SEC Chairman Christopher Cox recently stated that the proposed SEC rules on disclosure of executive compensation will “almost certainly address options backdating explicitly.” I. Companies have considerable discretion in determining the timing of stock option awards.Most employee stock options are, or purport to be, granted “at-the-money,” meaning that the exercise price of the option equals the market price of the underlying stock on the date of the grant.The stock plans of many public companies prohibit the granting of below-market options; other companies disclose in their SEC reports that stock options are granted at market and prepare their financial statements on that basis.
The practice of “backdating” stock option grants has recently captured the attention of regulators, prosecutors, the plaintiffs’ bar, shareholders and the media.
The SEC’s Enforcement Division and the offices of the United States Attorney are investigating the option granting practices of dozens of companies and actions taken by their executives.
Several companies have expressed their intent to restate financial statements due to option timing issues, and opportunistic attorneys have already filed derivative and class action lawsuits.
The author of the academic study who is credited with focusing regulators on this issue estimates that at least 10% of “at-the-money” grants of options to CEOs between 19—before Sarbanes-Oxley shortened the reporting period for option grants—were backdated.
Options granted as of the commencement of employment based on the market price as of the date of acceptance may be problematic if the plan does not permit below-market grants or the grant is not treated as a discounted option for accounting and tax purposes.
Options granted as of the date of employment acceptance are also troublesome if the plan does not permit grants to non-employees or if the additional tax and accounting issues relating to grants to non-employees are not adequately addressed. A company may decide to grant options on a specific date but the corporate formalities may not be completed until a later date.This problem occurs most often when boards or committees act by unanimous written consent but there is a delay in the receipt of all of the signed consents.Although these practices involve different types of conduct, both create problems because the date when the exercise price is set is not the same as the date on which the option is awarded. Another scenario involves the allocation of grants to employees from an authorized pool.If the exercise price is set when the pool is authorized by the board or committee but the allocation and actual grants occur later (when the stock price has increased), backdating issues may arise. Option grants to new employees have their own set of backdating issues.A company may want to give a new employee the benefit of any increase in the stock price from the date of acceptance of the employment offer.Grants to new employees based on inaccurate employment commencement dates are troublesome.