The CEO Cash Time Machine - - Back Dating Options – a Form of Time Travel?

Stock options are generally granted to executives as an incentive – often at the fair market value of the stock price on the date of grant. Or, at a discount so that the executive “earns” the incentive as share prices increase (for shareowners). Options are supposed to effectively link executive compensation to shareholder returns – they allow executives to earn compensation equal to the difference between the stock price at the date of the grant (the “strike price”) and the stock price on the date the option is exercised.  Boards approve stock option plans.

This arrangement is an incentive for the executive to work to grow (increase) the company’s stock price – the market cap, the total valuation.  If there is no increase in stock price -- there is no gain for the executive. At the time of the grant, the option usually has no real money value.

Some executives and boards have permitted stock option backdating – a practice which establishes the stock option grant reflecting a date in the past when the stock price was lower than the real date of the grant or when more favorable conditions existed for the cashing in of options held. This deliberate falsification allows the executive recipient to take advantage of a more opportune date with a low stock price, which will eventually equal greater income when the option is exercised. 

Stock option grants that have intentionally been altered or misrepresented may be an act of fraud and criminally punishable. Aside from the tax and accounting consequences to the company, the potential penalties for those individuals involved in this scandal can range from criminal charges - - to shareholder lawsuits -- to SEC sanctions and -- to termination of employment.  The executive in question, the company’s CFO other executive suite members and/or governing board members could all face some or all of these consequences.

Also, it should be expected that shareholders will attempt to recover all compensation earned by executives through backdated options, likely including all compensation earned on the option grant.

This practice—perhaps more widely practiced than first thought was first uncovered by several academics and then reported in The Wall Street Journal several years ago.  The initial and follow up stories and subsequent investigations by the SEC have led to limited punitive and criminal actions – so far.   It is estimated that more than 100 companies are under investigation by SEC and that as many as 600 companies with aggressive accounting practices may have been involved in backdating.  This really is waiting for more shoes to drop. With more companies going under the microscope regarding this practice ---  the editors of AC have branded it a hot corporate topic for 2008!

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