Ethics of Options Repricing and Backdating
Banishing Greed from Corporate Governance and Management

By Cecily Raiborn, Marcos Massoud, Roselyn Morris, and Chuck Pier

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OCTOBER 2007 - Just when it seemed that America’s corporate scandals had tapered off and public trust in executives was beginning to rebound, the media revealed two techniques that corporations were using to enhance management pay packages: the repricing and the backdating of stock options. Stock options have been used as a means of paying top-level employees since approximately 1957; they became extremely popular in the early 1980s for employees in the high-tech start-up companies of Silicon Valley.

Stock Options

Stock options allow employees to purchase a particular number of common shares of company stock at a specified price over a specified time period. The option or “strike” price was commonly set at the market price at the date of the option grant. Tying the option price to the market price benefited both the issuing company and the employee at the grant date: The company did not have to record any compensation expense for accounting purposes upon issuance; the employee did not receive a taxable benefit upon issuance and needed to pay taxes only when the exercised options were sold in the future. In the wake of FASB’s issuance of Statement of Financial Accounting Standards (SFAS) 123(R), Share-Based Payment, all stock options must be recognized as compensation expense based on the option’s fair value on the grant date. Even options with a strike price set at or below the stock’s fair-market value on the grant date carry some value, and compensation expense must be estimated by the use of an option-pricing model.

Options were commonly issued to supplement the amount of executive non–performance-based cash compensation above the tax-allowed $1 million deductibility level, to provide executives with an “owner perspective,” or to incentivize executives to work for (or remain at) an organization that was currently cash poor but had strong future prospects. Essentially, stock options were designed to reward current performance with a future benefit when executives neither needed nor desired additional current cash. Because stock options could be cashed in and the shares subsequently sold, there always existed a motivation for executives with options to quickly boost the stock price, through fair means or foul. As some recent corporate scandals show, foul often meant manipulating financial statements to increase net income and, concurrently, stock prices. In addition to financial statement shenanigans, net income could also be increased by firing workers and closing plants—tactics well known to Al Dunlap, especially during his tenure as Sunbeam’s chairman of the board. In other words, it is possible for executives to engineer opportunities for their stock options to rise in value.

Repricing Stock Options

When stock prices rise above a given option price, the expectation is that the managers who received such options will exercise them and become larger shareholders in the corporation. Such holdings should motivate executives to have a greater interest in making the entity ever more profitable, because personal and corporate performance objectives are aligned. The bull market of the 1990s brought substantial value to stock options, but when the market began a downturn, investor value dropped substantially. Although investor value dropped with share prices, the average CEO total compensation in American companies was higher in 2002 than in 1999 (“Leaders: Running Out of Options; Pay for Performance,” The Economist, December 11, 2004). In other words, executive-owners continued to benefit from huge pay packages while investor-owners suffered from the downturn in the value of their stock portfolios. At least some decrease in portfolio values was a direct result of the market’s reaction to the financial scandals created by the executive-owners of corporations.

As stock prices declined, the value of executives’ stock options also fell. In many cases, the market price fell below the option price, meaning the option is “underwater” or “out of the money,” making the original compensation benefit worthless.

One solution that some companies adopted was to reprice previously granted stock options to a price below the current market price. Disclosure of repricings for stock options held by “named executive officers” (generally the CEO and the other four most highly compensated executives) is required under Regulation S-K Item 402(i). In 2000, FASB Interpretation (FIN) 44, Accounting for Certain Transactions Involving Stock Compensation, determined that such repricings would require variable accounting treatment from the modification date. (Instead of repricing the options specifically, a company may also engage in “synthetic” or “6&1” repricing, which has no current income statement effect. In this technique, the company cancels the underwater options and replaces them with new options six months and one day later; the new options are set at the then-current market price.)

This variable accounting treatment would create a negative income statement impact equal to the number of repriced shares multiplied by the difference between the original option price and the year-end market price; the treatment would continue for each year until the options were exercised, forfeited, or cancelled. Therefore, the more the stock’s market price rises after the repricing, the greater the reduction in future earnings. The executive benefits from the reduction in option price, but the company and the other non–stock-option-holding investors face a lowered net income, which, in turn, could generate a lower share price. Repricings effectively reward executives for corporate difficulties, rather than hold them accountable. In addition, if the company has to acquire treasury stock in the future to satisfy option holders upon exercise, the market activity could create an even higher price and greater gains to the exercising employee. Such gains would benefit all stockholders but could make potential new investors less able to acquire the higher-priced stock.

It is important to note that a company does not have to reprice all outstanding options, but “may tailor [its] repricings to include or exclude certain options and/or groups of employees or optionees” (P. Garth Gartrell, “Stock Options and Equity Compensation after the ‘Crash,’” Journal of Deferred Compensation, Fall 2001). If options for high-level executives were repriced while those of lower-level employees were not (or were not repriced to the same degree), one might view such discriminatory treatment as unethical, given that the executives should be held responsible for the downturn in earnings that presumably precipitated the downturn in stock price.

Boards of directors have defended the repricing of executive stock options by stating that it helps retain executives who are essential to company performance. The authors believe that the issue that must be addressed in the face of this logic is how essential such executives actually are if they were the people in charge during the market decline. There is some evidence that the performance and retention rationales behind repricing are flawed. First, results from one study spanning five decades showed “no evidence of a systematic relationship between equity and firm performance” (Catherine M. Daily and Dan R. Dalton, “The Problem with Equity Compensation,” Journal of Business Strategy, July/August 2002). Second, three separate studies indicated that “over the two-year period after repricing, CEO turnover [was] approximately twice as high for repricing firms compared to a matched group of firms that did not reprice” (Dan R. Dalton and Catherine M. Dalton, “On the Decision to Reprice Stock Options: Almost Never,” Journal of Business Strategy, vol. 26, no. 3, 2005).

Backdating Stock Options

As discussed earlier, when stock options are issued, the strike price is typically set to equal the market price at the option date to avoid recording compensation expense and the incurring taxable income to the recipient. The results of a study by Erik Lie (“On the Timing of CEO Stock Option Awards,” Management Science, May 2005) suggested that many stock option awards made during the period 1992 to 2002 were actually “timed retroactively”—dated to coincide with a low price, which then rose after the grant date. In 2006, Charles Forelle and James Bandler (“The Perfect Payday,” Wall Street Journal, March 18, 2006) reported that all six of the option packages granted to Affiliated Computer Services Inc.’s CEO Jeffrey Rich from 1995 to 2002 were dated at the bottom of a steep drop in stock price, with the odds of such an occurrence “around one in a billion.” The SEC decided to look into the issue of backdating option prices, and by mid-2007 more than 140 companies were under investigation. The companies involved range from the low-tech to the high-tech, from the start-up to the well-established. Some companies came forth voluntarily; some were subpoenaed. Many are conducting their own internal investigations. It seems that the practice of backdating has been prevalent but hidden for quite a while.

Prior to 2002, a company was not required to report its issuance of stock options until after the close of the fiscal year, providing ample time to backdate options. Section 403 of the Sarbanes-Oxley Act (SOX) tightened the reporting requirements for the issuance of executive stock options; companies now must report options on Form 4 within two days of their issuance. This requirement should significantly reduce the opportunity for backdating, if companies comply with the new regulation. However, a recent study found that, from September to November 2002 (SOX was enacted in July 2002), one-fifth of companies were still not meeting the two-day requirement (Randall Heron and Erik Lie, “Does Backdating Explain the Stock Price Pattern Around Executive Stock Option Grants?” Journal of Financial Economics, February 2007). One would hope that such delays have been resolved since that study was conducted.

Another troublesome issue has arisen in companies’ response to backdated stock options. According to Charles Forelle (“Executives Get Bonuses as Firms Reprice Options,” Wall Street Journal, January 20–21, 2006), some companies (such as KLA-Tencor Corp.) that engaged in backdating have opted to adjust the executive options to reflect the price actually existing on the grant award dates, but have provided the executive with a cash “bonus” for the amount lost from repricing. Such a tactic could be seen as an extra reward to the executive, who obtains cash even if the stock prices fall from the bad publicity resulting from backdating: a win-win situation for the executive and a lose-lose situation for other shareholders.

Rather than accepting executive greed or poor organizational ethics as the crux of the problem, blame is now being partially placed on the same 1993 tax law that caused a surge in stock options by limiting the deductibility of executives’ non–performance-based cash compensation to $1 million. According to SEC Chairman Christopher Cox (who was a member of Congress when the 1993 law was enacted) and Public Company Accounting Oversight Board (PCAOB) Chairman Mark Olson, this law “unintentionally sparked a trend … for companies to get more creative with incentives for their executives” (Marie Leone and Sarah Johnson, “Backdating Blamed on 1993 Tax Rule,” CFO, September 6, 2006, Some U.S. senators are now contending that the law should be repealed, that companies should be allowed to pay executives any amount, fully deductible for tax purposes.

It is obvious to the authors that the law did, in fact, prompt many companies to use stock options as a form of noncash compensation, but to infer that this justifies the backdating of options seems a huge leap of logic. Whether all cash compensation of CEOs should be tax deductible is an issue that should be addressed on its independent merits, or lack thereof, with a clear eye toward acknowledging the massive discrepancy that exists between worker pay and executive compensation in the United States. According to a BusinessWeek survey of large U.S. corporations, CEO pay rose from 107 times that of an average worker in 1990 to 431 times that of an average worker in 2004, with a multiple of 525 in 2000 (United for a Fair Economy, The Growing Divide: Inequality and the Roots of Economic Insecurity, February 2006;
). These relationships do not seem to indicate that the backdating of stock options was somehow necessary to provide a “reasonable” wage for CEOs!

The problem with options backdating is not just the improper benefit provided to the executives receiving the options, but also the detriment caused to other investors and to the organization’s reputation. One study showed that backdating stock options added approximately $600,000 to the average executive’s pay at 48 companies between 2000 and 2004, but the market value decline in those companies since the investigations into the practice began has been approximately $500 million, or more than $10 per share, on average (Eric Dash, “Report Estimates the Costs of a Stock Options Scandal,” New York Times, September 6, 2006). In addition, companies are now facing potentially massive restatements that could reduce reported income, which would likely trigger further downturns in stock value. Shareholder and pension-fund lawsuits have been launched against some companies and are on the horizon for others. During 2006, despite a large decline in the total number of class-action lawsuits involving securities issues from the previous year, 20 suits related to options backdating were filed against companies (Nathan Koppel, “Legal Bear: Stock Class-Actions Fall,” Wall Street Journal, January 2, 2007). Companies providing corporate directors and officers (D&O) insurance are also asking questions, attempting to determine whether premiums are sufficient or, in the event of illegal activities, whether coverage is in effect.

Spring-Loading and Bullet-Dodging

Because the SOX disclosure requirements make it essentially impossible to backdate stock options, some companies have turned to two other tactics to increase executive pay: spring-loading and bullet-dodging. Spring-loading refers to the practice of issuing options shortly before announcing good news to investors; bullet-dodging refers to delaying an option grant until after bad news has been reported. Some people are criticizing these techniques as being a form of insider trading or trading in the company stock by using nonpublic information that, if known by the general investing public, would significantly influence the company’s stock price. SEC Commissioner Paul Atkins (“Remarks Before the International Corporate Governance Network 11th Annual Conference,” July 6, 2006; disagreed that these tactics are equivalent to insider trading, in part because corporate boards always have “inside information” but cannot predict how the news will affect the investing public. Atkins believes that opportune timing of options grants merely provides the best benefit to the grantee at the least cost to the corporation.

Potentially, however, the issue could be viewed as an extension of Regulation Fair Disclosure, issued by the SEC in August 2000. Regulation FD’s stated purpose is to curb selective disclosures by corporate boards and executives of material, nonpublic information to favorite research analysts or portfolio managers before giving the information to the general public. Technically, the timing of options grants does not fall under Regulation FD; however, a case could be made that the end results are similar: Someone or some group benefits to the exclusion of others. In the case of selective disclosures, certain analysts and their clients benefit; in the case of option timing, certain inside executives benefit.

Using Indexing to Determine Option Price

Many people might argue that backdating and repricing have occurred because companies thought it was unfair to penalize executives for recent downturns in stock prices that were due to macroeconomic pressures and industry fluctuations beyond the control of CEOs. While backdating and repricing present questionable behaviors by corporate compensation committees, an alternative methodology—indexing stock options—might be viewed as more fair and effective in rewarding the highest-performing executives. In such a process, the board of directors would select a group of companies, such as industry rivals, to serve as a benchmarking peer group. The option-issuing company indexes or ties the exercise price to the benchmark group. In theory, economic and industry factors should affect similar companies in similar fashion. Thus, if share prices for the benchmark group rise by an average of 10% in a given year, then the option-issuing company’s shares should rise comparably. If instead the company’s shares rise 15%, then an assumption can be made that the executives provided a positive 5% controllable organizational impact and, as such, deserve additional performance-based pay. Indexed options cannot be exercised at a profit unless the issuing company’s stock price either outperforms, or falls less steeply than, its peer comparison companies. Schering-Plough began using performance-based indexed options as part (20%) of the stock-option compensation granted to its senior executives in 2005. Other companies using indexed stock options include Level 3 Communications, Chiron, Capital One, RCN Corp., Perceptron, and Nuvelo. Many other companies voted on adopting the use of indexed options in 2006, but few of those measures were approved.

Despite the inherent fairness in the indexing concept, many major U.S. companies oppose it. The authors believe this is so primarily because it would make one organization’s compensation plan less attractive than those offered by competitors. A second possibility is that indexing could create more pressure to “do anything necessary” to outperform the index group and, potentially, lead to more corporate frauds. Consider the monetary benefits that would have been awarded to Enron executives had the company’s performance been tied to any industry group! On the positive side, indexing would eliminate the situation in which CEOs are granted millions of dollars of options in a rapidly rising stock market when the companies led by those CEOs performed worse than competitors. Indexing would also stop the practice of repricing stock options.

Ethical Issues

Given the impetus for a positive “tone at the top,” as well as the massive difference in pay between the upper and lower levels of employees in an organization, compensation committees should investigate how the stock option issue is judged from other, acceptable ethical frameworks. Such perspectives can serve as the basis for asking important questions when compensation packages are being awarded.

It was noted above that repricing options differently for different groups of grantees may be viewed as unethical. Using virtue ethics to gauge this tactic, the authors examined both the action and the reasons for taking a particular action as follows: If repricing is motivated by self-interest and by the company’s interest in retaining the executive, then the action is unethical because the remaining stakeholders of the organization are not being considered or are being deceived by the process. The justice theory of ethics requires equals to be treated the same way but allows unequals to be treated differently; executives could be viewed as equals and all others could be viewed as unequals. As such, differential repricing between the two groups would be considered ethical and appropriate. Consider, however, that the Organization for Economic Cooperation and Development (OECD) and the International Corporate Governance Network (ICGN) state that boards should treat all shareholders of a corporation “equitably” and make certain “that the rights of all investors … are protected” (“ICGN Statement on Global Corporate Governance Principles: OECD Principles as Amplified, Section II—The Equitable Treatment of Shareholders,”
). The international business community, in the form of the OECD and ICGN, provides no indication that executives should be viewed any differently from other shareholders. In remuneration guidelines adopted in July 2006, the ICGN stated that repricing stock options without shareholder approval should be considered “inappropriate” and that in “no circumstances should boards or management be allowed to back date grants to achieve a more favorable strike price (in the case of options)” (ICGN Remuneration Guidelines,

Assessing options repricing and backdating from an ethical theory of rights perspective requires determining who is entitled (or has the right) to what. Investors and creditors who have provided funds to an organization have the right to receive accurate, reliable, and transparent financial statements. Options backdating and repricing either ignore or do not consider that right of those investors and creditors, and, as such, these techniques would be seen as unethical. Any corporate officers who are CPAs must remember that the accounting profession’s ethics place the public interest (investors and creditors) ahead of all other interests. Engaging in options backdating and repricing as a corporate employee, or an external auditor, with knowledge that such actions have taken place, would be unethical from a professional perspective.

Options backdating and repricing can also be viewed from a utilitarian perspective. The decision of whether the actions are ethical would be made by weighing the benefits to management as individuals and the perceived benefits to the company and its shareholders (via increases in share price) against the costs of the action and the long-term negative effects on investors and creditors of false and misleading financial information. From an ethical perspective, an individual who rationalizes an unethical action designed to increase the decision maker’s wealth by claiming that the action benefits the company and its stakeholders has fallen victim to the rationalization part of the fraud triangle discussed in Statement on Auditing Standards (SAS) 99, Consideration of Fraud in a Financial Statement Audit.

The Kantian theory of ethics (named for the 18th-century German ethicist Immanuel Kant) directs one to act only as if the action were to become universal law. From this perspective, if stock option backdating and repricing were intended to manipulate or deceive any stakeholders, then the action would be considered a lie and could not be justified by Kantian ethics; the ends do not justify the means.

The issues of spring-loading and bullet-dodging can also be viewed from these three ethical standpoints. If one accepts the fiduciary responsibility of management to all organizational shareholders, then selectively timing the distribution of options places executives in a better position than other shareholders and, as such, discriminates against nonexecutive owners. The ethical theory of utilitarianism is violated by spring-loading and bullet-dodging because there are more market participants who are not executives than there are those who are executives. These two tactics also violate Kantianism: It is highly unlikely that the populace would agree that treating one category of market participants (executives) differently from another category (all other investors and potential investors) would be appropriate. In addition, if spring-loading and bullet-dodging are analyzed from the perspective of Aristotle’s moral theory (i.e., an action is ethical if it is what a “virtuous” person would do under the circumstances), it is difficult to conclude that people of high virtue would knowingly engage in such a form of discrimination. Thus, although these two activities are undoubtedly legal, they are without question unethical—and the investing public has had its fill of the lack of business ethics!

New Reporting Requirements for Options

The manner in which stock options are recorded and reported has been a controversial subject since the 1972 issuance of Accounting Principles Board (APB) Opinion 25, Accounting for Stock Issued to Employees. More recent guidance, such as SFAS 123, Accounting for Stock-Based Compensation; SFAS 148, Accounting for Stock-Based Compensation: Transition and Disclosure (2002); and SFAS 123(R), Share-Based Payment (2004), has not settled the controversy.

SEC rules [conforming with SFAS 123(R)] now require that the entirety of each executive officer’s compensation be shown in a single amount and that the policies and goals of the compensation programs be made in “plain English.” Tabular compensation presentations must include the following:

  • The SFAS 123(R) grant date and the fair value of the option on the grant date by officer;
  • The closing market price on the grant date if that price is higher than the option exercise price; and
  • The date that the board of directors (or compensation committee of the board) actually granted the options, if that date differs from the grant date.

According to SEC Chairman Christopher Cox (testimony given concerning options backdating, U.S. Senate Committee on Banking, Housing and Urban Affairs, September 6, 2006;, reports to investors must also describe “whether, and if so how, a company has engaged (or might engage in the future) in backdating or any of the many variations on that theme concerning the timing and pricing of options. For example, if a company has a plan to issue option grants in coordination with the release of material nonpublic information, that [information] will now be clearly described.” Thus, if the new SOX section 403 disclosure rules are adhered to completely, it is unclear how future backdating activities could occur. But if such activities do transpire, they are significantly more likely to occur with knowledge by and complicity of the board’s compensation and audit committees.

The First to Fall

The first company to actually pay a fine in connection with backdating charges was Brocade Communications Systems Inc. Formal charges were announced in July 2006 and the company agreed to pay a $7 million penalty to settle the allegations on May 31, 2007. (In April 2007, Apple Inc.’s former CFO, Fred Anderson, agreed to pay a fine of $150,000 and to repay option gains of about $3.5 million, but the company itself had not been sued by the SEC.) In January 2005, Brocade announced earnings restatements for fiscal years 1999–2004; those restatements reduced the company’s net earnings by $279 million.

In June 2007, a criminal trial commenced against Brocade’s former CEO, Gregory Reyes, who was charged with 10 felony counts of securities fraud, including defrauding shareholders by changing stock options dates and falsifying and forging related documents to hide such activities. At that time, Reyes was the first executive to stand trial, although executives at other companies had been charged with crimes related to backdating. (Interestingly, Reyes never backdated any options to himself, only for employees he wanted to retain at the company.) Reyes’ lawyer took the position that the CEO had no intent to defraud: The accounting rules were too complex to be understood by Reyes and many others. The trial lasted until early August 2007, and, after six days of deliberation, the jury found Reyes guilty of all charges—apparently not buying the “byzantine accounting” argument.

Balancing Ethics and Incentives

Companies that have been found to backdate options must restate the financial statements. SEC Staff Accounting Bulletin (SAB) 99 specifically addressed this issue by requiring that an error involving an increase in management compensation be restated regardless of the amount. The company’s taxable income could also be affected if restatements require the recognition of additional compensation expense. In turn, the option recipients may find themselves subject to an IRS tax audit, because additional corporate recognition of compensation expense would entail the recognition of income by the recipients. The use of stock option pricing models required by SFAS 123(R) could create future ethical and technical problems if those models are based on inaccurate assumptions or variables as input to the valuation process. The PCAOB was concerned enough about stock option auditing to issue guidance on this subject in Staff Questions and Answers—Auditing the Fair Value of Share Options Granted to Employees (October 2006;

So much interest and concern over stock option backdating and repricing, evinced by so many individuals and organizations, bodes poorly for the legitimacy of the potential motives for such actions. Such actions cannot withstand examination under any ethical test and should raise concern among investors, creditors, executives, and boards of directors. Based on the outcome of the Brocade case, such concerns have permeated the minds of potential jurors and thus the wider public.

Stock options were designed as a way to provide pay for performance, not to reward poor performance by backwards-looking repricing or backdating. Such activities undermine the incentive justification for use of stock option plans. Executives deserve compensation packages that provide both short-run benefits and a long-run motivation to increase organizational value for all stakeholders. Compensation methods that cause the tone at the top to be perceived as a cacophony of greed should be banished from the orchestra.

Cecily Raiborn, PhD, CPA, CMA, is the McCoy Endowed Chair in Accounting at Texas State University, San Marcos, Texas.
Marcos Massoud, PhD, CPA, is the Robert A. Day Distinguished Professor of Accounting at the Peter F. Drucker Graduate School of Management of Claremont McKenna College, Claremont, Calif.
Roselyn Morris, PhD, CPA
, is a professor of accounting, and Chuck Pier, PhD, is an assistant professor of accounting, both at Texas State University, San Marcos, Texas.




















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