Stock Options Backdating
SFMS is investigating a number of companies for activities relating to the backdating of executive stock options.
What are Stock Options? Stock options have long been used as incentives to attract and retain high quality employees. Companies give employees the right to buy a set number of shares of the company at a fixed price, called the “exercise price,” after a certain period of time. The exercise price is set on the “grant date,” and is generally the price at which the stock trades when the options are granted.
For example, the executive is given stock at an exercise price of $100 on January 1, 2000, when the company’s stock price on the grant date is $100 per share. In other words, the executive has the right, but not the obligation, to purchase that share for $100. If, on January 1, 2005, the stock is trading at $150, the executive could “exercise” the stock option by buying the share for $100 and selling it for $150, a gain of $50.
What is Back Dating of Stock Options? When the grant date of the option is changed, problems can arise. At worst, the practice is called backdating because an executive may move the date of the grant of a stock option back in time, because the stock price has increased. Doing that lowers the exercise price of the options so executives can make more money.
In our example, if the executive exercised his options at the exercise price of $100 when the stock is trading at $150, he will earn $50 per share. However, if the grant date of the option is backdated to a time when the stock price was $75 per share, then the executive will earn $75 per share when the stock is trading at $150.
What is Wrong with Backdating Stock Options? The proper use of stock options will align the interests of employees with shareholders. That is because the executives will work to improve a company’s performance in a manner that also benefits shareholders. If the stock price rises, the executive benefits, but if the price falls, the executive loses the ability to gain from the stock’s increase in value. Options backdating to a time when the stock price was lower eliminates this risk to the executive, and is problematic because it is based upon information that was not publicly known at the time of the exercise of the option. In other words, it is like playing the lottery numbers after the drawing has already occurred. Other companies purposely adopted policies that priced options at a future low point in the stock, awarded grants just before good news hit, or held off on grants until after releasing bad news so employees would get lower-priced options. All of these practices harm shareholders who do not have the benefit of the information when the stock is bought or sold. In essence, backdating is stealing from the company.
Often, companies did not follow disclosed policies or properly account for options. In a number of the cases we are investigating, the exercise price of the option was less than the closing stock price as of the date of the grant. Accounting rules require companies to record this executive compensation expense if the exercise price is less than the closing stock price on the date of the grant. If companies properly recorded this expense, then the value of the company would have been less than it was, and public shareholders would have paid less for the stock.
Companies that have engaged in options backdating have schemed to give executives windfall profits and may have to restate their historical financial statements to record additional compensation expense, all to the detriment of the company and its shareholders
To see all the cases we are currently tracking: Stock Option Backdating Case List.
FOR MORE INFORMATION, PLEASE CONTACT:
Natalie Finkelman Bennett
Patrick A. Klingman
James E. Miller
Karen M. Leser
Laurie Rubinow
Scott R. Shepherd
Nathan Zipperian
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