Grand Theft Stock Options: Backdating 101

Take-Two Interactive Software, makers of the popular Grand Theft Auto video game, paid $3 million to settle with the U.S. Securities and Exchange Commission last week being charged with stock options backdating. The company neither admitted nor denyied the SEC’s allegations that they falsified financial records as part of the stock option backdating scheme.

The SEC charged Take-Two with backdating stock options for its officers, directors, and key employees. These options could be exercised at a strike price lower than what the stock was trading on the date the options were granted. Take-Two was accused of defrauding investors by failing to properly record the stock option compensation grant date and strike price.

Take-Two is not alone. The SEC has settled numerous stock option-backdating cases over the past several years for millions of dollars. Among those affected have been security software maker McAfee and Apple Computer.

What Is Backdating?

Stock options backdating is when an employee stock option is granted with a date prior to the actual date that the company granted the option. While the practice of backdating (or granting of discounted stock options) is not illegal, it becomes so when Backdating stock options is not necessarily illegal. Backdating becomes illegal when a company’s shareholders are misled. Companies get into trouble when they do not disclose the backdating practice and/orfalsify documents that are submitted to investors and regulators.

Why Backdating Is Beneficial

Stock options are usually granted at-the-money, which means the exercise price is equal to the market price of the underlying stock on the grant date.  The less the grantee has to pay for it, the more valuable the option is.  Therefore grantees prefer to be granted options when the stock price is at its lowest.  Backdating allows executives (who are also the grantees!) to cherry pick a past date when the market price was particularly low, thus increasing the value of the options. 

Academics knew for a long time that share prices rose dramatically in the days following grants of stock options to senior management. But in late 2005 and early 2006, several financial analysts expanded upon the acadmic research to develop lists of companies whose stock price performance immediately after options grants to senior management was suspicious.

In some cases the backdating will specifically relate to the of news that will affect the stock price.

Hey, That’s Not What We Approved

Companies may backdate stock options to give grantees a better deal. For example, a company may grant stock options to Joe CEO on May 1 when the stock price is $100. If they backdate the options to April when the price was $80, Joe CEO gets a much higher return. So why is this a problem?

Usually because the shareholders have not approved the practice, and may not even know about it. If the formal stock option plan states that options are to be granted at an exercise price no lower than fair market value on the date of the option grant, and the company backdates them, these grants are now more favorable to Joe CEO than the shareholders intended.

Income Tax Issues

Some companies have used backdating as a loophole for the ‘reasonable compensation’ deduction restrictions. Backdating and cherry-picking dates with the lowest market price allows them to compensate exectutives more lavishly without accounting or tax consequences.

As an individual, if you receive a stock option with an exercise price below current fair market value, it is considered to have intrinsic value equal to the difference, which is taxable as income. Backdating can be viewed by the IRS as an illegal avoidance of  income recognition.

 Further Reading on Stock Options Backdating

IRS Whistle Blower – This 2004 NYT article tells the story of Remy Welling, a senior auditor for the Internal Revenue Service who when asked to sign off on a secret deal that would allow a Silicon Valley company and its top executives to escape at least $51 million in additional taxes, blew the whistle instead. The plan in question is known in backdating lingo as a 30-day look-back plan.

Early Backdaters- In 2005, University of Iowa finance professor Erik Lie collaborated on this WSJ article that identifies suspected backdaters according to Lie’s studies.

Senate Testimony- Professor Lie’s 2006 testimony to the U.S. Senate Commitee on Banking, Housing, and Urban Affairs.

Image Credit: jonserr, Flickr