AmLaw ran a post yesterday discussing the recent Broadcom settlement in the derivative suit alleging stock option backdating (reported as historically one of the largest settlement amounts). And late last month, reports were rampant about the unending litigation involved with the Brocade Communications backdating matter (It’s over! *Psyche* Those cases collectively create their own “Never Ending Story”). Only briefly: there, a federal appeals court overturned the criminal conviction of CEO Reyes. I have done research on the options backdating scandals that hit in 2006, and the petering litigation that has followed (though more frequently, settlements). These news stories catch my eye because of that context, although before such, I only had a passing familiarity with what stock option backdating was. Assuming some of our readers may be in a similar position, I wanted to offer a brief skeleton of what backdating entails.Corporate compensation frequently includes equity-based stock option grants. Stock option grants are typically a component of executive and managerial compensation, but are also given to employees throughout the corporate structure as a means of incentive and creating a vested interest in the corporation's pursuits. When the grant is given, it creates within the recipient the right to purchase a specific number of stocks at a specific exercise price on a specific date. Many stock options are granted “at-the-money.” This describes the exercise price being equal to the current fair market price of the stock on the day of the grant. “In-the-money” options, on the other hand, describe the exercise price being lower than the fair market price of the stock on the day of the grant. Backdating is the act of changing the grant date to an earlier date so that the exercise price is lower than the fair market stock price on the day of the proper grant. Backdating can occur either at the time the grant is written, or retroactively after the grant is written.
If I have adequately explained this, the affect is apparent: recipients of backdated options stand to gain more money that was originally granted; that is, between the lower backdated price and the higher grant date price.
Backdating in-and-of-itself is not illegal. Backdating is legal when done with board authorization, in full disclosure, and in compliance with applicable accounting and tax provisions. And there’s the hiccup … or the dozen different hiccups. For example, as regards taxes: at-the-money stock options are considered performance-based. Performance-based awards do not count towards a corporation’s one million dollar executive compensation deduction cap under IRS Code § 162(m). In-the-money options, on the other hand, are not considered performance-based as specifically regards the difference between the low exercise price and the higher fair market price of the stock on the day of the grant. That difference in price, then, counts towards the one million dollar deduction under § 162(m). The rub: corporations may have taken full deductions on amounts that should have been limited.
After the jump: GAAP and SOX hiccups discussed.
Another frequent example of where backdating may go wrong is in regards to financial statements represented as “GAAP compliant.” To be so compliant, a corporation must record in-the-money stock options as a compensation expense. The expensed amount is, again, the difference between the lower price of the stock on the day the option is exercised and the higher fair market price of the stock on the day it was properly granted. If this expense was not properly recorded during the financial period it was incurred, a corporation may need to restate its financial statements. Uber problematic: options are accounted for over the course of their vesting period, which typically entails a period of several years. This translates into multiple restatements to accommodate that same several year period.
Also the subject of possible fraud allegations: SOX compliance and the Compensation Discussion & Analysis (“CD&A”). The CD&A requires the corporation to publicly articulate in detail executive compensation packages; objectives to meet, elements used to incentivize performance. It will include information, such as the exercise date that stock option grants are given. Backdating a grant to an earlier exercise date would obviously alter this information. Keep in mind the CD&A is filed with the SEC, and therefore subject to both the ’33 and ’34 Acts. It is also shared publicly via the corporation's proxy statement.
FWIW – happy starter primer. Sls.
Photo credit: Irving Underhill.
