At the time, I wrote a paper on the subject describing the issues at hand and also what makes it so enticing to backdate options. Imagine if you could backdate options on Apple that had a $150 strike price that ended in the money but were issue when Apple was at $110, to a back date when the stock price was around $80. You would make much more profit from holding that option. Do it a few times over as the stock price rises, as Apple's has over the last decade, and you would build up a small fortune.
Should these companies have been held more accountable for these actions? Should back dating be illegal, and not just un-ethical?
First, I will republish the original paper from October 14, 2006. I will also publish a mock debate on the subject between two experts: John Ruskin and Andrew Carnegie, which can be read here.
Stock Option Backdating
Should Stockholders Be Worried?
The stock option, both powerful in its potential, and complicated in its design, has made
some of the richest investors and businessmen of our times. But the manipulation of their price, a
strategy called backdating, has also recently been in the scope of controversy.
Stock options originate from the idea of purchasing the right to by property or securities
without having to buy the property or security upfront, and within a specified time period. This
type of purchasing power has numerous advantages, and was first used in land and real estate
purchases.
Options, whether it is an option on stocks or a real estate option, allows the party
interested in buying the asset to buy at what is called the strike price. This guarantees the owner
of the asset a specific buying price sometime in the future when the option holder exercises the
option. The option buyer pays an option price to purchase the option, which has an expiration
date, by which time the option holder must exercise the option. The option holder has the right to
sell either the option, or the underlying asset.1
This means that if you buy an option on a stock, currently worth $20, for an option price
of $1 per option, and then a few months later, exercise your option when the price of the stock is
$25, you will make $4 on each option. So, if you bought 100 options, you would have paid $100,
and made $400, because the option would have been what is called “in the money’ which means
the stock is above the strike price. From this we can see that a lot of money can be made from a
small buying price, which helps to minimize risk, and makes a convenient way for investors who
wouldn’t have enough money to put down, to still play off their bets. If we wanted to have made
the same $400 on the above hypothetical example by purchasing the actual stock, you would
have to purchase 100 shares of stock at $20, which is a $2000 investment. Remember, however,
that with the option we made the same amount of money by spending only $100. Similarly, if
the stock were do have gone down instead of going up, say to $10 per share, you would have
(Jim Cramer’s Real Money as well as Characteristics and Risks of Standardized Options)
lost $1000. However, with the option, you would have only lost $100 since your option would
become void and worthless, or what is called “out of the money” which means the stock is below
the strike price, and it cannot be exercised.
Options to buy the underlying stock are called “call” options and options to sell the
underlying stock are called “puts”. Puts are different from calls, in that you make money
on the put option as the price of the stock goes down. Jim Cramer explains in his book Real
Money: “Options are quite handy, and most of us have used them; we just haven’t used them to
buy or sell stock. When we speculate in real estate, we often ask for an option to buy something.
We pay for that option even if we end up not buying the land beneath it. When we buy insurance,
we are buying a put. We are putting a little money… 2. Options are also similar to the way in
which movie producers buy the right to produce a movie from a book; however, they are not
obligated to make the movie because they have only purchased an option.3
From our example, it can be seen how stock options are a great way for companies to
offer incentives and benefits to their employees. These types of stock options, called Employee
Stock Options, are the same as call options on the company stock at which the employee works,
except they have more restrictions.4 The company issues the employee a stock option grant,
which is a grant of a certain number of shares. The grant usually has a schedule that determines
how fast the grant will vest, and also has an expiration period. Because of the vesting schedule,
usually over a series of years, options are seen as a way that companies can attract bright,
hardworking employees, and keep them, due to the fact that the employee may feel obligated or
wish to stay at the company until the options can be exercised. The strike price is determined by
taking the stock price at the time of the grant, or sometimes the average price between the price
on first day of the month and the last day of the month in which the grant was issued. There are
also other ways to do this as determined by each individual company.
Jim Cramer’s Real Money Pg. 266
Wikipedia - http://en.wikipedia.org/wiki/Stock_options - Historical uses of options
4 Wikipedia - http://en.wikipedia.org/wiki/Employee_stock_option - Employee stock option
Employee Stock Options also differ from regular call options, in that the employees are
not required to pay for the option. Normally, the grants are part of the companies’ incentive plans
or their benefit plans, and are granted at the time the employee is hired. This makes Employee
Stock Options an added benefit to the employee, since a good amount of money can be made,
without having to expend any funds. Also, because of the nature of options explained above, the
employee suffers no loss if the options become worthless, because nothing was paid, and nothing
becomes due when the option expires or becomes void.
Adding to this, companies will sometimes offer additional grants to employees who have
outperformed their peers, or to top executives for having great successes. Some of these so-called
incentive stock options have the benefit of being charged reduced taxes.5 They sometimes
even make stock options the method of payment. An example is Gil Amelio, who was made the
CEO of Apple, and five-hundred days later was fired. His stock options became worthless: “
AMELIO 6
There were numerous other examples of this, as dot com companies could not afford
to pay high wages, and attempted to compensate the employees with stock options. For some
companies, this worked fantastically, and stories ran the presses about low level employees
making millions. However, many other employees never made a dime from their grants. As their
companies sank into the whirlpool of dot com destruction; as they were laid off from the ailing
companies, or simply ousted, their options grants became worthless paper. They found out the
hard way, just like Amelio.
To counter these potentially large losses, or the potential that an option won’t meet the
specified strike price, some companies have been involved in the backdating strategy. Although
it is questionable whether backdating is illegal, it has ethical and moral ramifications that must
be considered. Among the frontrunner companies to be investigated for such activities are
SmartMoney - http://www.smartmoney.com/tax/capital/index.cfm?story=options_iso - Taxes on Incentive
Stock Options
6 Gil Amelio On the Firing Line: My 500 Days at Apple
Apple Computer, Brocade Communications, and CNET. These are a few out of some 120 other
companies under investigation by the FBI and the SEC. 7 Interestingly, only a few months ago,
no one was worried –or discussing the issue, of options backdating. Adding to that fact, the main
group finding and reporting options backdating issues as requested by the SEC are the tech sector
companies, the same sector of companies that only a few years ago faced tough declines in stock
prices, and suffered the most from the declines in the overall economy and the crashing dot com
The way backdating works is by manipulating the option’s strike price date. If the strike
price was issued at, say, $20, but the stock then falls to $18, the option becomes worthless.
However, what if the option could be backdated a few months when the stock price as $16? Then
the option is no longer worthless, and can be exercised for a profit. SEC Chairman Christopher
Cox stated before congress: “There are many variations on the backdating theme. But here is a
typical example of what some companies did: They granted an "in-the-money" option-that is, an
option with an exercise price lower than that day's market price. They did this by misrepresenting
the date of the option grant, to make it appear that the grant was made on an earlier date when
the market value was lower. That, of course, is what is meant by abusive "backdating" in today's
parlance.”8 This may be considered unethical, but it is not illegal.
What causes the questions and scrutiny, and potential illegality is how options are
supposed to be reported by the companies in their quarterly reports -–as an expense. It is also
questionable due to the fact that someone was sold a stock, or had the likelihood of being sold a
stock, at a value that was less than what was predetermined by the option grant’s strike price.
This is the reason the SEC is investigating these cases. Since the option grants are
supposed to be reported as expenses on the quarterly balance sheets of the companies that offer
them, if the options are backdated, or manipulated in any way to the benefit of the company
CNN.com and AppleInsider.com
SEC - http://www.sec.gov/news/testimony/2006/ts090606cc.htm - Testimony Concerning Options
Backdating
or option holder, the expense report will not be accurate. In fact, it will show that company
expenses were actually less than what they were, making profits seem larger. This has huge
implications, due to the fact that the stock price of a company is largely based on the earnings per
share ratios. The so-named P/E Ratio is a key determinant of how much an investor should be
willing to pay for a particular stock. If the company appears to be earning more money than it
actually is, then the stock price will not reflect the true P/E ratio, and will be higher than it should,
because investors would, theoretically, bid the price up to the false P/E Ratio. The shareholders
of the company are then being cheated because they are putting confidence in a stock and a
company which they think is earning a lot more money than is actually true.
The SEC Chairman stated further: “A few years ago, the SEC began working with
academics to decipher market data that provided the first clues something fishy was going on.
One of the academics with whom the SEC worked was Erik Lie of the University of Iowa, who
subsequently published a paper in 2005 that showed compelling circumstantial evidence of
backdating.
“Dr. Lie's data showed that before 2003, a surprising number of companies seemed to
have had an uncanny ability to choose grant dates that coincided with low stock prices…
“For example, in 2003, the Commission charged Peregrine Systems, Inc. with financial
fraud for failing to record any expense for compensation when it issued incentive stock options.
The SEC's complaint alleged that at each quarterly board meeting, the company's directors would
approve a total number of options for employees. The company would then allocate the options to
the employees during the quarter. But the options wouldn't be priced until the day after the next
quarterly Board meeting. On that day, the company looked back at the market price of its stock
between the two quarterly Board meetings, and picked the lowest price. That turned the options
into in-the-money grants. But even though accounting rules required that they then be recorded as
compensation expense, the company didn't do that. As a result, Peregrine understated its expenses
by approximately $90 million…
“When these stock option practices surfaced, Brocade was required to restate and revise
its financial statements for six fiscal years, from 1999 through 2004. The scheme resulted in the
inflation of Brocade's net income by as much as $1 billion in the year 2000 alone…”9
As can be seen, untold billions of dollars were misreported over the years for companies
who were involved in backdating their stock option grants. It means that the stocks for these
companies may have been overvalued. It means that purchasers of the stock may have had to
purchase at a higher price, much to the elation of cunning executives. This affects employees
who did not know they were being granted backdated options. It affects board members, top
executives, and shareholders, whose companies will now face investigations, and who have
similarly faced a decline in stock value due to the investigations. Some executives have even had
to resign, some have been fined, others convicted. "I'm not an opponent of stock options. They
can be a good incentive tool if used correctly. But they can also be dangerous for companies and
shareholders when they are exploited by executives. I'm not for that,” said Erik Lie, the college
professor whose research has led to this newfound corruption.10
Moreover, this corruption affects the overall economy, as Emerson put it so plainly:
TheStreet.com - http://www.thestreet.com/_tscs/stocks/general/10299710.html and SEC - http://
www.sec.gov/news/testimony/2006/ts090606cc.htm - Testimony Concerning Options Backdating
10 The Salt Lake Tribune - http://www.sltrib.com/search/ci_4387153
