Springloaded Options? We Thought You Would Never Ask
31/07/2006
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Options backdating refers to the practice of selecting (in retrospect) the most advantageous or lowest share price within a given period of time to establish the date and exercise price of a company’s share option grant.

In addition to the potential financial gain obtained by executives (at the expense of shareholders), this practice lets companies avoid the compensation expense for discounted options they should have shown on their income statements, under accounting rules in effect before 2005.

Backdating, if done deliberately and in violation of a company’s share option plan, is clearly improper and possibly illegal. In the first charges to come out of the widening share-options scandal in the US, criminal and civil actions have been filed against Gregory Reyes, the former CEO of Brocade Communications Systems, and Stephanie Jensen, Brocade’s former vice president of human resources. They were charged with concealing millions of dollars in expenses, overstating the company’s income and falsifying records of share options grants.

A murkier practice, from a legal standpoint, is spring-loading — granting options just before the release of good news or postponing a grant until after the dissemination of bad news.

Backdating of option grants is not necessarily illegal if the following conditions hold:

  • No documents have been forged.
  • Backdating is clearly communicated to the company’s shareholders.
  • Backdating is properly reflected in earnings.
  • Backdating is properly reflected in taxes.

In the US, more than 2,000 companies appear to have used backdated share options to sweeten their top executives’ pay packages, according to a new study that suggests the practice is far more widespread than previously disclosed.

The new statistical analysis, which comes amid a broadening federal inquiry of the practice of timing options to the stock market, estimates that 29.2 percent of companies have used backdated options and 13.6 percent of options granted to top executives from 1996 to 2005 were backdated or otherwise manipulated.

So far, more than 60 companies have disclosed that they are the targets of government investigations, are the subject of investor lawsuits or have conducted internal audits involving the practice, in which options are backdated to days when the company’s shares traded at low prices.

Among the investor plaintiffs is the New South Wales Treasury, which filed a lawsuit against American Tower in Massachusetts.

The study by Professor Lie and Randall A. Heron, of the Kelley School of Business at Indiana University, was posted Saturday to a University of Iowa Web site. The two men examined 39,888 share option grants to top executives at 7,774 companies dated from Jan. 1, 1996 to Dec. 1, 2005.

The findings were based on an analysis of whether share values increased or declined after option grant dates. “Half should be negative and half should be positive,” said Professor Lie to the NY Times. “That’s the underlying logic.”

But the analysis revealed that the distribution was shifted upward.

“This is not random chance. It’s something that’s manipulated, clearly,” said Professor Lie.

Of the companies examined, 29.2 percent, or 2,270, had at some point during the period manipulated share option grants, the study estimated.

The study concluded that before Aug. 29, 2002, 23 percent of unscheduled grants — as distinguished from grants that companies routinely schedule annually — were backdated. Unscheduled grants are easier to backdate.

On that day, the SEC tightened reporting requirements to require that executives report share option grants they receive within two business days. After that, the backdating figure declined to 10 percent of unscheduled grants, the paper said.

Professor Lie said that a number of companies simply ignored the new reporting rule.

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