Options Backdating
Corporate Governance Remains a Challenge

By By Marc A. Siegel

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OCTOBER 2007 - Just when it seemed safe to close the book on the scandals of the pre–Sarbanes-Oxley, pre–Internet bubble era, the stock options backdating fiasco that came to light in 2006 is a reminder that the history of the period is still being written.

While the legality of stock options backdating will ultimately be decided case by case in the courts, dozens of companies are currently under investigation. Internal investigations may be initiated by a company’s board of a directors through a special committee. Other investigations are externally provoked, the result of an SEC notice or a U.S. Department of Justice (DOJ) subpoena. Accountants, auditors, investors, and analysts alike should understand the history of backdating, the risks companies under investigation face, how to search for indicators of backdating, and how these scandals might ultimately affect businesses and shareholders.

What Is Options Backdating?

Options backdating is the practice of using hindsight to choose a beneficial calendar date in the past for purposes of granting a stock option to an employee, officer, or director of a company. Any option granted using a date at a low point in a company’s stock price would immediately be “in the money,” because the strike price of an option is almost always set to be equal to the market value of the stock on the grant date. The benefit of the resulting jump in stock price would go to the holder of the option. See Exhibit 1 for an example of an options grant that may have been well timed or may have been backdated to maximize the benefit to the option holder.

Prior to the passage of the Sarbanes-Oxley Act (SOX) in July 2002, the regulations surrounding the disclosure of option grants in financial and proxy statements and the requirements for filing notice of option grants to the SEC were fairly loose. While SOX now requires a company to file a Form 4 with the SEC within two days of an option grant to key employees, before SOX it might have been months before notice of an option grant was filed with the SEC. Along with this more lax disclosure requirement, companies may also have not had robust enough internal controls to catch those backdating without proper authority. Consider the pressure facing a large number of technology start-up companies that were competing intensely for talent and lacking the ability to compensate employees with cash. In addition, the accounting treatment for stock options under Accounting Principles Board Opinion 25 allowed most companies to avoid recording any compensation expense for commonly used stock option plans. These factors created the opportunity and incentive to provide potential hires and current employees with very generous options packages as part of their overall compensation scheme.

How Widespread Was Backdating?

Academics have performed research estimating that as many as 29% of options were backdated in the years leading up to Sarbanes-Oxley. A study by Erik Lie of the University of Iowa and Randall Heron at Indiana University (see “Does Backdating Explain the Stock Price Pattern Around Executive Stock Option Grants?,” Journal of Financial Economics, February 2007) formed the basis of a Pulitzer Prize–winning series of investigative articles by the Wall Street Journal in 2006.

The Center for Financial Research and Analysis (CFRA) performed a survey of the 100 companies with the greatest (as a percentage of revenues) pro forma options compensation in the pre-SOX period. Of those 100 companies, 17 had, on three or more occasions, option grant dates that were at or near 40-day stock price lows which were immediately followed by a significant stock increase. These option grant dates warrant attention and review to determine if options backdating occurred. Those companies in the technology and biotechnology sectors may have used options more frequently and might be at higher risk than those in other sectors.

Risks of Backdating

SEC/DOJ risk. As of this writing, approximately 100 companies are conducting either internal or external (or both) investigations into their option-granting practices. These investigations not only take a significant amount of time, because they are document-intensive, but they can also be quite costly. Some companies have as many as four separate ongoing investigations: one each by the SEC and DOJ, and one each undertaken by management and the board of directors. Internal investigations are generally separated because management might find itself at odds with the board.

One notable company ensnared in options-backdating scandals, Mercury Interactive, reported that its investigations cost the company more than $70 million. The cash cost of this could be exacerbated by the intangible costs, such as management distraction, as well as other unrelated items that could be found by the SEC during its work.

Earnings restatement risk. Companies that are found to be backdating options will likely have to restate their financial results for prior periods. This is because such companies probably would not have recorded any compensation costs on the income statement for the options in question, as their policy would most likely be to set the intrinsic value of the option to zero, with the strike price of the option equal to the market value of the stock on the grant date. If the date was reported improperly, however, the company must recalculate the intrinsic value of the option as of the “real” grant date and reflect that value over the vesting period of the options, as they were earned. Regardless of the size of these restatements, most companies will dismiss them in public communications as “noncash.” Nevertheless, it is important to understand this within the context of the reported earnings and the balance sheet during the time period in question. Some companies, for example, could jeopardize debt covenants through changes in book value.

Tax position risk. While an earnings restatement is decidedly a noncash issue, options backdating could result in large cash outflows. This is due to the fact that many companies usually took deductions for option exercises on their tax returns. Under IRC section 162(m), compensation expense is generally not deductible to the extent it exceeds $1 million per year. An exception is made for incentive stock options that are “performance-based.” The rationale is that because incentive options are usually granted “at the money” (i.e., the stock price fixed on the grant date), they have value only if the business improves and the stock price goes up. A backdated option, however, is effectively non–performance-based because it is “in the money” right from the start.

United Health (UNH), for example, has estimated that the likely amount of cash that will have to be paid to the IRS in connection with backdated options granted to management is approximately $200 million. While this is certainly a lot of money, for a company with $60 billion in market capitalization it need not have a big impact on the company’s future prospects.

Management credibility risk. This is arguably the most important risk. Should investors lose faith in the credibility of the management team, backdating that may have taken place seven to 10 years ago could make an investor today skeptical about the ongoing prospects of the company. In some cases, the board of directors has responded to backdating scandals by dismissing the individuals allegedly involved. Executives at Mercury Interactive, Comverse Technologies, Brocade Communications, Vitesse Semiconductors, and others have been

Arbitrage risk. Certain companies have come under attack by opportunistic hedge funds as an indirect result of the options-backdating scandal. The hedge fund’s strategy is to buy the corporate bonds of a company embroiled in backdating investigations. Most companies in the middle of an investigation delay the filing of their regulatory statements until the investigation is complete. This resulted in the delisting of several companies from Nasdaq and other exchanges. The late filings and the delistings also often trigger violations of debt covenants, allowing the hedge funds to call the debt. A hedge fund that has bought up a company’s bonds can insist upon payment of large sums of money at a premium after only a short investment timeframe.

How Can the Risk of Backdating Be Assessed?

Users of financial statements can attempt to ascertain whether there is an element of options-backdating risk by a thorough review of filings. The steps include analyzing the proxy statements for the years leading up to Sarbanes-Oxley and noting each and every option grant. Most often, the actual grant date is not disclosed in the proxy statement; only the expiration date of the option is noted. As a result, the grant date must be inferred. For example, an option grant made during the 2000 calendar year with an expiration date of May 6, 2010, would likely have a grant measurement date of May 6, 2000. To discover if that indeed was the date of record, one must compare the historical market price on that date with the strike price of the option. While this confirms the grant date in most circumstances, there are other times when the record date was a different day, perhaps the prior day.

Once the grant date is inferred, the stock price chart surrounding that date should be reviewed. The grants that warrant further attention include those where there is a pronounced V-shaped pattern (see Exhibit 1) with the grant date at the bottom of the “V.” See Exhibit 2 for further discussion of factors that can be assessed to judge the risk of options backdating at a specific company.

What Happens Now?

The SEC has been very aggressive in its pursuit of identifying and investigating companies that may have practiced options backdating. One should not expect this to end soon. SEC Chairman Christopher Cox has called backdating “poisonous.” Cox has also publicly indicated that one primary focus of his tenure at the SEC will be to improve transparency and regulation surrounding executive compensation. Options backdating provides Cox with a means to display his conviction.

While the practice of backdating prior to SOX was, in this author’s opinion, reprehensible, investors have to decide whether a company’s backdating activities in the past change the prospects for a company in the future. The case of Mercury Interactive is an interesting example of how options-backdating scandals can play out. Since Mercury came under scrutiny almost two years ago, it has conducted investigations, terminated executives, and was even delisted from Nasdaq for not filing SEC documents. The company’s stock price was depressed throughout this time. Mercury’s underlying business, however, had value. Hewlett-Packard recently purchased the company because of its relatively cheap valuation. If there is an underlying value to the business, investors might decide that the immediate sale of a stock that has come under backdating scrutiny is not warranted.

Perhaps more than anything else, however, the options-backdating scandal should remind investors, auditors, and analysts about the need to remain vigilant of the means by which the combination of poor corporate governance, lax regulatory oversight, and the lack of controls can result in financial shenanigans.

Marc A. Siegel, CPA, is the global head of accounting and legal research for Risk Metrics Group.




















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