Employee Stock Options: Accounting and Legal Implications
Raquel Meyer Alexander, Mark Hirschey, and Susan Scholz
- Until recently, financial research has been puzzled by an unusual
pattern of stock returns during the period surrounding stock option
grant dates for CEOs and other top executives. David Yermack (“Good
Timing: CEO Stock Option Awards and Company News Announcements,”
Journal of Finance, vol. 52, no. 2, June 1997) and Keith
W. Chauvin and Catherine Shenoy (“Stock Price Decreases Prior
To Executive Stock Option Grants,” Journal of Corporate
Finance, vol. 7, no. 1, March 2001) first documented that stock
prices tend to fall in the period before, and rise in the period
following, employee stock option grant dates. 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. Erik Lie (“On the Timing of CEO Stock Option
Awards,” Management Science, vol. 51, no. 5, May
2005) dug deeper into this phenomenon, documenting an unusual pattern
of negative returns prior to option-award grant dates that reversed
in the post–grant date period. Lie concluded: “Unless
executives have an informational advantage that allows them to develop
superior forecasts regarding the future market movements that drive
these predicted returns, the results suggest that the official grant
date must have been set retroactively” (emphasis
added). In solving this financial puzzle, Lie touched off a firestorm
with immediate and far-reaching public-policy implications.
Attorney’s Office, the SEC, the FBI, and the IRS are conducting
investigations into stock option grant manipulations. In one of
the first cases involving stock option grant manipulation, the
U.S. Attorney’s Office, the SEC, and the FBI filed criminal
and civil securities fraud charges against former Brocade Communications
executives on July 20, 2006.
researchers may have been puzzled by this phenomenon, jurists
are not. On August 7, 2007, former Brocade CEO Gregory Reyes was
convicted of 10 counts of conspiracy and securities fraud. Reyes,
once listed on the Forbes 400 list, now faces 20 years
in prison and a $5 million fine. Because prosecutors view Brocade
as a litmus test for future backdating litigation, this article
begins by examining the Brocade case’s legal complexities
and the severe consequences of backdating stock options.
discuss the accounting treatment of stock options under Accounting
Principles Board (APB) Opinion 25, “Accounting for Stock
Issued to Employees,” and SFAS 123(R), Share-Based Payment.
Next, the authors examine Sarbanes-Oxley Act (SOX)–related
problems that arise from backdated stock options. The article
concludes by presenting the potential financial implications of
backdating for investors.
Study: Brocade Communications Systems, Inc.
Attorney’s Office, the SEC, and the FBI concluded 18-month
investigations of Brocade Communications Systems, Inc., by filing
charges against former CEO Gregory Reyes, former human resources
vice president Stephanie Jensen, and former CFO Antonio Canova
on July 20, 2006. The charges alleged that Reyes and Jensen regularly
caused Brocade to grant “in-the-money” options to
both new and current employees between 2000 and 2004, but backdated
documents so that it appeared the options were “at-the-money”
when granted. 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 SEC filed a civil complaint against
Canova, alleging that he had received written notification of
option-paperwork forgery but took no action, failed to advise
Brocade’s auditors and audit committee, and signed false
and misleading financial statements and SEC filings. On August
12, 2006, Reyes and Jensen were indicted on eight charges of conspiracy,
securities fraud, mail fraud, and false entries in the company’s
books. In addition, Reyes was indicted on four counts of making
false statements to the company’s accountants.
complaint also charged Reyes and Jensen with securities fraud.
The SEC’s civil complaint, filed in federal court, charged
Reyes, Canova, and Jensen with fraud and other violations of federal
securities laws. These include violations tied to books and records,
internal controls, misrepresentations to auditors, and SOX certification
provisions. The maximum statutory penalty for securities fraud
in this matter is 20 years in prison and a fine of $5 million,
The Brocade executives’ troubles extended to taxes. The
IRS filed charges of aiding and abetting personal income tax evasion
related to stock options from 1999 to 2004. On September 7, 2006,
Kevin V. Ryan announced that the IRS’s criminal investigation
unit would join the local stock options–backdating task
force. It is likely the IRS is also interested in Brocade’s
corporate tax return and the personal tax returns of other top
executives. Publicly traded companies are limited to $1 million
in tax-deductible executive compensation for each of the five
highest-paid officers. While at-the-money options are excluded
from the cap, in-the-money stock options generally count toward
the $1 million limit. By concealing its granting of in-the-money
stock options, Brocade may have deducted excess executive compensation
expense on its corporate tax return, and underreported the affected
employees’ wages for personal income tax purposes.
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. Brocade’s
option-backdating scheme led to two separate restatements totaling
$351 million for financial statements spanning 1999 through 2004.
Aided by overstated performance, Brocade’s stock price soared
from May 1999’s split-adjusted price of $8.06 to $133.72
in October 2000, a stunning 1,659% rise. After Brocade’s
restatement, the stock price fell to $3.34 in November 2005, a
breathtaking 97.5% collapse.
Stock Option Accounting
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 2005, accounting principles for awards of stock-based
compensation to employees have required a fair-value method of
accounting for employee stock options under SFAS 123(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 2005, when companies were encouraged,
but not required, to record employee option grants as compensation
123, companies had discretion to use the intrinsic-value method
of accounting prescribed by APB Opinion 25. Under the intrinsic-value
method, compensation cost is any excess of the quoted market stock
price at measurement date over the employee’s purchase price.
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 25. 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.
concept of a “measurement date” for stock-option grants
under APB Opinion 25 is discussed in a September 19, 2006, letter
to the AICPA and Financial Executives International (FEI) from
then–SEC Chief Accountant Donald T. Nicolaisen. 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
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. Nicolaisen’s
opinion was that employee stock-option award measurement dates
should be delayed until all required granting procedures have
been completed. 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.
Problems Caused by 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. Therefore, option-backdating
practices present significant problems for corporate CEOs, CFOs,
and their auditors under SOX.
financial accounting problems and reporting issues exposed by
corporate scandals such as Enron and WorldCom. Penalties under
SOX sections 302, 304, 802, 906, and 1102 are intended to deter
corporate fraud. Sections 302 and 906 require corporate CEOs and
CFOs to certify quarterly and annual reports filed with the SEC.
With their certification, the CEO and the CFO attest to the following:
have reviewed the report.
on their knowledge, the report is truthful and does not omit
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.
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.
were required as early as 2003, prior to the change in option
accounting rules. Any executive intentionally violating the certification
process is subject to severe criminal penalties. Moreover, under
section 304, 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 12-month period. Sections 802 and
1102 create severe penalties for those who disrupt any official
investigation of potential SOX violations.
the passage of SOX in July 2002, 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. As noted previously,
former Brocade CEO Gregory Reyes was convicted of conspiracy and
securities fraud on August 7, 2007.
should expect backdating problems to be expensive for affected
companies. As noted above, penalties may be imposed under SOX
section 302 for false certifications. Investors should also expect
higher fees for accounting and legal work related to correcting
accounting mistakes and restating financial statements. Zoe-Vonna
Palmrose and Susan Scholz (“The Accounting Causes and Legal
Consequences of Non-GAAP Reporting: Evidence from Restatements,”
Contemporary Accounting Research, vol. 21, no. 1, Spring
2004) found that restatements are often associated with costly
shareholder litigation. 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. (See Zoe-Vonna Palmrose, Vernon Richardson, and Susan
Scholz, “Determinants of the Market Reaction to Restatement
Announcements,” Journal of Accounting and Economics,
vol. 37, no. 1, February 2004; Jacqueline S. Hamersley, Linda
A. Myers, and Catherine Shakespeare, “Market Reactions to
the Disclosure of Internal Control Weaknesses and to the Characteristics
of those Weaknesses Under Section 302 of the Sarbanes Oxley Act
of 2002,” Review of Accounting Studies, forthcoming
2008; and Hollis Ashbaugh-Skaife, Daniel Collins, William Kinney,
and Ryan LaFond, “The Effect of Internal Control Deficiencies
on Firm Risk and Cost of Equity Capital,” working paper,
University of Wisconsin–Madison, February 2006.) 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
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. Mark Huson, Robert Parrino, and Laura T.
Starks (“Internal Monitoring Mechanisms and CEO Turnover:
A Long-term Perspective,” Journal of Finance, vol.
56, no. 6, December 2001) reported that only about one in six
(16.2%) of all CEO departures represent forced departures. 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 53.5% of forced CEO departures result in the appointment
of an outsider as CEO.
problems are most obvious when companies have experienced robust
increases in stock price, investors may view forced CEO departures
as both surprising and negative. Stewart D. Friedman and Harbir
Singh (“CEO Succession and Stockholder Reaction: The Influence
of Organizational Context and Event Content,” Academy
of Management Journal, vol. 32, no. 4, December 1989) studied
CEO succession and found that stockholder reactions to CEO replacements
tend to be positive when the company’s prior performance
was poor and the board of directors was responsible for initiating
the replacement of a poorly performing CEO. 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.
Fallout of Backdating
At this point,
the full scale and ultimate ramifications of the developing option
backdating scandal are not yet known. According to Steve Stecklow
and Peter Waldman (“Brocade Ex-CEO Found Guilty in Backdating
Case—Criminal Trial Victory for U.S. Likely to Serve as
Model for Prosecutors,” Wall Street Journal, August
8, 2007): “Some 140 companies have come under federal investigation
for backdating, and about 70 executives have lost their jobs as
companies conducted internal probes.” Scores of other companies
have undertaken or disclosed internal probes. Even more companies
have been implicated on the basis of circumstantial statistical
evidence (see Randall Heron and Erik Lie, “Does Backdating
Explain the Stock Price Pattern Around Executive Stock Option
Grants?,” Journal of Financial Economics, vol.
83, no. 2, February 2007).
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.
over backdating will likely influence future regulatory policies
as well. In December 2006, the SEC issued an interim rule (SEC
Release 33-8765, “Executive Compensation Disclosure”)
adjusting certain option disclosures from grant date to vesting
date. 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 123(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
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
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.
Meyer Alexander, PhD, is an assistant professor; Mark
Hirschey, PhD, is the Anderson W. Chandler Professor of
Business; and Susan Scholz, PhD, is an associate
professor and the Harper Faculty Fellow, all in the School of Business
of the University of Kansas, Lawrence, Kan.
Alexander’s article “Tax Shelters Under Attack”
(coauthored with Randall K. Hanson and James K. Smith, The
CPA Journal, August 2003) received an Honorable Mention in the
area of taxation in the Max Block Outstanding Article Award program