Policy

The sordid history of stock option backdating

From: Blog

Stock option backdating is not illegal. Improper identification and disclosure of grants, however, can violate accounting rules, SEC rules, and IRS rules.

Why is stock option backdating a tax issue? When a company backdates an incentive stock option (ISO) award, it assigns a “grant date” that is earlier than the actual grant date. The option is backdated to give it a lower exercise price, thereby making the option immediately valuable. That renders the incentive purpose of the option moot and violates IRS rules. Properly reported, an “in-the-money” option should be treated as a non- qualified option (NQO) and reported as wages with full federal state, local and payroll tax liabilities accounted for. The company’s financial statements should recognize the cost of the grant as compensation expense.

The fifth and latest edition of the classic textbook, Taxes and Business Strategy, A Planning Approach, includes a compact primer on the tax issues surrounding the 2005-2007 stock option backdating controversy.

Merle Erickson, a professor of accounting at Chicago Booth, joins Myron Scholes, Professor of Finance Emeritus at Stanford University, Nobel Prize winner, Chicago PhD, and former professor of finance at Booth from 1974 to 1983, and four more distinguished authors in a book that provide business professionals of all kinds with a general framework for thinking about taxes at the corporate and individual level.

Erik Lie of the University of Iowa gets the credit for identifying, in a 2005 research paper, a systemic pattern by companies to assign a grant date that coincides with the lowest share price that month, thereby manipulating the option exercise price to immediately maximize the value of the option grant. Lie suggested that as many as 2000 companies may have backdated stock options. His paper prompted an investigation by the SEC, Department of Justice, IRS, and the audit regulator the Public Company Accounting Oversight Board (PCAOB).

Erickson and the authors explain that, per SFAS 123, an accounting standard, “in-the-money” stock options should have been disclosed, in the financial statement footnotes, as compensation expense. According to research firm Audit Analytics, the stock option backdating investigations resulted in 153 restatements of previously issued financial statements by companies during 2006 and 2007 because companies failed to properly disclose this compensation expense. The stock market reacted negatively to these restatements. This reaction provides, according to a study in 2009 by Gennaro Bernile and Gregg Jarrell, an estimate of the size of agency costs—unanticipated management opportunism arising from poorly governed companies.

Audit Analytics also says only 13 cases were filed against auditors for giving bad advice and only four auditor settlements exceeded one million dollars. Booth Professor Emeritus Roman Weil, and his co-author Jennifer Milliron, argue in a chapter of the Handbook of Litigation Services that the financial illiteracy of executives, lawyers, and auditors with regard to stock option accounting and disclosure rules during the period leading up to Lie’s discovery, while regrettable, is understandable. “The courts should not expect anyone to have followed ‘rules’ that the accounting profession failed to clarify.”

Weil and Milliron scoured the accounting guidance and literature on stock option accounting and auditing and found that for “as-of” grants—those granted with a date prior to the actual grant date—the accounting literature failed to clearly define the technical terms “date of grant” and “measurement date” until 2006. They defend senior executives from “charges of known or reckless behavior with respect to accounting issues” because executives, especially in the technology industry where the practice was prevalent, generally lacked focus on Generally Accepted Accounting Principles (GAAP) during the years when the practice was common. The ambiguity of the accounting rules didn't help.

But should we let auditors, in particular, off the hook so easily? Every Big Four audit firm made millions in additional consulting fees as forensic accounting investigators hired by law firms to investigate stock option backdating issues. In a recent blog post, venture capitalist Ben Horowitz says everyone knew auditors advised on and blessed the stock option backdating approaches that eventually resulted in civil and sometimes criminal penalties.

Some law firms, like McDermott Will & Emery, warned audit firms as early as in 2006 that claims against them were coming. “Often it is the auditing firms that provide advice concerning issuance of stock options and related tax ramifications. Moreover, auditors review and opine on the financial statements of public companies quarterly and annually.” McDermott advised auditors to steer clear of involvement in internal investigations of the backdating issues if the auditor played any part in designing, approving, or implementing the plans in question.

The Sarbanes-Oxley Act of 2002 changed the reporting requirements for stock option grants. Corporate insiders now have to report grants and exercises in two days rather than ten. If options are backdated by more than two days, it will appear as if the grants are being reported late. It’s now impossible to materially juice the value of the option grant through backdating without inviting suspicion. New backdating of grant dates, and exercise dates, has almost disappeared now that the window of opportunity has narrowed.
 
—Francine McKenna 
Cat:Policy, Business,Sub:Accounting,