Stock option backdating Featured

7:00pm EDT November 24, 2006

It seems like large companies are falling more and more under the microscope for various financial wrongdoings. One of those wrongdoings is stock option back-dating.

Dana R. Hermanson, Dinos Eminent Scholar chair of private enterprise and professor of accounting in the Coles College of Business at Kennesaw State University, says evidence of backdating is widespread and companies need to perform internal audits to make sure they aren’t penalized by an investigative agency.

Smart Business spoke with Hermanson about what exactly stock option backdating is, why so many companies are being scrutinized for it, and what those companies can do to make sure they’re on the up-and-up.

What exactly is stock option backdating and why are so many companies now being scrutinized for this?
Stock option backdating is lying about the date that stock options were granted to executives or employees so as to make the options more valuable. For example, assume that ABC Company issues three-year options for 100,000 shares to an executive on June 13, when the company’s stock price is $22 per share. The stock options give the executive the right to buy the company’s stock for $22 per share three or more years from then. This executive then has an incentive to work hard to increase the stock price in the future — so he or she can buy the stock for $22 and resell it for much more.

Apparently, some companies secretly backdated their options so that those options were more valuable to the person receiving them. In the example above, the company might ‘pretend’ that the options really were issued on April 11, when the company’s stock price was only $14 per share. This backdating of the options means that the executive is getting options on June 13 with an exercise price of $14 when the market price has already risen to $22. The options are already ‘in the money’ by $8 per share rather than being ‘at the money’ — where the exercise price equals the market price on the grant date. In this manner, the incentive compensation scheme has been rigged, as the executive already has paper profits of $8 per share when the grant is made. Shareholders are the big losers in this deal.

Building upon previous work by professor David Yermack at NYU, professor Erik Lie at the University of Iowa provided evidence suggesting widespread backdating. He found that stock prices typically dropped just before option grants and rose after the grants. Either the executives receiving options had been incredibly lucky, or someone was secretly fudging the grant dates. Following Lie’s research, regulators started to investigate.

Why have technology companies fallen victim to the most severe scrutiny?
Tech companies have traditionally been very heavy users of stock options, so it’s not surprising that many of the backdating allegations have been in this sector. Tech companies often have limited cash flow during their early years, so it’s difficult for them to afford high salaries. These companies have attracted talent by using options to provide potentially large payoffs. Also, many tech companies have vigorously fought against the expensing of stock options, so some tech companies might not have held the accounting rules for stock options in very high regard.

What steps can they take to solve the problem?
Solving the problem will require serious and sincere effort on the part of the board of directors. Executives involved in backdating may need to be fired, and the company will need to notify regulators of the problem and fix its internal control weaknesses. It also is critical to communicate with shareholders about the impact on the company. Ultimately, the board will need to focus on repairing the company’s reputation and on setting a clear tone that such behavior will not be tolerated.

What sort of actions or penalties can a company face if wrongdoing is found?
Companies that secretly backdated their options avoided recording compensation expense and, therefore, overstated their profits. We are seeing numerous restatements of previous financials due to understated compensation expense. In addition to restatements of previous financial results, companies engaged in this practice can expect Securities and Exchange Commission (SEC) investigations and possibly civil sanctions. Even more serious, some executives involved in backdating face criminal investigations or charges, and several executives have been fired.

Is backdating now a thing of the past?
The Sarbanes-Oxley Act now has made it more difficult to secretly backdate options. However, Lie and professor Randall Heron of Indiana University recently found evidence that backdating still is occurring, but to a lesser extent.

DANA R. HERMANSON is Dinos Eminent Scholar chair of private enterprise and professor of accounting in the Coles College of Business at Kennesaw State University. Reach him at (770) 423-6077 or dhermans@kennesaw.edu.