Stock options backdating allows a company to inflate the profit that executives or other employees stand to receive from their stock options. By acting as if the options were issued earlier than they really were, backdating potentially widens the spread between the price that options holders must pay for shares of stock and the price they can get for selling them. The federal government has cracked down considerably on backdating.
A stock option gives you the opportunity to purchase shares of stock at a specific price, known as the "strike price," at some point in the future. If the market price of the stock is higher than the strike price when it comes time to exercise the option, you can make a quick profit by buying the shares at the strike price and immediately reselling them at the higher market price. Of course, if the strike price is higher than the market price, there would be no point in exercising the option, so you'd let it expire.
Setting Strike Price
When companies issue stock options to their employees, they typically set the strike price equal to the market price of the stock on the day the options are issued. That way, the options have no "intrinsic value" that would represent taxable income to the employee. Also, many companies' corporate bylaws prohibit granting options that are already "in the money" -- that is, with a strike price below current market price. Companies generally have to disclose information about granted stock options in their financial statements and regulatory filings.
Backdating occurs when a company issues options to an employee on one date but reports them as having actually been issued on an earlier date. The purpose of backdating is obvious: By pushing the issue date farther back in time, the company can set a lower strike price, producing a bigger potential profit for the recipient -- or at least increasing the likelihood that options will be in the money when it comes time to exercise them.
Strictly speaking, backdating stock options isn't illegal, although financial-industry reform legislation passed by Congress in 2002 significantly tightened the rules and made it much harder to effectively backdate within the law. Prior to the 2002 Sarbanes-Oxley law, companies in most cases had to report the options they issued within 45 days. So a company could have given an executive stock options on, say, April 14, but legally claim that the effective date of the option was March 1. In some cases, companies had a full year to report options. With Sarbanes-Oxley's passage, options now must be reported within two days. Of course, a stock price can still show movement in two days, but typically not as much as in 45 days to a year.
- Smith, Gambrell & Russell, LLP: Options Backdating
- Stoel Rives LLP: Corporate Law Alert - Backdating Stock Options
- "Financial Accounting for MBAs," Fourth Edition; Peter Easton, et al; 2010