Stock Option Backdating
Stock option backdating is the practice of altering the date a stock option was granted to an earlier time, when the stock’s price was lower. This makes the options more valuable because they have an artificially low strike price, which increases the potential profit when the options are exercised. When done surreptitiously and not disclosed or accounted for correctly, backdating can be illegal and fraudulent.
Here’s a breakdown:
- Typical Stock Option Grant: When an employee is granted stock options, they’re typically given the right to buy the stock at its current price, known as the “strike price.” As the stock price increases over time, the options become more valuable, providing an incentive for the employee to help improve the company’s performance.
- Backdating: Instead of granting the option with a strike price set to the current date’s stock price, the grant date is set to an earlier date when the stock price was lower. This gives an immediate, and often substantial, paper gain on the options.
- Potential Illegality: If stock option backdating is not properly disclosed or accounted for, it can mislead investors and regulators about the company’s financial performance. The reason is that the compensation expense associated with the options is understated, leading to inflated earnings reports.
- High-Profile Cases: In the mid-2000s, stock option backdating came to light as a significant issue, with many companies being investigated by the Securities and Exchange Commission (SEC) and the Department of Justice for their backdating practices. Several corporate executives faced legal repercussions.
Example of Stock Option Backdating
Let’s explore a hypothetical example to illustrate the concept of stock option backdating:
Example: TechGiant Corp and CEO Mr. Smith
Background: TechGiant Corp is a tech company that has been experiencing a steady growth trajectory. Mr. Smith, the CEO, has been influential in this growth and the board wishes to reward him.
January 1, 2020: TechGiant’s stock is trading at $25 per share.
June 1, 2020 : TechGiant has released a series of successful products, and its stock price has risen to $45 per share.
The Stock Option Grant: On June 15, 2020, the board decides to grant Mr. Smith 100,000 stock options as a part of his compensation package. However, instead of setting the strike price at $45 (the current market price), the board backdates the grant to January 1, 2020, when the stock was trading at $25. This gives Mr. Smith the right to buy shares at the much lower $25 price.
Scenario Without Backdating: Had the stock options been dated properly on June 15, Mr. Smith’s potential profit per share, assuming he exercises the option when the stock price is at $60, would be:
Profit = $60 (future stock price) – $45 (strike price) = $15 per share
Scenario With Backdating : With the backdated options, Mr. Smith’s potential profit, if he exercises the option at the same $60 stock price, would be:
Profit = $60 (future stock price) – $25 (backdated strike price) = $35 per share
Repercussions: When the backdating is discovered by a vigilant auditor, it creates a scandal. Shareholders are furious because they were misled about the company’s compensation expenses, which were understated. The company’s financial statements for the period would need to be restated to reflect the higher compensation cost, which could lower reported profits.
Furthermore, the Securities and Exchange Commission (SEC) launches an investigation. Mr. Smith and the board members face legal consequences, including fines and potential jail time. The company’s reputation suffers, and the stock price might decline as a result of the scandal and the loss of trust from investors.
This example underscores the importance of transparency, proper governance, and adherence to legal and accounting standards in corporate practices.
