Consequences of options backdating

Backdating is the practice of marking a document, whether a check, contract or other legally binding document, with a date that is prior to what it should be.

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Because the option value is higher if the exercise price is lower, executives prefer to be granted options when the stock price is at its lowest.Backdating allows executives to choose a past date when the market price was particularly low, thereby inflating the value of the options.The number of shares subject to option was 250,000 and the exercise price was (the trough in the stock price graph below.) Given a year-end price of , the intrinsic value of the options at the end of the year was (-) x 250,000 = ,750,000.In comparison, had the options been granted at the year-end price when the decision to grant to options actually might have been made, the year-end intrinsic value would have been zero.There is no statute that explicitly outlaws backdating stock-option grants, but it seems virtually impossible to backdate options and achieve the ultimate goal of putting grants “in the money” without first deliberately falsifying documents and then covering up the sham.

At least that seems to be the conclusion reached by the Department of Justice and the Securities and Exchange Commission regarding their first case against executives charged with fraud related to backdating.

Backdating does not violate shareholder-approved option plans.

Most shareholder approved option plans prohibit in-the-money option grants (and thus, backdating to create in-the-money grants) by requiring that option exercise prices must be no less than the fair market value of the stock on the date when the grant decision is made. For example, because backdating is used to choose a grant date with a lower price than on the actual decision date, the options are effectively in-the-money on the decision date, and the reported earnings should be reduced for the fiscal year of the grant.

That promise is considered to be an in-the-money options grant.

In-the-money options are different from performance-based compensation in the eyes of the Internal Revenue Service and the Financial Accounting Standards Board.

That means that if an option is in the money as a result of backdating, the company forfeits its tax deduction for the covered employees, explains Lehman Brothers tax expert Robert Willens.