Backdating of executive stock options

Attorney's Office in Northern California has launched a series of investigations and in July issued criminal and securities fraud charges against two top executives at Brocade Communications. National concern about the practice has been spurred by a series of articles in the Wall Street Journal. Companies found to have practiced this could be forced to restate their earnings. District Attorney's Office has also issued several subpoenas in launching a criminal probe. The typical practice was to record a felicitously timed prior date as the grant date, such as the point when the stock had been at its lowest in recent months, instead of the date when the award was actually granted.A separate analysis of grants issued at other than the current price of the shares at grant also shows a pattern of manipulation, but it was only about 60% as prevalent for this type of award (these awards were not very common at the time, however, because of adverse accounting rules).More telling, only 0.9% of the scheduled grants showed a pattern of fortuitous timing, strong proof that the pattern in unscheduled grants could not be the result of random variation.

Even Steve Jobs, the iconic boss of Apple, did it—though, unlike dozens of other executives, he has not (so far) had his collar felt by the authorities.Other companies, however, may have followed the same pattern without making these changes.Backdating is not per se illegal, but, under the Sarbanes-Oxley Act, top executives must report grants made to them within two days of the grant (before Sarbanes-Oxley, it was 45 days).To be fair, since the bursting of the dotcom bubble in 2000, and the more recent backdating scandal, companies have talked about reducing their dependence on options, not least in favour of less asymmetric share-related schemes. As Messrs Sanders and Hambrick note, share options still represent the largest single form of CEO compensation.Dozens of companies are under investigation by the Securities and Exchange Commission for backdating stock options. Alternatively, a company could hit a low without actually backdating its options by granting awards just before a major (positive) earnings announcement, a practice known as "spring-loading." A more extreme and more clearly illegal practice was to say that an award was exercised on a date other than its actual exercise date.To test these theories, they examine the impact of the options awarded to the chief executives of some 950 American firms during 1993-2000.This showed that the bigger the role played by share options in the boss's pay package, the more likely firms were to invest heavily in risky activities.One possible explanation is that everyone in Silicon Valley at the time was so convinced in the potency of options that the possibility of illegality was not even contemplated.After all, the accounting rules did not even count options as a cost of doing business—unless, as it turned out, they were backdated.Volatility is especially significant: 29% of companies with high volatility appear to have manipulated grant dates, compared to 13% of those with low volatility.New rules under the Sarbanes-Oxley Act have reduced the practice to 10% of the companies granting options.

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