Executive Fraud Blog

Heron and Lie in their study provide characteristics of companies that have seen the highest incident of option manipulation. They found the typical firm is: in the technology industry, small in size (under $100 million market capitalization), high in stock price volatility and a client of non-Big 4 accounting firms for their annual audit. Also, their study uncovered that roughly 29% of top executives’ options during 1996-2005 were backdated. The new requirement of the 2 day filing has improved reporting substantially but they found that after August 2002 there was still roughly 10% option manipulation. The continuing problem is largely caused by companies’ blatant disregard for the filing requirement.

As each month passes there are more companies coming to the surface admitting that they must restate their financial statements to correct for option backdating. Glass Lewis & Co. has reported that 152 companies have been discovered in violation of the rules and have collectively lost $5.1 billion in market capitalization by the exposure of the problem. This number is seen by many as just the tip of the iceberg and there will be many other company restatements as the SEC continues their investigations.

Critics of the numbers presented have claimed that the economic value of the option backdating is not as significant as one would imagine. They claim that there are six factors going into an option price when using the Black-Scholes model and the strike price is only a small part of the valuation. Ultimately, they acknowledge that the practices are bad for the market because it destroys investor confidence but they claim that many other factors dictate the value executives receive from their options.

In the future, regulators will likely improve definitions of the requirements for filing options and will continue to enforce disclosure in order to encourage further declines in the backdating practice. Investors can take advantage of information that certain companies have a higher risk of option manipulating by shorting the stock prior to SEC or internal investigations. After companies have admitted problems there will likely be a drop in stock price especially when there is uncertainty of the restated earnings.

Issues that will come under further scrutiny as well when companies are under investigation include spring-loading and bullet dodging which involve timing options before good news or after bad news in order to reap the benefits of lower stock prices. Once regulators crack down on backdating it is likely a new form of manipulation will prevail. Despite this difficult truth, companies that demonstrate consistency in transparent financial reporting and swift justice against violations such as asset misappropriation will be rewarded with the confidence of investors.

Authoritative literature on the accounting for stock options until 2005 had been Accounting Principles Board Opinion No. 25 “Accounting Stock Issued to Employees”. Under APB 25, as long as the options were issued at the money (exercise price equal to than current price) there was no recognized expense until the options were exercised. Manipulation of these rules during the technology boom of the late 1990s allowed them to recruit executives without having to show any effect on the financial statements. Although once the reported earnings led to significant returns for the executives they would exercise the options causing immediate current period expenses that would destroy the company’s earnings.

In response to this behavior, the Financial Accounting Standards Board issued FAS 123, “Share-Based Payment” that encouraged the use of the fair value method but still allowed company’s to use APB 25 as long as they disclosed pro forma financial statements. In 2005, FAS 123R eliminated the use of the intrinsic value method and made fair valuing of options the standard.

Another rule change has come from the SEC in August 2002 for the disclosure of the grants that they must be filed within 2 days of the grant date instead of the original 45 days before the year end. Sarbanes-Oxley legislation has also created higher reporting standards for public traded companies.

Stock Option Backdating - What is it?
Compensation packages for executives often use stock options as performance incentives for their actions that increase the company’s stock price. Recently executives have been criticized for receiving abnormal historical returns related to when their options were issued causing government agencies such as the SEC to review the practices used to issue these options.

The most egregious manipulation of stock options involves retroactively issuing unscheduled options after a period of significant growth in stock price. Other such abnormal returns they have found are related to timing grants with predicted stock price increases or timing beneficial information after the issuance of options. These timing issues do not necessarily result in fraud but the company must adhere to several criteria.

Criteria for Legal Backdating
If you followed the rules, there’d be no reason to backdate when you could issue more favorable, newer options.

1. No documents can be forged.
This is specifically an issue after a favorable stock increases because executives create documentation for the issuance of their options and forge authorization of the transaction.

2. If there is backdating of options then the information must be communicated to the company’s shareholders prior to the issuance.
As long as those affected by the dilution of the stock price are aware of the upcoming backdating and approve the transaction then there will not be unexpected damages. Ultimately shareholders are giving up some value of their stock price to compensate the executive for their success during that period.

3. Backdating is properly reflected in taxes and earnings.
The US tax system provides favorable treatment of performance based compensation but if the options were issued in the money they would not receive the deduction. Rules regarding the expensing of stock options for earnings have changed over the years but as long as the company is in compliance with these rules the options are legal.

Stock option backdating schemes took the scene as the media's newest corporate scandal less than a year ago. Since then there have been many executives that have been able to escape jail sentences and have walked away with a slap on the wrist or a plea deal out of court. Unfortunately for investors and lawyers, these cases are extremely difficult to define in terms of criminality because the defense typically holds that the practices were commonplace, under the discretion of the board of advisors pre-Sarbanes Oxley, and that in many cases these executives were relying on the advice of their current lawyers and/or accountants. Although in most cases there was not a significant impact on investors from the original options it is still an issue of disclosure and ethics of these executives.

Disclosure in these cases was not done properly. Filings to the SEC about the grant dates of these options was improperly filed. Although in many cases prior to new regulation this was commonplace, it is still a clear example of improper financial disclosure. The issue of backdating the options is also fine as long as they had told investors that this was their method of issuing options and made the proper entries accordingly. In most of these cases that are out there in trial this is not what was done.

Ethical executives are crucial to establishing shareholder confidence. Failing to properly disclose these practices is an admittance of guilt because had they told people what they were doing at the time it would not have been fraud. Some of these later cases that have been sought against executives have even less of an excuse because now that the practice has been deemed as fraud they should retroactively disclose these transactions. By coming clean prior to being "caught" it at least shows the public that you were unaware at the time that you were doing something considered to be wrong.

In general, theres a clear reason they backdated the options. More MONEY!! To say now that they were unaware and are innocent of any responsiblity is ridiculous and should come with the proper sentence. Had they owned up to what they did and had documentation of these legal/accountant opinions then it is reasonable that they at least didn't know what they were doing was wrong.