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Backdating Stock Options
FROM:
MAR-APR 2007 | BY
VERN KRISHNA
Backdating stock options is the newest forbidden fruit – the crime
du jour of the 2000s – causing securities regulators to investigate high profile CEOs for civil and criminal fraud. Accountants and corporate lawyers are in the midst of the
legal melee.
Stock options are supposed to link executive compensation and shareholder value. As management adds value to the company, stock prices increase, options on the shares become valuable and the market rewards corporate executives. Since options are highly leveraged derivatives, they can produce much greater profits than the percentage increase in the underlying stock.
There are, however, risks with stock options. Some companies eliminate the risk of holding stock options by backdating them so that they are “in the money” at the time that the company issues them. If the strike price is lower than the fair market value of the underlying stock, this option is equivalent to cash in the bank.
There are two variations on backdating. The first is to declare a stock option at a board meeting but without setting the strike price at that time. The board sets the strike price at a subsequent meeting with the benefit of hindsight of the stock’s performance. A more egregious variation of backdating has the board simply erase the first issue date and substitute another date with the benefit of hindsight.
So, what is wrong with backdating options if a board exercises its judgment to compensate executives this way? Backdating options is not fair. Stock options are supposed to motivate executives and provide an incentive for
future performance that will enrich both shareholders and the executive. Compensating the executives by issuing stock options that are already “in the money” is not an incentive for future performance. Backdating is surreptitious and serves no useful business purpose.
Ultimately, all economic rules are behavioural. Increased disclosure of stock option perquisites will cause companies to be more forthcoming in their executive compensation policies. Absent regulatory, judicial, or tax sanctions, however, directors will be tempted to savour the fruits of backdated stock options as additional executive compensation.
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Vern Krishna
is counsel, Borden Ladner Gervais, LLP and executive director, CGA Ontario Tax Research Centre, Ottawa.