involves obvious self-dealing and malicious obstruction of justice by top management, the CEO, CFO, and others may be replaced. Anticipating stock-price reactions to forced CEO departures stemming from an options-backdating scandal is made difficult by the fact that forced CEO departures are relatively rare.
Most CEO successions are customary retirements that cause no significant stockholder reaction. Because severe options-backdating problems can be expected to result in SOX violations, forced departures of CEOs are apt to result in similarly forced departures of CFOs and other members of top management.
It seems likely that forced departures of CEOs and other top executives may result in a new CEO from outside the company, and the appointment of outside CEOs is far from customary. Huson, Parrino, and Starks found that Because options-backdating problems are most obvious when companies have experienced robust increases in stock price, investors may view forced CEO departures as both surprising and negative.
CEO departures that occur following good company performance tend to have modestly negative stock market repercussions, as do unplanned CEO departures due to death or disability. In short, immediate negative returns are apt to reflect a one-time deadweight loss from accounting fees, legal expenses, and potential civil sanctions. There appears to be little reason for shareholders to fear long-term damage. The Fallout of Backdating At this point, the full scale and ultimate ramifications of the developing option backdating scandal are not yet known.
Although external auditors are not yet the clear focus of popular outrage, the fallout from the backdating scandal will likely affect them as well. By definition, most backdating activities have included creating fraudulent documentation designed specifically to deceive external parties. While frauds involving high-level collusion are notoriously difficult for auditors to discover, the public maintains an expectation that auditors are at least somewhat responsible for identifying such illicit activities.
The outrage over backdating will likely influence future regulatory policies as well. According to the SEC, the purpose of the change is to avoid exaggerating compensation and to more closely track the compensation expense mandated under SFAS R. Absent backdating, such a modification would likely have been unremarkable.
In the current environment, however, the change has outraged both commentators and legislators, who perceive it to be a relaxation of disclosure rules at a time when corporate officers appear to need more, not less, oversight.
There is also speculation that attempts to relax some of the more onerous provisions of SOX will be slowed by these backdating activities. A key argument of those who propose rolling back SOX is that only a few companies and bad actors were responsible for the earlier wave of accounting scandals. Backdating activity, however, appears to be widespread, and criticism can be expected to grow as investigations continue.
It is ironic that all this havoc was created trying to conceal what can be a perfectly legal method of compensation.
Had the companies in question appropriately acknowledged the grants of in-the-money options and recorded the noncash expense, there would be no scandal. Indeed, the coverup is often worse than the crime. Hanson and James K.