Aug 19, The string of options-backdating cases showed how difficult it was to the practice of backdating stock options came to light seven years ago. Option Backdating and Its Implications. Jesse M. Fried*. Abstract. Thousands of U.S. companies appear to have secretly backdated stock options. This Article. Option backdating is the practice of altering the official date on which a stock option is granted. The intent of this change is to set the option date on that date.
This shortened time frame essentially removes the significant benefits of backdating because the limited volatility most stocks experience over the course of two days narrows the potential discount margin between the market price on the grant date and the strike price. Section requires the principal executive and financial officers of publicly-traded corporations to certify each annual or quarterly report filed with the SEC.
This certification represents that the officers reviewed the company's financial data, and that it presents the financial condition of the company in all material respects. The officers also certify that they are responsible for establishing and maintaining internal corporate controls to ensure the proper disclosure of all material information.
If an executive who participated in backdating certified the company's financial reports, and those reports did not disclose and account for backdating, then he would be liable for making a fraudulent certification. In addition, any inadequate internal controls that led to the inaccurate reporting would constitute a separate violation. Intent Requirement For Securities Fraud Under the securities acts, a defendant must act 'willfully' or 'willfully and knowingly.
Though federal courts have inconsistently construed these terms,4the most widely accepted interpretation requires a defendant to have intentionally committed a securities violation knowing the conduct was wrongful, but not necessarily knowing it was unlawful. Tax Fraud Executives who used backdating practices may also face criminal prosecution for federal tax fraud.
The Criminal Implications Of Backdating Stock Options | Corporate Counsel Business Journal
Three possible violations of the Internal Revenue Code 'Code' could create criminal liability for backdating: Like securities fraud, the criminal tax fraud statutes require an intent element.
Therefore, to be criminally liable under the Code's criminal statutes, a person must 'willfully attemptto evade or defeat any tax imposed by [the federal government]. Internal Revenue Code Section m Section m caps the annual deduction for compensation paid to top executives at one million dollars.
Certain 'performance-based' compensation payments are not counted toward the cap, including stock options that are granted with an exercise price equal to or greater than the FMV of the companies' shares on the date of the grant.
Because backdated options have an exercise price lower than FMV as of the grant date, they are not excepted and must be included when calculating whether an executive's compensation has exceeded the cap. Aside from interest and penalties that might accrue if a company amends its income tax returns, executives who implemented backdating practices may also be criminally liable for willfully failing to pay taxes, seee.
Internal Revenue Code Section Section permits public companies to grant employees 'incentive stock options' ISOsallowing them to purchase the company's stock at a discount rate and free from taxes, unless and until the employee later sells any purchased shares.
To qualify as an ISO, an option must have an 'option price  not less than the fair market value of the stock at the time such option is granted. The company would be liable for any taxes it failed to withhold, as well as interest and other penalties, and executives' concomitant personal liability would depend on whether they committed these acts 'willfully' and in violation of the Code's criminal provisions. Internal Revenue Code Section A Section A requires companies that grant discounted stock options to treat them as a form of 'non-qualified deferred compensation' for taxation purposes.
In addition, discounted options that do not have a fixed exercise date are subject to an additional twenty percent penalty tax. Section A would apply only to options granted since its enactment in Under either statute, the penalties are the same and a conviction can result in substantial fines plus up to 20 years imprisonment. July 20, No. DixonF.
Options backdating - Wikipedia
In the modern business world, the Sarbanes-Oxley Act has all but eliminated fraudulent options backdating by requiring companies to report all options issuances within 2 days of the date of issue. District Court for the Northern District of California. However, in late and earlythe issue of stock options backdating gained a wider audience.Stock Options Explained In 2 Minutes
Numerous financial analysts replicated and expanded upon the prior academic research, developing lists of companies whose stock price performance immediately after options grants to senior management the purported dates of which can be ascertained by inspecting a company's Form 4 filings, generally available online at the SEC's website was suspicious.
For instance, public companies generally grant stock options in accordance with a formal stock option plan approved by shareholders at an annual meeting. Many companies' stock option plans provide that stock options must be granted at an exercise price no lower than fair market value on the date of the option grant.
Thus, backdating can be misleading to shareholders in the sense that it results in option grants that are more favorable than the shareholders approved in adopting the stock option plan. The other major way that backdating can be misleading to investors relates to the method by which the company accounts for the options.
Until very recently, a company that granted stock options to executives at fair market value did not have to recognize the cost of the options as a compensation expense. However, if the company granted options with an exercise price below fair market value, there would be a compensation expense that had to be recognized under applicable accounting rules. If a company backdated its stock options, but failed to recognize a compensation expense, then the company's accounting may not be correct, and its quarterly and annual financial reports to investors may be misleading.
Although many companies have been identified as having problems with backdating, the severity of the problem, and the consequences, fall along a broad spectrum. At one extreme, where it is clear that top management was guilty of conscious wrongdoing in backdating, attempted to conceal the backdating by falsifying documents, and where the backdating resulted in a substantial overstatement of the company's profitability, SEC enforcement actions and even criminal charges have resulted.
Toward the other extreme, where the backdating was a result of overly informal internal procedures or even just delays in finalizing the paperwork documenting options grants, not intentional wrongdoing, there is likely to be no formal sanction—although the company may have to restate its financial statements to bring its accounting into compliance with applicable accounting rules.
With respect to the more serious cases of backdating, it is likely that most of the criminal actions that the government intended to bring were brought in There is a five-year statute of limitations for securities fraud, and under the Sarbanes-Oxley Act ofoption grants to senior management must be reported within two days of the grant date.
This all but eliminated the opportunity for senior management to engage any meaningful options backdating. Therefore, any criminal prosecution is likely to be based on option grants made before Sarbanes-Oxley took effect, and the deadline facing the government for bringing those prosecutions has already passed.