Stock Options: The Backdating Issue
Prepared for Members and Committees of Congress
Employee stock options are contracts giving employees the right to buy the company’s common
stock at a specified exercise price, at a specified time or during a specified period, and after a
specified vesting period. The value of the option when granted lies in the prospect that the market
price of the company’s stock will increase by the time the option is exercised (used to purchase
stock). At the grant date for the options, rather than selecting an exercise price based on the
current market price for the stock, officials at some companies have selected a prior date with a
lower market price; that is, they backdated stock options to an earlier grant date. If this
backdating occurred without public disclosure, the recipient of the stock options received
increased compensation in violation of Securities and Exchange Commission (SEC) regulations,
generally accepted accounting rules, and tax laws. Some backdating is said to involve
“sloppiness,” not fraud. The backdating of stock options has imposed costs on shareholders,
employees, bondholders, and taxpayers.
A corporate official who has profited from undisclosed backdating of stock options may not be
responsible or even knowledgeable of the backdating. “Nonqualified” stock options, which have
no special tax criteria to meet, are the focus of the backdating controversy primarily because they
can be granted in unlimited amounts.
The magnitude of stock option grants grew dramatically in the 1990s, subsequent to passage of
the Omnibus Budget Reconciliation Act of 1993, a stock market boom, and revised accounting
rules. Recent corporate disclosure changes have reduced the opportunities and rewards for
backdating stock options. Empirical studies about backdating have been done by academics and
Four recent regulatory actions may have reduced the backdating of stock options, but problems
persist. On December 16, 2004, the Financial Accounting Standards Board issued new rules
requiring companies to subtract the expense of options from their earnings. After August 29,
2002, the Sarbanes-Oxley Act required that companies notify the SEC within two business days
after granting stock options. In 2003, the SEC required increased disclosure of stock option plans.
The SEC issued enhanced option grant disclosure rules effective December 15, 2006. Policy
options to further reduce backdating and other timing manipulation include changes in SEC
regulations and a change in the tax law.
The SEC, various state prosecutorial, and Department of Justice (DOJ) probes into backdating
abuses are ongoing. In addition, many firms have mounted their own internal probes into possible
abuses. By November 2007, the SEC’s investigation caseload had fallen from a peak of 160 to
about 80, and the SEC had brought civil enforcement actions against seven companies and 26
former executives associated with 15 firms. And according to reports from the DOJ, there were at
least 10 criminal filings against defendants for backdating. As of January 2, 2008, the only CEO
to be convicted of charges related to backdating was Greg Reyes, former Brocade CEO.
This report will be updated as issues develop or new legislation is introduced.
Introduc tion ..................................................................................................................................... 1
Illustration of Undisclosed Backdating...........................................................................................3
Types of Stock Options....................................................................................................................4
Nonqualified Stock Options......................................................................................................4
Qualified Stock Options............................................................................................................4
Growth of Stock Options in the 1990s............................................................................................5
The Omnibus Budget Reconciliation Act of 1993....................................................................5
Higher Marginal Individual Income Tax Rates...................................................................5
“Excessive Remuneration”—Section 162(m).....................................................................5
The Stock Market Boom of the 1990s......................................................................................7
Cost Accounting Rules for Certain Stock Options....................................................................7
The Extent of Timing Manipulation of Options..............................................................................7
The Potential Costs of Backdating..................................................................................................8
Costs to Shareholders................................................................................................................8
Costs from Earnings Hits....................................................................................................8
Costs of Reduced Executive Performance..........................................................................8
Costs from Delistings..........................................................................................................9
Costs from the Actions of Bondholders..............................................................................9
Costs of Additional Taxes...................................................................................................9
Costs of Probes, Fines, and Lawsuits................................................................................10
Employees ...................................................................................................................... ......... 10
Bondholde rs ............................................................................................................................ 10
Ta xpaye rs ...................................................................................................................... ........... 11
Key Legislative and Regulatory Developments.............................................................................11
American Jobs Creation Act of 2004 (Section 409A)..............................................................11
FASB Rule for Expensing Stock Options................................................................................11
Sarbanes-Oxley Act: Stock Option Disclosure Reforms.........................................................12
SEC’s 2003 Requirement of Approval of Compensation Plans..............................................12
SEC’s 2006 Executive Compensation Disclosure Rules.........................................................12
Gateke eper s .................................................................................................................... ............... 14
Corporate Boards and Compensation Committees.................................................................14
Securities and Exchange Commission....................................................................................18
The Question of the SEC’s Alertness to Misconduct........................................................20
Potential Policy Options................................................................................................................20
Improve Enforcement of Timely Filing of Option Awards.....................................................21
Require Same Day Filing of Option Grants............................................................................21
Require Scheduling of Grants of Executive Stock Options....................................................21
Ban Equity-based Pay for Top Attorneys and Board Members...............................................22
Increase Shareholder Roles in the Election of Board Members..............................................22
Eliminate the Cap on Deduction for Executive Pay................................................................23
Appendix A. Other Forms of Timing Manipulation......................................................................24
Appendix B. Qualified Stock Options...........................................................................................25
Appendix C. Literature about Backdating.....................................................................................27
Appendix D. Literature about Other Types of Timing Manipulation............................................33
Author Contact Information..........................................................................................................34
Employee stock options are contracts giving employees (including officers), and sometimes
directors and other service providers, the right to buy the company’s common stock at a specified
exercise price or strike price at a specified time or during a specified period after a specified
vesting period. Options have most often been issued “at-the-money” (i.e., with an exercise price
equal to the market price of the underlying stock at the date of grant) but may also be issued
either “in-the-money” (i.e., with an exercise price below the market price of the underlying stock
at the date of grant) or “out-of-the-money” (i.e., with an exercise price above the market price of
the underlying stock at the date of grant). The intrinsic value of the option is the market value of
the stock less the exercise price, which is only relevant if the stock option is issued in the money.
The time value of the option when granted lies in the prospect that the market price of the
company’s stock will increase by the time the option is exercised (used to purchase stock); that is,
its potential appreciation value. Setting a lower exercise price increases the value of the option.
At the grant date for the options, rather than selecting an exercise or strike price based on the
current market price for the stock, officials at some companies have selected a prior date with a
lower market price; that is, they backdated stock options to an earlier date. Thus, officials
backdated the grant date of the option (e.g., on January 10 the company’s officials decided to
grant stock options as of January 5), which resulted in stock options being granted in the money.
If backdating occurred without disclosure, then the recipient of the stock options receives an
increase in compensation at the expense of other shareholders when he exercises his options to
purchase stock. Undisclosed backdating of stock options violates regulations of the Securities and
Exchange Commission (SEC), accounting rules, and tax laws.
Failure to disclose backdating and recognize adverse tax and accounting consequences may result
in (1) material errors in financial statements, fraud and other violations of securities law,
including falsifying books and records; and misrepresenting financial filings to auditors—central
concerns of the SEC (with respect to violations of civil law) and the Department of Justice (with
respect to violations of criminal law); and (2) the loss of tax deductions and imposition of
penalties and interest for failure to withhold and accurately report income and employment 1
taxes—central concerns of the Internal Revenue Service (IRS).
Backdating the grant date could be undertaken for innocent reasons (e.g., to provide equity for
recently-hired employees when stock prices are volatile) that were undertaken in ignorance of the 2
negative accounting and tax complications. Backdating is not necessarily illegal. The SEC has
resource constraints and thus is limited in the number of backdating cases that it can pursue.
According to Stephen J. Crimmins, formerly of SEC’s Enforcement Division and co-manager of
its Trial Unit, as the SEC pursues the stock option cases,
it will be particularly interesting to see how the government handles situations where
individuals did not knowingly violate the law or deceptively cover up their activities, where
1 Eric Dash, “Dodging Taxes Is a New Stock Options Scheme,” New York Times, Oct. 30, 2006, p. 1.
2 Although numerous empirical studies have found statistical support for the hypothesis that corporate executives and
directors have benefitted from the undisclosed backdating of stock options, this does not prove that a particular
corporate official was responsible or even knowledgeable of the backdating.
individuals lacked an understanding of the accounting and tax rules involved in option
grants, where they relied on in-house or outside professionals to alert them to potential
compliance issues, and where problems stemmed from imprecision or outright sloppiness in 3
tending to the formalities that drive the setting of grant dates.
By November 2007, the SEC’s backdating investigation caseload had dropped from a peak of 160
firms to about 80. However, officials at the Division of Enforcement indicated that the number
could grow in the future as the agency continues to examine subprime lending and other types of 4
potential financial fraud. On September 18, 2007, the deputy director of the SEC’s Division of 5
Enforcement stated that backdating continued to be a main focus area for his division in 2007.
About 200 companies have been under federal investigation and/or have restated earnings.6 And
by November 2007, the SEC has brought civil enforcement actions against seven companies and
criminal filings against defendants for backdating. The first stock DOJ backdating case to go trial
was that of Gregory Reyes, former CEO of Brocade Communications Systems. The criminal trial
ended in August 2007 with Mr. Reyes’ conviction, which some observers suggested might be a
watershed development with respect to future trials.
As of January 2, 2008, by far the largest backdating abuse settlement involves a December 2007
agreement involving William McGuire, former chairman and CEO of UnitedHealth Group Inc.,
the nation’s largest health managed care firm. If approved by a court, the settlement with pension
funds invested in UnitedHealth would involve Mr. McGuire giving back to the firm about $419
million in options and other benefits—in addition to about $200 million of options that he had 8
The repayment represents the first SEC-sanctioned use of Section 304 (the “clawback” provision)
of the Sarbanes-Oxley Act of 2002 against an individual. The provision is aimed at depriving
executives of stock profits and bonuses earned while misleading investors.
Mr. McGuire also agreed to pay a $7 million fine in an agreement yesterday with the U.S. 9
Securities and Exchange Commission related to the alleged backdating. As part of the settlement,
Mr. McGuire neither admitted nor denied wrongdoing. A Department of Justice (DOJ) criminal
probe, the SEC’s probe into the firm itself, and various shareholder class-action lawsuits are still
3 Stephen J. Crimmins, “Sorting Out the Cases Involving Backdating of Stock Option,” Viewpoint in Daily Tax Report,
no. 232, Dec. 4, 2006, p. J1.
4 Andrew Osterland, “SEC Halves Backdating Backlog,” Financial Week, Dec. 12, 2007.
5 Carolyn Wright LaFon, “SEC Officials Discuss Enforcement Priorities for 2007,” Daily Tax Report, Sept. 18, 2007.
6 For a list and status of 140 of these companies (last updated on Sept. 4, 2007), see the Wall Street Journal online site
7 Therese Poletti, “Buck Stops Here Rhetoric Doesn’t Wash,” MarketWatch, Dec. 13, 2007.
8 Others have suggested that the case is also an example of the value of an effective special litigation committee, which
oversaw an internal investigation of backdating at the firm. They argue that many committees that have been
established by boards in response to accusations of misconduct have tended to “whitewash” official malfeasance. For
example, see “A Behavior Standard For Executives’ Options,” Gretchen Morgenson, The International Herald
Tribune, Dec. 10, 2007.
9 “Former UnitedHealth CEO McGuire to Pay Record $468 Million for Options Backdating,” Daily Report for
Executives, no. 235, Dec. 7, 2007, p. K4.
Elsewhere, executives who the SEC has sued for backdating abuses have come from companies
that have included Mercury Interactive, KLA-Tencor, Juniper Network, Apple, McAfee Inc.,
Monster Worldwide, Comverse Technology, and Symbol Technologies. An updated list of SEC
cases both settled and pending can be found at http://www.sec.gov/spotlight/
Some executives at other firms are under SEC, state prosecutorial, and Justice Department
scrutiny. It is uncertain how many of these probes will ultimately result in criminal or civil
charges, or SEC penalties.
While undisclosed backdating of stock options is the focus of this report and the most important
type of timing manipulation, it should be noted that there are other forms of timing manipulation,
which are discussed in Appendix A. In some cases when more than one form of timing
manipulation occurs, it may be difficult to empirically separate the relative magnitude of the cost
to the shareholders of these different forms of manipulation, including backdating.
In order to fully understand the backdating issue, this report covers the following topics:
illustration of undisclosed backdating, types of stock options, growth of stock options in the
1990s, the extent of timing manipulation of options, the potential costs of backdating, key
legislative and regulatory developments, gatekeepers, and potential policy options.
A hypothetical case of undisclosed backdating is shown in the following example, which
demonstrates violations of laws and regulations. It should be emphasized that backdating can take
a variety of forms, and in some cases an employee may not be aware that his stock options have
Assume that ABC, Inc. is a publicly held corporation whose stock is selling for $50 a share on
December 31, 1998. As a part of his compensation plan, ABC, Inc.’s chief executive officer
(CEO) is granted options on that date to buy 10,000 shares of stock for $50 a share (at the
money). But, without disclosure, the CEO knowingly selects a prior grant date of August 15, 10
1998, when the stock price was at its low for the year ($30). In other words, the grant date has
been backdated, resulting in a reduced exercise price of $30. Because of backdating, in 1998, the
CEO received an undisclosed gain on paper of $20 ($50—$30) per share for a total of $200,000
($20 X 10,000). This gain was not indicated in the financial statements of the corporation in
1998. Shareholders were unaware of the backdating, which occurred at their expense. This
undisclosed gain is not consistent with the options agreement that the company filed with the
Assume that the vesting period is two years and any time over the next eight years he may
exercise his options. On December 31, 2000, his options become vested; that is, he receives an
unrestricted right to buy 10,000 shares of stock for $30 a share. Assume that on December 31,
2000, the stock price is $75. He decides to exercise his options. (He could have delayed
10 Members of the company’s compensation committee are responsible for determining the CEO’s compensation
including grants of stock options. But some CEOs have simply set their own grants of stock options or have
“influenced” members of the compensation committee to grant them their desired level of stock options.
exercising his options at any time until December 31, 2008). He pays ABC $300,000 ($30 X
these are nonqualified stock options, in the year that the options are exercised (2000), the CEO
owes taxes on the gain in value and ABC, Inc. deducts only $300,000 as the cost of these options.
Thus the actual cost of the options to the company is understated. The CEO has the choice of
selling some (or all) of his shares or delaying their sale with the hope that the price of the stock
will rise further.
The Internal Revenue Code (IRC) recognizes two fundamental types of options. One is
“nonqualified” options, which have no special tax criteria to meet, but are taxed to the employee
as wage income when their value can be unambiguously established (which IRS says is when 12
they are no longer at risk of forfeiture and can be freely transferred). They are deductible by the
employer when the employee includes them in income (IRC Section 83). The other is called
“statutory” or “qualified” options, which are accorded favorable tax treatment if they meet the
IRC’s strict qualifications (IRC Section 421-424). Qualified stock options are excluded from
employment (payroll) taxes.
Nonqualified options may be granted in unlimited amounts; these are the options making the
news as creating large fortunes for some officers and highly paid employees and are the focus of
the backdating controversy. In addition to employees, these options may also be awarded to
anyone “providing services” to the company, including members of the board of directors and
even independent contractors. They are taxed when exercised and all restrictions on selling the
stock have expired, based on the difference between the price paid for the stock and its market
value at exercise. The company is allowed a deduction for the same amount in the year the
employee includes it in income; that is, in the same year it is taxable to the recipient. They are
subject to employment taxes also. Although taxes are postponed on nonqualified options until
they are exercised, the deduction allowed the company is also postponed, so there is generally
little if any tax advantage to these options. Since most of these options go to highly compensated
individuals, whose marginal tax rates are approximately equal to the company’s, the government
probably suffers little if any revenue loss. The justification for the postponement of taxes on the
recipient and the deduction to the corporation is the uncertainty of their actual value; the tax rules
follow the practical path of postponing tax until their value is realized, as is the case with capital
Qualified (or “statutory”) options include “incentive stock options,” which are limited to
$100,000 a year for any one employee, and “employee stock purchase plans,” which are limited
to $25,000 a year for any qualified employee. Employee stock purchase plans must be offered to
11 Nonqualified options are defined in the next section of this report.
12 Nonqualified options are not guaranteed; that is, they have no value if the company goes bankrupt.
all full-time employees with at least two years of service; incentive stock options may be
confined to officers and highly paid employees. Qualified options are not taxed to the employee
when granted or exercised (under the regular tax); tax is imposed only when the stock is sold. If
the stock is held one year from purchase and two years from the granting of the option, the gain is
taxed as long-term capital gain. The employer is not allowed a deduction for these options.
However, if the stock is not held the required time, the employee is taxed at ordinary income tax
rates and the employer is allowed a deduction. The value of incentive stock options is included in 13
minimum taxable income in the year of exercise.
The magnitude of stock option grants grew dramatically in the 1990s because of the passage of
the Omnibus Budget Reconciliation Act of 1993, the stock market boom, and changes in
The Tax Reform Act of 1986 broadened the individual income tax base and lowered marginal tax
rates. It can be argued that the Omnibus Budget Reconciliation Act of 1993 (P.L. 103-66) made
two changes in the tax law that contributed to a substantial increase in the granting of stock
options to corporate executives: higher marginal income tax rates and a deductibility cap of $1
million on applicable compensation.
The Omnibus Budget Reconciliation Act of 1993 raised marginal individual income tax rates,
which had a current maximum rate of 28%. The new maximum marginal tax rate was 39.6%. The
stated reasons for raising marginal income tax rates were “to raise revenue to reduce the federal 14
deficit, to improve tax equity, and to make the individual income tax system more progressive.”
These higher marginal income tax rates gave an incentive to individuals to receive types of
remuneration that would be taxed at a lower rate. Some returns on stock options are subject to the
long-term capital gains rate. In addition, some individuals can defer redeeming stock options until
their marginal tax rate declines. The importance of higher marginal tax rates was lessened,
however, by the reductions in marginal rates during the Bush Administration—the highest 15
marginal tax rate for 2007 is 35%.
The Omnibus Budget Reconciliation Act of 1993 established code section 162(m), titled “Certain
Excessive Employee Remuneration,” which applied to the CEO and the four highest compensated
13 A detailed description of qualified stock options is presented in Appendix B.
14 U.S. Congress, House Committee on the Budget, Omnibus Budget Reconciliation Act of 1993, report to accompany
H.R. 2264, 103rd Cong., 1st sess., H.Rept. 103-111, (Washington: GPO, 1993), p. 635.
15 For historical data on individual income tax rates, see CRS Report RL30007, Individual Income Tax Rates: 1989
through 2007, by Gregg A. Esenwein.
officers (other than the CEO) of a publicly held corporation. For each of these “covered
employees,” the publicly held corporation could only deduct, as an expense, the first $1 million of
applicable remuneration. The reason for this change was that “the committee believes that
excessive compensation will be reduced if the deduction for compensation ... paid to the top 16
executives of publicly held corporations is limited to $1 million per year.” Exceptions to this $1
million in applicable remuneration include (1) “remuneration payable on commission basis” and
(2) “other performance-based compensation.” In order to qualify for this second exception, four
conditions must be met:
• It is paid solely on account of the attainment of one or more performance goals.
• The performance goals are determined by a compensation committee of the
board of directors of the taxpayer, which is comprised solely of two or more
• The material terms under which the remuneration is to be paid, including the
performance goals, are disclosed to shareholders and approved by a majority of
the vote in a separate shareholder vote before the payment of such remuneration.
• Before any payment of such remuneration, the compensation committee certifies 17
that the performance goals and any other material terms were in fact satisfied.
Undisclosed backdating of stock option grants in the money is not “disclosed to shareholders and
approved by a majority of the vote in a separate shareholder vote before the payment of such
remuneration”; hence, the third condition is not met.
Economic theory suggests that the $1 million cap on deductible compensation would increase the 18
relative importance of performance-related compensation including stock options. In retrospect,
the provision appears to have made stock options relatively less expensive than base salaries,
bonuses, or stock grants, which were subject to the cap.
With the backdating scandals as a catalyst, a number of policymakers have recently sought to
examine some of the policy implications of the law. Charles Grassley, former Chairman of the
Senate Finance Committee, has said
companies have found it easy to get around the law. It has more holes than Swiss cheese.
And it seems to have encouraged the options industry. These sophisticated folks are working
with Swiss watch-like devices to game this Swiss cheese-like rule. I want to know what went 19
wrong and consider whether it makes sense to make changes.
SEC Chairman Christopher Cox testified that
16 H.Rept. 103-111, p. 646.
17 IRS Code Sec. 162(m), (4)(C).
18 A National Bureau of Economic Research (NBER) study found that section 162(m) had no significant effects on
overall executive compensation because of the exemption from the cap of performance-based compensation, the ability
to defer compensation, and the cap only applying to salaries of five executives. For these results, see Nancy L. Rose
and Catherine Wolfram, “Regulating Executive Pay: Using the Tax Code to Influence CEO Compensation,” NBER
Working Paper 7842, Cambridge, Mass.: National Bureau of Economic Research, Aug. 2000, 47 p.
19 “Grassley Takes Aim at Stock Options Backdating, Executive Pay,” Press Release from Senator Grassley’s Office,
Sept. 6, 2006.
I well remember that the stated purpose [of the tax law] was to control the rate of growth in
CEO pay. With complete hindsight, we can now all agree that this purpose was not achieved.
Indeed, this tax law change deserves pride of place in the museum of unintended 20
The substantial stock market advances of the 1990s provided a significant boost to the attraction
of option awards. It could also be argued that because shareholders also benefitted from the
market’s gains, their inclination to criticize the growing size of executive option grants may have 21
Going into the 1990s, companies had the choice of recognizing the estimated value of stock
options grants commonly awarded to executives and rank and file workers as costs in their
income statements or simply disclosing option grants in the footnotes to the financial statements,
where they had no impact on reported earnings. Most opted to do so via the footnote disclosure.
In 1991, the Financial Accounting Standards Board (FASB), the private sector entity that writes
accounting rules, proposed that an estimated value of such stock options be a mandatory cost item
in a firm’s financial statements. But after vigorous corporate opposition, particularly from high
tech industry firms, FASB opted not to adopt the proposal until 2004. Many have since argued
that had the proposal been adopted earlier, firms might have been less generous in their executive 22
option grant awards.
The literature on timing manipulation of stock option grants is extensive. Major empirical studies
of timing manipulation other than backdating are summarized in Appendix D. These studies find
strong statistical support for the hypothesis that some CEOs have arranged for their award of
stock options to occur shortly before a positive public announcement by their company
(springloading). Other studies have statistically verified the hypothesis that some executives
controlled the flow of both positive and negative news around dates of scheduled grants of
options. Another study found statistical support for the hypothesis that executives timed the
repricing of stock options based on the release of corporate news.
20 “Testimony Concerning Options Backdating by Christopher Cox, Chairman, U.S. Securities and Exchange
Commission Before the U.S. Senate Committee on Banking, Housing and Urban Affairs,” Sept. 6, 2006.
21 JoAnn S. Lublin and Scott Thurm, “Behind Soaring Executive Pay, Decades of Failed Restraints,” Wall Street
Journal, Oct. 12, 2006, p. A16.
22 In 2004, FASB adopted a controversial accounting rule, FAS 123(R), which requires public companies to incorporate
the estimated value of their option grants as a cost in their financial disclosures. For most firms, the requirement went
into effect for fiscal years after June 15, 2005. One study found that after the accounting change, firms appear to have
reduced their level of executive option grants, replacing them with other forms of compensation. Mary Carter, Luann
Lynch, and A. Irem Tuna, “The Role of Accounting in the Design of CEO Equity Compensation,” The Accounting
Review, March 2007.
This report focuses on the backdating of the grant date for stock options. The relevant literature,
which is summarized in Appendix C, is divided between academic studies and empirical
analyses in The Wall Street Journal. The first academic study was undertaken in 2004 by
Professor Erik Lie, who found strong econometric evidence of extensive backdating. His
subsequent work with Professor Randall A. Heron found that between January 1, 1996, and
December 1, 2005, 29% of 7,774 companies engaged in timing manipulation (primarily
backdating) in granting stock options to top executives. Other studies examined the role of
outside directors and the effect of the options backdating scandal on stock-price performance of
Corporate executives appear to have profited handsomely from undisclosed backdating, although 23
they may ultimately be faced with a number of costs related to such actions. However, there is
clear evidence of backdating’s direct or indirect costs to specific entities, including shareholders,
employees, bondholders, and taxpayers. This section describes such costs.
In general terms, the undisclosed backdating of stock options secretly transfers wealth from a
company’s shareholders to its option recipients, understating a company’s expenses, and
overstating net profits. When options are exercised, companies always receive less than what the
shares are worth on the open market. Backdating increases this cost.
Firms where backdating is detected may have to adjust to the accounting shortfall by downward
restatements of previous earnings disclosures. Public announcement that a restatement may be
forthcoming usually has a strong negative effect on share prices. As mentioned in the
introduction, an empirical study concluded that the options backdating scandal had reduced the 24
value of the stock of 110 corporations by at least $100 billion.
By artificially lowering an option’s exercise price, backdating can reduce some of a stock option’s
performance incentive effects on executives. Backdating the grant date of the options reduces the
exercise price below the market price on the day of the award and gives an executive an
immediate windfall. This means that over a certain share price range, there is no linkage between
an executive’s potential gain from an option award and the performance of the underlying stock.
23 Corporate executives involved in undisclosed backdating of their stock options may lose their jobs, may have to pay
substantial penalties for violating tax and securities laws, and also risk incarceration. In addition, these executives must
bear high costs of litigation. The executives who have engaged in undisclosed backdating have violated SEC’s
disclosure rules, accounting rules, and tax laws.
24 Bernile, Jarrell, and Mulcahey, “The Effect of the Options Backdating Scandal on the Stock-Price Performance of
110 Accused Companies,” p. 11.
Officials of firms involved in backdating probes may find that a significant amount of their time
is diverted to probe-related matters, taking them away from more conventional corporate
concerns. In more extreme circumstances, some corporate executives have been fired or forced to
step down, introducing the prospect of corporate inefficiencies due to leadership discontinuities.
Shareholders risk additional losses if the stock is delisted. Exchange bylaws call for the delisting
of companies that fail to release required quarterly or annual financial disclosures on time. But
due to internal option probes, it has been reported that nearly 50 firms with market capitalizations
of $75 million or more had postponed their quarterly filings for the second quarter of 2006. By
October of that year, it was reported that 54 firms had been told that they faced potential
delistings for such delays. Several companies have had their stock delisted by Nasdaq for failing
to publish audited financial reports on time due to problems with backdating of options. Delisting
is usually followed by a sharp drop in associated share price, and delisted firms tend to face
increased borrowing costs. If they migrate to another trading venue, it is generally a more
marginal entity like the OTC Bulletin Board or the Pink Sheets, markets generally associated with 25
low and volatile stock prices, and high trading costs.
Shareholders may experience financial losses due to bondholders demanding payments for
breached indentures. Corporate bonds normally contain an indenture, a detailed contract between
the issuer and the debt holders that requires the firm to file quarterly and annual reports with
those holders at or around the same time it files with the SEC. This means that late filers,
including many of the firms undergoing backdating probes, may be in technical default of their
indentures. Historically, however, the convention has generally been that in such cases debt
holders give the issuers adequate time to work things out. But there are reports that some
bondholders, including hedge funds, have targeted a number of firms with delayed filings due to
backdating concerns, and are either demanding immediate payment of the value of the debt or
requiring the borrowers to pay substantial fees. For example, in the summer of 2006, Amkor
Technology came close to missing the deadline for paying bondholders who had demanded
repayment of more than $1.5 billion in debt. And during the same summer, the Sanmina-SCI
Corporation asked its bondholders for an extension on the terms of its indenture, offering them
financial concessions of $12.5 million.
Firms found to have been involved in abusive backdating may also incur additional tax expenses
because the pay to their top five executives is not eligible for the same tax deductions that
performance-based options are if the options they receive do not depend on a performance
measure like an appreciation in the stock price after the option grant. Backdated options confer
25 While New York Stock Exchange (NYSE) bylaws mandate a delisting when annual reports are not provided on time,
the Nasdaq (where the vast majority of firms with backdating concerns are listed) can delist when there is a late
quarterly report. A delisting also results in fiscal pain to the exchange since it is forced to forego the listing fees that the
firms pay them. In 2006, companies listed on the Nasdaq paid an annual fee of $75,000 if they had total shares
outstanding of over 150 million. In 2007, this fee was raised to $95,000. Current data on the Nasdaq fee structure for
listing is available at http://www.nasdaq.com/about/nasdaq_listing_req_fees.pdf, visited Dec. 31, 2007.
immediate paper profits and are not treated like performance-based options, making them
ineligible for such deductions.
Firms that decide to conduct internal backdating probes can incur significant costs. In addition,
the ongoing SEC, Department of Justice (DOJ), and IRS probes may result in certain firms facing 26
significant fines. A growing number of firms currently face backdating-based shareholder suits
that allege either breach of fiduciary duty or violation of anti-fraud provisions of the U.S.
Securities Exchange Act of 1934. The suits consume corporate resources in the form of legal
expenses and may result in significant money judgments against the firms. Again, these are
expended funds that cannot be reinvested in longer-term, potentially share-price-enhancing
corporate growth or distributed as shareholder dividends.
Some employees may not be aware that their stock options have been backdated. Consequently, 27
they may be liable “for unanticipated tax as well as interest and penalties.” Some companies
distributed stock options to many levels of employees without disclosing to these employees (or 28
the public) that their options had been backdated. Some of these employees with gains on their
incentive stock options (ISO) may have paid only capital gains taxes rather than regular income
tax on the rise in value due to backdating. Now, these employees may owe the difference between 29
the higher regular income tax and the capital gains tax, plus interest. Furthermore, these
employees may owe additional payroll taxes because backdating cancels an exemption from ISOs
from payroll taxes. If an employee’s stock options vested after December 2004, then-section
exercised. Thus, these employees may also be liable for a 20% penalty and interest.
A number of firms that have grappled with publicly disclosed backdating concerns have seen their
debt trade at substantial discounts to par value, which can mean a loss in value for their
debtholders. Bond raters may lower the debt ratings of firms that are confronting backdating
problems. Lower rated debt raises the cost of corporate financing.
26 The general convention is that at the end of an internal probe, a firm is expected to provide its findings to federal
prosecutors who use the information to determine whether to pursue the case further. Historically, providing such self-
investigated findings has often resulted in federal agencies showing greater leniency in the punishment that they mete
out to offending firms. James Bandler and Kara Scannell, “Legal Aid: In Options Probes, Private Law Firms Play
Crucial Role; As More than 130 Companies Come Under Scrutiny, Government Relies on Help; Questions about
Fairness,” Wall Street Journal, Oct. 28, 2006, p. A1.
27 Anne Tergesen, “Those Options Could Cost You,” Business Week, Oct. 2, 2006, p. 96.
28 On Feb. 8, 2007, the IRS announced it will provide penalty and interest relief to workers who unwittingly exercised
backdated and other mispriced stock options in 2006, but the compliance initiative does not extend to company
executives or other insiders who benefitted most from the schemes. Internal Revenue Service, IRS Offers Opportunity
for Employers to Satisfy Tax Obligations of Rank-and-File Employees with ‘Backdated’ Stock Options, IRS News
Release, IR-2007-30, Feb. 8, 2007, p. 1.
29 Tergesen, p. 96.
If recipients of backdated stock options underpay their taxes, then taxpayers in general lose. In
order to raise a given amount of revenue, these other taxpayers must pay higher taxes. Some
corporate executives have not reported the backdated basis price, and thus understated the
realized gain on the sale of stock and underpaid their income tax. Some corporations involved in
backdating have claimed deductions for executive remuneration above the $1 million limit that
was not performance related. For qualified options, if some employees are able to illegally obtain
additional compensation from backdating in the form of long-term capital gains, then tax revenue
is lost because the marginal tax rate on long-term capital gains is below that on regular income.
Also, taxpayers must cover the cost of litigation in prosecuting undisclosed backdating cases.
Several major legislative and regulatory developments may have reduced the use of options in the
aggregate, and thus reduced options-related abuse, but they are not aimed at backdating per se.
The American Jobs Creation Act of 2004 (P.L. 108-357 ) included new statutory requirements
under Code Section 409A concerning deferred compensation, that is, the delay of the receipt of
compensation and taxes on compensation to a future tax year. This section was included “in 31
response to perceived abuses by executive employees in the recent wave of corporate scandals.”
This section applies to amounts deferred in tax years that begin after December 31, 2004 and
includes stock appreciation rights if the exercise price is less than the fair market value of the 32
underlying stock on the date the stock appreciation rights are granted. Section 409A generally
amounts deferred under a nonqualified deferred compensation plan for all taxable years are
currently includible in gross income to the extent not subject to substantial risk of forfeiture 33
and not previously included in gross income, unless certain requirements are met.
Thus, stock options, subject to 409 A, were included in income when they vested rather than
when they were exercised. Consequently, Code Section 409A reduced the tax advantage of stock
options, and presumably reduced the use of stock options.
On December 16, 2004, the Financial Accounting Standards Board issued new rules [FAS
123(R)] requiring companies to subtract the expense of the estimated value of their option grants
31 Joni L. Andrioff, “Deferred Compensation Revolution—Tough Transition to a Statutory System,” Taxes: The Tax
Magazine, vol. 83, no. 5, May 2005, p. 65.
32 Ibid., p. 66.
33 Internal Revenue Service, “Interim Guidance on the Application of Section 409A to Accelerated Payments to Satisfy
Federal Conflict of Interest Requirements,” Internal Revenue Bulletin, 2006-29, July 17, 2006, p. 1. Available at
from their earnings as disclosed in their financial statements.34 The requirement, which applies to
the fiscal years beginning April 21, 2005, meant that firms can no longer choose between
formally expensing the estimated value of their options grants or merely disclosing that value in
footnotes. For many companies, especially the high tech firms that extensively issued options to
their rank and file workers as well as their executives, the rule dramatically reduces their reported
net earnings. In the rule’s aftermath, grants of executive options are still quite substantial but the
rule ( in conjunction with other factors like the end of the 1990s stock market boom) has helped 35
reduce the overall level of option awards.
Enacted in the wake of widespread accounting scandals at firms like Enron and WorldCom, the
Sarbanes-Oxley Act of 2002 (SOX) contains a host of corporate governance and accounting
regulatory reforms. Prior to SOX, firm insiders were required to disclose grants of stock options
within 45 days of the end of a company’s fiscal year. SOX requires that all insider transactions in
a company’s stock, including option grants, be disclosed within two business days. The
requirement went into effect on August 29, 2002.
In a number of instances, this “fiscal year plus 45-day” reporting window may have given
companies time to review their earlier stock price performance, identify the low point, and
retroactively designate that date as the stock option grant date. After August 29, 2002, the
Sarbanes-Oxley Act required that companies notify the SEC within two business days after
granting stock options. This requirement reduced the frequency of backdating and the magnitude
of the gains to executives from backdating. But many companies fail to file the required Form 4 36
within the two day period.
In 2003, the SEC approved changes to the listing standards of the New York Stock Exchange and
the Nasdaq Stock Market that require shareholder approval of almost all equity-based
compensation plans. Firms must disclose the material terms of their stock option plans, prior to
obtaining shareholder approval for them. The required disclosures include the terms on which
options will be granted, including whether the plan permits options to be granted with an exercise
price that is below market value on the date of the grant.
While the aforementioned initiatives may have played a role in reducing the incidence of abusive
backdating, a July 2006 SEC rule making, which went into effect in 2007, may have a salutary 37
future effect in this area. It consisted of a package of rules designed to enhance the transparency
34 Financial Accounting Standards Board, “FASB Issues Final Statement on Accounting for Share-Based Payment,”
FASB News Release, Dec.16, 2004.
35 Mary Ellen Carter, Luann Lynch, and A. Irem Tuna, “The Role of Accounting in the Design of CEO Equity
Compensation,” The Accounting Review, March 2007.
36 Erik Lie, Testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, Sept. 6, 2006, p. 1.
37 See CRS Report RS22583, Executive Compensation: SEC Regulations and Congressional Proposals, by Michael V.
of proxy compensation disclosures for CEOs, chief financial officers (CFOs), the other three
highest paid executive officers, and directors, the first such major reform since 1992. Passing no
judgment on the practice’s legality or illegality, the rules include provisions that require
companies to disclose whether they are timing options grants to make them more lucrative to 38
executives and other employees.
The rules require companies to present, in tabular form, the stock price on the grant date, the
grant date under accounting rules, the market price on the grant date if it is greater than the
exercise price, and the date the compensation committee or full board granted the award if
different than the grant date for accounting purposes. In a new section of the proxy,
Compensation Discussion and Analysis, management must discuss material information such as
the reasons a company selects particular grant dates for awards and the methods a company uses
to set the terms of awards.
To provide investors with a better handle on firms’ use of springloading (issuing options just
before the release of good news, a practice which is not illegal per se), the rules also require
management to answer questions such as:
• Does the company coordinate the timing of option grants to executives, including
new executives, with the release of material nonpublic information?
• How does any such program fit in with granting options to employees more
• What role did the compensation committee and executive officers play in such a
• Does a company plan to time, or has it timed, its release of material nonpublic 39
information for the purpose of affecting the value of executive compensation?
SEC officials have said that along with the aforementioned two-day option award reporting
requirement ushered in by SOX, the new executive disclosure rules should inject more
transparency into the option grant award process and should essentially eliminate “easy 40
opportunities to get away with secretive options grants.” Agency officials and other observers
have also indicated that largely due to the tightened option award window required by SOX, the
opportunity for corporate officials to retroactively date option awards appears to have been all but 41
But several recent academic studies suggest that this sanguine view may be overstated and
perhaps somewhat premature. The research found that although the incidence of backdating
appears to have been greatly reduced, a relatively small but not insignificant level of option grant 42
manipulation still persists, manipulation that likely includes backdating.
38 These new rules are stated in 17 CFR Parts 228, 229, et al., pp. 53,158-53,166.
39 “SEC Votes to Adopt Changes to Disclosure Requirements Concerning Executive Compensation and Related
Matters,” SEC Press Release 2006-123, July 26, 2006.
40 “Testimony Concerning Options Backdating by Christopher Cox, SEC Chairman, Before the U.S. Senate Committee
on Banking, Housing, and Urban Affairs,” Sept. 6, 2006, p.1.
41 For example, see “Options Backdating: The Enforcement Perspective,” Speech by Linda Chatman Thomsen,
Director, Division of Enforcement, SEC, Oct. 30, 2006.
42 For example, see Lucien Bebchuk, Yaniv Grinstein, and Urs Peyer, “Lucky CEOs,” Harvard Law School Working
Furthermore, critics argue that the new proxy tables do not include all stock options data because 43
of two factors. First , before FAS 123(R) took effect, over 900 companies accelerated the
vesting of stock options to collectively erase about $8 billion of future stock option expenses 44
from their books. Second, in December 2006, the SEC changed a rule to allow corporations “to
report the amount of stock options that vest per year rather than the total value of the options 45
granted to an executive.”
A number of entities are commonly viewed as general protectors of investors’ interests, a
responsibility that arguably becomes more pronounced with the prospect of corporate misconduct
such as abusive backdating. This section examines the roles of key “gatekeepers”—corporate
boards, their compensation committees, outside auditors, and the SEC.
Among other things, corporate boards, particularly their non-managerial members known as
outside directors, are responsible for upholding shareholders’ interests vis-a-vis potentially self-
serving executive behavior. This view is reflected in a number of statutory and regulatory rules,
including requirements that only outside directors serve on board audit and compensation
A corporate board generally possesses the ultimate authority for determining and overseeing the
compensation of its key executives. A majority of the board may, however, broadly delegate that
authority to board committees. Typically, such authority is delegated to the compensation
committee which is responsible for (1) recommending compensation programs and pay levels for
the CEO and other top executives; (2) approving employment agreements and other contracts
with such executives; and (3) administering equity-based and other long-term incentive
compensation plans, including option grants.
When a compensation committee recommends option-based compensation for company
executives, the firm’s board then adopts a stock option plan describing the basic terms of the plan.
Option plans typically say that the options will have exercise prices close to the prevailing share
price on either the day they are awarded or the preceding day.
In most cases, option plans are then submitted to the company’s stockholders for approval as
required by the exchange listing requirements discussed above. After approval of the plans,
Paper, 2006. Available at http://www.law.harvard.edu/faculty/bebchuk, and M.P. Narayanan, P. Seyhun, and Hasan
Nejat, “The Dating Game: Do Managers Designate Option Grant Dates to Increase Their Compensation?” 2006.
Available at http://ssrn.com/abstract=896164.
43 David Cho and Carrie Johnson, “Executive-Pay Summaries Conceal as They Reveal,” Washington Post, Feb. 16,
2007, pp. D1, D2.
44 Ibid., p. D2.
responsibility for overseeing the provision of option grant awards to specific individuals tends
generally rests with compensation committees.
Corporate boards are thus integral to the option grant award process. And the centrality of this
role—combined with the fact that historically CEOs have had significant influence in the
selection of board members—has raised concerns over director complicity and oversight in the 46
An examination of articles on various firms embroiled in options backdating reveals a wide
spectrum of potential board involvement and non-involvement in improprieties involving
backdating. For example, there have been reports of board members: (1) being duped by firm
executives who manipulated the option grant dates; (2) giving executives blanket approval in the
choice of their own option grant dates; and (3) being very much “out of the loop” with respect to
the “nuts and bolts” responsibilities over options issuance (which could raise issues over the
effectiveness of the board’s oversight).
An exhaustive study of option grant awards to the outside directors of publicly traded firms
between 1996 and 2005 found that a substantial number of directors have benefitted from
suspiciously timed option grant awards, raising concerns over director involvement in backdating
abuse. The study, by a group that included Lucien Bebchuk, director of the Harvard Law School
Program on Corporate Governance, examined 29,000 option grants given to 1,400 outside
directors and found that 9% (or approximately 800) were granted on the day of the lowest
monthly share price. The likelihood of such a large percentage of grants occurring on monthly
lows was so statistically improbable that the authors concluded that these “lucky grants” were 47
evidence of deliberate and opportunistic timing.
The authors’ conclusion that the timing was generally deliberate in nature appears to have been
buttressed by the finding that grant events were more likely to be “lucky” during months in which
the difference between the median price and the lowest price was the greatest. The research also
found that when the award dates for directors’ grants coincided with those for the executives,
especially the CEO, the director grants were more likely to be lucky. The study did not address
key questions surrounding the backdating abuse such as who was responsible, who knew what,
and the mindset of the parties involved.
Still, such findings raise fundamental concerns over the effectiveness of many outside directors as
shareholder guardians vis-a-vis potentially self-dealing executives. The research also raises
important corollary concerns about the adequacy of corporate governance structures and protocol.
For example, the director grant study also finds that firms lacking a majority of outside directors 48
were more likely to award lucky grants to their board members.
In another study, the same authors examined executive option grant awards issued by several
thousand firms between 1996 and 2006 and found that lucky CEO grants were more apt to occur
when a firm lacked a majority of outside directors. That research also determined that the longer a
46 For example, SEC Commissioner Roel Campos has said that if the evidence was there, he would not be surprised to
see a number of enforcement actions against non-managerial directors. “How to be an Effective Board Member,”
Speech before the HACR Program on Corporate Responsibility, Aug. 15, 2006.
47 Lucien Bebchuk, Yaniv Grinstein, and Urs Peyer, “Lucky Directors.”
48 Ibid. (Since 2004, firms listed on the NYSE and NASDAQ have been required to have a majority of outside
CEO’s tenure, the greater the prospect of option manipulation, probably reflecting that executive 49
influence over board composition and behavior may tend to grow over time. Another study
examined the firm characteristics that help influence the extent to which CEO’s wield power and
influence over their boards and compensation committees, and found evidence suggesting that
weaker corporate governance tends to increase the likelihood that executive option grants will be 50
As of January 2, 2008, a number of directors have been sued in civil court, and some directors
have resigned their positions. But board members outside of CEOs who also served as board
chairs have not been implicated in backdates abuses with the exception of Michael Shanahan Jr.,
a former member of the board of directors and the compensation committee of Engineered
Support Systems. In July 2007, Mr. Shanahan was one of three firm officials who were indicted
by a federal grand jury in St. Louis on multiple counts of fraud in connection with a stock options 51
To comply with U.S. securities laws, and to help ensure their financial accountability and to help
identify weaknesses in their internal controls and systems, companies contract with independent
accountants known as external auditors or outside accountants to conduct an audit of their
financial statements, records, transactions, and operations. The most common kind of audit is a
financial statement audit, which judges the reliability of the data in the financial report in light of
generally accepted accounting principles.
As such, outside auditors are widely expected to serve a “watchdog” role over the integrity of a
firm’s internal accounting. Like the massive corporate financial reporting problems at firms like
Enron and Worldcom that led to the Sarbanes-Oxley Act and major accounting regulatory reform,
some of the abusive backdating appears to involve faulty financial disclosure.
Most backdaters failed to make accurate disclosures, putting them in a position of potential non-52
compliance with GAAP. When such problems emerge, questions are invariably raised about the 53
role played by the outside auditors.
49 Lucien Bebchuk, Yaniv Grinstein, and Urs Peyer, “Lucky CEOs,” Harvard Law School Working Paper, Nov. 2006.
Available at http://www.law.harvard.edu/faculty/bebchuk.
51 For a list of corporate officials who have come under scrutiny for past stock-option grants, see http://online.wsj.com/
public/resources/documents/info-optionsscore06-exec.html, visited Jan. 2, 2008.
52 A related concern is that for some companies, abusive or inadvertent backdating could also be symptomatic of
inadequate internal controls over accounting procedures. The controversial Section 404 of the Sarbanes Oxley Act of
2002 requires management to assess and publicly report on the effectiveness of a company’s internal controls. The
requirement has been particularly criticized by smaller publicly traded companies for its costs. See CRS Report
RS22482, Section 404 of the Sarbanes-Oxley Act of 2002 (Management Assessment of Internal Controls): Current
Regulation and Congressional Concerns, by Michael V. Seitzinger.
53 Concerns that compromised outside accountant integrity may have contributed to the implosion of firms like
WorldCom and Enron led to a number of provisions in the Sarbanes Oxley Act of 2002. Among other things, the
provisions mandate that corporate audit committees: (1) be composed entirely of independent (non-management)
directors, (2) receive information about accounting policies and problems directly from the outside auditor, (3) approve
any consulting or non-audit services provided by the auditor to the corporation, and (4) include at least one director
who qualifies as a “financial expert.”
At this juncture, there is a wide range of speculation on the roles that outside auditors may have
played in the corporate backdating misconduct. For example, one notion is that outside auditors
should not have been expected to question the veracity of firm documents showing particular
option grant dates. But a more critical perspective is that the auditors may have regarded options-
based accounting reporting as a low-risk concern, approaching these concerns in a cursory and
superficial way, at best, and taking companies’ reporting at face value and expending little effort 54
to confirm the documents’ veracity, at worst.
At this stage in the probes, no outside accountants have been implicated for their roles in
corporate backdating. All the Big Four accounting firms, (KPMG LLP, PricewaterhouseCoopers
LLP, Deloitte & Touche LLP, and Ernst & Young LLP) have corporate clients who have been
implicated for backdating misconduct. But none of the auditors appears to have found any
misconduct, although according to allegations of one firm that is suing Deloitte, the accounting 55
firm gave its approval to a form of backdating.
Research conducted by Eric Lie and Randall Heron found that among large and small accounting
firms, PricewaterhouseCoopers and KPMG were associated with a lower percentage of stock 56
option manipulation. It also found little evidence that accounting firms actually promoted
backdating to their audit clients, as some have alleged. The study also concluded that smaller
auditors in contrast to larger ones were associated with a larger proportion of option grant award 57
disclosures that were tardily filed, as well as unscheduled option grant awards, which are more
apt to lead to backdating.
The possibility that outside auditors may have been negligently complicit in the instances of
abusive backdating has led to several actions. In the summer of 2006, the Public Company 58
Accounting Oversight Board (PCAOB) issued an unprecedented audit practice alert telling
auditors that they must carefully scrutinize their clients’ stock option practices. About the same
time, the SEC accounting office asked accounting firms to identify errors by their public
company clients that may have contributed to backdating, an initiative that would help the agency
conduct its ongoing investigation of the matter.
One of the broad objectives of the Sarbanes-Oxley Act of 2002 was to help ensure that corporate
audits are performed in an independent manner devoid of self-serving corporate bias. To date, the
preponderance of the backdating being probed appears to have taken place before the enactment
of the act. While many feel that the act’s expedited option grant award reporting provision has
virtually eliminated current backdating abuse, others are less convinced. And to the extent that
this view proves credible, questions could be raised anew about the extent to which the act has led
to greater auditing accountability in areas such as this.
54 Some observers claim that some accounting firms have admitted that historically, they have tended to take client firm
options documents at “face value.” See The Statement of Kurt Schacht Managing Director, Centre for Financial Market
Integrity, Chartered Financial Analyst (CFA) Institute Committee on Senate Banking, Housing and Urban Affairs,
Sept. 6, 2006.
55 David Reilly, “Outside Audit Backdating Woes Beg the Question Of Auditors’ Role,” Wall Street Journal, June 23,
2006, p. C-1.
56 Erik Lie, and Randy Heron, “Does Backdating Explain the Stock Price Pattern Around Executive Stock Option
Grants?” Available at SSRN at http://ssrn.com/abstract.
57 Scheduled grant awards are awarded during the same time each year, in contrast to unscheduled awards.
58 The PCAOB is a non-profit, private sector entity created by the Sarbanes-Oxley Act of 2002 to oversee the work of
To date, we are not aware of any auditors who have been implicated in option backdating
As indicated earlier, along with the IRS and the DOJ, the SEC is currently involved in a number
of backdating investigations. SEC officials have said that if Congress saw fit to provide it with 59
additional resources for its work in this area, the funds would be put to good use. The SEC faces
the perennial challenge of marshaling adequate resources to deal with capital markets that
continue to grow in both complexity and scope. Agency officials have said that they have
sufficient resources to adequately pursue the backdating probes but acknowledge opportunity
costs, meaning that other regulatory or enforcement endeavors will have to be sacrificed in order 60
to shift resources to the backdating inquiries.
The agency’s investigators are reportedly combing corporate disclosures to identify patterns that
suggest that executives consistently exercised their stock options at advantageous share prices,
such as a monthly or quarterly low. When such cases trigger suspicions, the investigators may
then request brokerage firm records and other documents from the firm to determine whether 61
actual and reported exercise dates are consistent.
At this early juncture in backdating probes, it is uncertain how widespread the abuse has been.
Some predict that a relatively small number of firms will be sanctioned. But others are less
sanguine about the pervasiveness of the abuse, citing the mounting number of firms that have
discovered possible backdating irregularities, and Lie’s finding that from 1996 and 2002, 29% of
the sampled firms appear to have backdated or otherwise manipulated their option grants. And
referencing what they perceive as problematic declines in SEC resources devoted to enforcement,
they question the SEC’s (and the DOJ’s) ability to both adequately and comprehensively 62
undertake the probes.
Assuming that many firms are found to have engaged in backdating, some predict that the SEC
and the DOJ may ultimately wind up pursuing a “manageable” number of deterrence-oriented
enforcements—and ultimately institute what some call a “voluntary compliance protocol.” For
example, John Coffee, Jr., a law professor at Columbia University and director of its Center on
Corporate Governance, speculates that
after some deterrent prosecutions are brought ... I think you’ll have to see the SEC and DOJ
come up with voluntary compliance schemes under which companies can conduct an
investigation, publish a report, make a confessional disclosure, install preventive controls
59 “U.S. Senator Richard Shelby Holds a Hearing on Stock Options Backdating, The Political/Congressional Transcript
Wire, Sept. 8, 2006.
61 Eric Dash, “Dodging Taxes Is a New Wrinkle in the Stock Options Game,” New York Times, Oct. 30, 2006, p. C-2.
62 The agency has also been criticized for the fact that in FY2006 it brought 574 enforcement actions, which represents
the lowest number since 2001 and a nearly 9% decrease from FY2005. SEC officials largely attributed this to reversible
short-term budgetary and human resource shortfalls. Some observers also note that the 128 agency enforcement actions
involving financial disclosure and reporting declined by nearly 31% from FY2005 and are at their lowest point since
2001, which suggests that SOX has helped instill greater discipline in the way that firms evaluate their internal controls,
resulting in fewer financial disclosure and reporting problems. Jack Ciesielski, “SEC Enforcement: Quality Or
Quantity?” The AAO Weblog Delivered by Newstex, Nov. 6, 2006.
and get immunity for doing that. Otherwise the DOJ will be doing these cases for a number 63
As indicated earlier, the longer option grant award disclosure deadlines that existed before SOX
appear to have provided much greater opportunities for backdating. Along with other factors like
the end of the bull market that began in the 1990s, SOX’s tightened reporting requirements appear
to have helped reduce backdating’s incidence, giving some SEC officials a sense that the abuse is
largely a thing of the past.
However, when grant award disclosures are filed late, greater opportunity exists for the
retroactive falsification of grant dates. And in the post-SOX era, there is research that indicates
the ongoing presence of a non-trivial level of late filings. For example, after examining several
thousand filings, one study found that (despite an SEC website that should have simplified the 64
filing process) 13% of the insider option grant award filings in 2005 were tardy. This finding led
the study’s authors, who include Erik Lie, the author of the backdating study that helped alert the
SEC to the existence of the backdating abuse, to question whether the late filings reflect the
existence of continued and widespread backdating.
Research by the proxy advisory firm Glass Lewis & Company, The Backdating Scandal’s Second
Act?, involved combing through hundreds of thousands of executive grant award disclosures
between January 2004 to June 2006. In the end, the study found some 6,000 questionably timed 65
stock-options grants to executives that had been tardily filed.
Reflecting on the potential ramifications of their research, analysts at Glass Lewis observed that
although they could not definitively ascertain the persistence of backdating from the study, they
noted that “given the sheer number of delinquent filings, the supposed method of regulation that 66
was going to close the door on backdating remains ajar.... ” Additionally, the analysts said the
study raised the prospect that “hundreds” of firms may have either knowingly or accidentally 67
backdated awards after the 2002 changes.
Since August 2002, the SEC has pursued enforcement actions against six delinquent filers, 68
usually as part of larger investigations. Noting that the lateness of the filings creates a greater
opportunity for option grant abuse, Glass Lewis’ researchers described the agency’s enforcement 69
as far too lax and thus lacking in significance as a meaningful deterrent to tardy submissions.
63 Carolyn Said, “Backdating Issue Moves to Forefront,” San Francisco Chronicle, July 22, 2006.
64 Randall Heron and Erik Lie, “What Fraction of Stock Option Grants to Top Executives have Been Backdated or
Manipulated?” University of Iowa School of Business Working Paper, July 2006. http://www.biz.uiowa.edu/faculty/
65 As reported in: Therese Poletti, “Silicon Image Prompted to Review Stock Option Grants,” The San Jose Mercury
News.com, Oct. 31, 2006.
67 Emily Chasan, “Stock Option Backdating Scandal Could Grow,” Reuters, Oct. 29, 2006.
68 Emily Chasan, “US SEC Pursued Few Late Stock-Option Filing Issues,” Reuters, Oct. 30, 2006.
69 Tiffany Kary and Kaja Whitehouse, “Late Form 4s May Suggest Backdating Continued After SOX,” Dow Jones
Newswires, Oct. 31, 2006.
In 2004, the SEC created a unit to pursue delinquent filers but, historically, enforcement against
late filers appears to have been viewed as a low priority area with relatively little benefit relative
to its costs. In response to the concerns raised by the Glass Lewis study, SEC officials spoke of
their intent to continue to monitor whether backdating appears to be linked to delinquent Form 4
filings and to pursue enforcement actions where appropriate. Agency officials also emphasized
that late Form 4 filings are most pronounced among smaller firms (with less stringent internal 70
controls) compared to larger firms with market capitalizations of at least $750 million.
As indicated earlier, the SEC’s interest in the backdating misconduct appears to derive from the
work of others, specifically research conducted by University of Iowa Professor Erik Lie. This
would appear to be the third time in little more than a decade in which the agency relied on the
“gumshoe” work of outsiders to learn of the existence of potentially widespread misconduct
among entities that it regulates.
• A series of mid-1990s SEC enforcement actions and Nasdaq regulatory reforms
stemmed from academic research that identified price rigging by some Nasdaq
• In 2003, New York Attorney General Spitzer announced that his office had
discovered evidence that major mutual fund companies had been complicit in
either illegal or unethical trading schemes, revelations that resulted in widespread
probes, money settlements, and the SEC’s adoption of a series of fund regulatory 71
In the wake of the fund scandals, the SEC implemented a host of internal administrative reforms
aimed at improving its alertness to misconduct. Still, when combined with current concerns over
the possibility that the agency may face serious resource constraints this latest example of SEC
reliance on investigations surfaced by others could be a potential area for oversight.
Generally expressing their faith in the efficacy of existing regulations and laws (like SOX’s two-
day option grant reporting requirement) to curb abuse, various officials at federal agencies
currently involved in the backdating probes, including the heads of the SEC and the IRS, question 72
the need for additional measures at this point. Yet, while it is almost universally agreed that
70 Ibid, and Jessica Guynn, “Late Options Filings Proliferate Firm Says,” San Francisco Chronicle, Oct. 31, 2006, p. D-
71 Prior to Sept. 2003, SEC staffers reportedly did not look for such fund trading abuses because agency officials tended
to view other fund actions as higher risk concerns. Agency officials also reportedly believed that mutual funds had
internal financial incentives to control frequent and potentially trading because it could lower their returns. But a 2005,
Government Accountability Office (GAO) report concluded that SEC inspectors should have detected the market
timing abuses before Sept. 2003, when regulators began an industry wide crackdown after New York Attorney General
Eliot Spitzer exposed the violations. GAO Report-05313, Mutual Fund Trading Abuses. Lessons Can be Learned From
the SEC Not Having Detected Violations at an Earlier Stage, April 2005.
72 For example, see “The Testimony Concerning Options Backdating by Christopher Cox Chairman, SEC, Before the
U.S. Senate Committee on Banking, Housing and Urban Affairs,” Sept. 6, 2006.
backdating is no longer the kind of problem that it was several years ago, some research suggests
it has been far from eliminated. Given these lingering concerns, this section describes a number
of initiatives promoted as ways to help further stem backdating. Possible benefits of a policy
option may be weighed against its administrative and compliance costs.
Historically, the SEC has reportedly viewed enforcing tardily filed executive grant award 73
disclosures as a low priority, low payoff exercise. From 2001 to 2005, the agency reportedly
brought 12 enforcement actions that included charges of late form 4 filings. Agency officials,
however, say that it has a program that regularly reviews delinquent filers and brings actions 74
where needed. But late disclosures provide greater opportunities for backdating and critics argue
that lax enforcement lowers deterrence, increasing the odds that firms may deliberately 75
Claiming that backdating could be eliminated by requiring that stock options grants, including
exercise prices, be filed electronically with the SEC on the day that they are granted, Professor 76
Lie has argued for the agency to institute such reform. While making the case for the change, he
has emphasized that filing is already a simple process, that the forms can be filed online, and that 77
some option grants are already filed on the same day. In research that appears to lend some
support to such reform, Professor Lie and co-researcher Randall Heron found that 7.0% of a large 78
sample of grants filed within the two day requirement were backdated, suggesting that the two
day filing window has reduced but not totally eliminated the opportunity to backdate option
Compared to scheduled option grant awards, unscheduled grant awards give executives greater
opportunity to take advantage of market vagaries, (or to time awards around the release of
positive or negative corporate news). As a consequence, some observers propose that firms only
be allowed to issue option grants on a regularly scheduled basis. One criticism of requiring only
scheduled option grants is that it would unfairly tie the hands of firms who need to make
unscheduled awards due to unexpected contingencies. From a jurisdictional standpoint, this kind
73 Emily Chasan, “US SEC Pursued Few Late Stock-Option Filing Issues.”
74 Tiffany Kary and Kaja Whitehouse, “Late Form 4s May Suggest Backdating Continued After SOX,” Oct. 31, 2006,
Dow Jones Newswires online.
75 For example, see “Testimony of Erik Lie Associate Professor of Finance Henry B. Tippie College of Business
University of Iowa Before the U.S. Senate Committee on Banking, Housing, and Urban Affairs,” Sept. 6, 2006.
76 Erik Lie, Testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, Sept. 6, 2006, p. 6.
78 Heron and Lie, “What Fraction of Stock Option Grants to Top Executives have Been Backdated or Manipulated?” p.
of reform is the traditional province of corporate boards, although some observers have suggested 79
that the SEC might have authority to intervene in this area.
Some observers have proposed banning the use of equity-based compensation for corporate
lawyers and directors. They argue that compared to conventional fixed compensation, equity-
based pay is more apt to undermine the officials’ roles as gatekeepers/protectors against executive
misconduct like backdating. It would be unprecedented for a regulator like the SEC or an
exchange in its capacity as an SRO to place limits on certain kinds of corporate pay. But
employing similar arguments against compensating directors with equity-based pay, a number of
firms are voluntarily deciding not to do so. For example, in October 2006, Campbell Soup
announced that starting in 2007, it would stop issuing stock options as part of its directors’
compensation. And in December 2006, IBM announced that beginning in 2007, as part of a
companywide effort to reduce the reliance on the grants, it would stop granting stock options to
its outside directors. Arguments against placing proscriptions on equity-based pay would,
however, include the following: (1) there is little empirical evidence linking such the provision of
such equity-based pay to improprieties on the part of corporate executives; and (2) there is
research that has found a positive correlation between paying directors with stock options and 80
certain measures of corporate financial performance.
In July 2003, the SEC proposed a rule that under certain conditions would have allowed public
company shareholders with more than 5% of a company’s voting securities to have their 81
nominees for board membership included in a company’s proxy materials. This would enable
large investors to formally nominate candidates for the board—a change from the current regime
under which board members are almost always nominated by firm executives. A response to
widespread concerns over the accountability of corporate directors after a number of corporate
scandals, the proposal received the support of various observers, including some institutional
investors who argued that the integrity of corporate boards would be enhanced by an expanded
shareholder role in the director nomination process. Similarly, it could be argued that such a
reform could result in boards being populated with a greater number of outside directors who are
less beholden to management and better able to provide independent oversight and scrutiny of
executive compensation practices and excesses, including backdating. It also could be argued that
the research described earlier—that found that large numbers of outside large directors appear to
79 For example, see John C. Coffee Jr., “The Dating Game,” The National Law Journal online, Sept. 4, 2006.
80 For example, see Eliezer M. Fich and Anil Shivdasani, “The Impact of Stock-Option Compensation for Outside
Directors on Firm Value,” The Journal of Business, vol. 78, 2005, pp. 2,229-2,254.
81 “Proposed Rule: Security Holder Director Nominations, Release nos. 34-48626; IC-26206; FILE NO. S7-19-03,
Securities and Exchange Commission,” Oct. 17, 2003. http://126.96.36.199/
search ?q =ca ch e: S 2 Z azKrK5 R IJ: www. s ec. go v/ ru l es/ p r op o s ed /3 4 -
48626.htm+sec+and+security+holder+director+nominations&hl=en&ct=clnk&cd=2&gl=us. At least one of two things
would have had to have taken place in the previous year’s board election to trigger the requirement: (1) 35% or more of
shareholders voted to withhold support for at least one director at the company’s annual meeting; or (2) a stockholder
or a group of shareholders with at least 1% of the company’s stock put a proposal on the proxy statement seeking the
right to nominate a director, and the proposal was approved by a majority vote.
have been the beneficiaries of options manipulation—provides additional support for such
In August 2006, the United States Court of Appeals for the Second Circuit reached a decision in
American Federation of State, County and Municipal Employees Pension Plan v. American
International Group, Inc. This ruling was the appeal’s courts response to an earlier petition by the
American Federation of State, County and Municipal Employees (AFSCME) that the American
International Group’s (AIG) rejection of its effort to place a binding shareholder proposal in the
company’s proxy materials that would have changed its bylaws to facilitate shareholder
nomination of directors be reversed. Historically, the SEC has allowed firms to exclude
shareholder proposals from their proxies, as it did in this case. However, the Second Circuit found
the SEC’s policy in this area to be inconsistent and asked the agency to clarify it.
The SEC issued a press release saying that the commissioners would be responding to the court
decision during an October 2006 meeting, which they did not do. Later, it issued a press release
saying that the commissioners would be considering proposals for revisions to its earlier 82
shareholder proxy access initiatives at a meeting on December 13, 2006, which they also did not
Meanwhile, Representative Barney Frank, Chairman of the House Financial Services Committee,
reportedly urged the SEC to promulgate a new policy that would be more accommodating to
activist institutional investors like AFSMCE who are interested in gaining access to the proxy
with respect to director nominations. Chairman Frank has suggested that Congress might need to 83
intervene in this area if the SEC does not act.
As previously indicated, in 1993, OBRA added Section 162(m) to the Internal Revenue Code,
which limited a company’s tax deduction on what it pays each of its top executives to $1 million,
but exempted “performance-based” pay like stock options. In conjunction with other
developments like the bull market of the 1990s and the pressure on firms to provide executive pay
that better aligned executives’ incentives with the interests of firm investors, OBRA is widely
believed to have been a factor in the rise in the use of stock options. Some have argued that
rescinding OBRA, or limiting the kinds of exempt performance-based pay could help stem the 84
use of stock options, thus limiting the supply of potentially backdatable stock options. This kind
of reform could, however, be criticized for being an exceptionally blunt approach that is only
weakly connected to the basic machinery of backdating, raising questions about its ability to help
stem the abuse. Moreover, a comprehensive look at OBRA’s impact on CEO pay found that given
the minimal impact that tax deductibility of executive compensation tends to have on firm
profitability, the actual role that OBRA has played on the configuration of CEO pay “remains an 85
82 “Remarks Before the Willamette Securities Regulation Institute by SEC Commissioner Roel Campos,” Oct. 19,
83 Michael Brush, “The Coming Crackdown on CEOs,” MSNMoneyonline, Dec. 30, 2006.
84 Senate Finance Chairman Max Baucus and ranking committee member Charles Grassley have both reportedly
suggested that OBRA may have helped engender the current backdating problems, and have expressed their interest in
possibly limiting it. Marie Leone, “Grassley Targets Backdating Advisors,” CFO.com, Sept. 7, 2006.
85 Nancy L. Rose, and Catherine Wolfram, “Has the ‘Million-Dollar Cap’ Affected CEO Pay?” American Economic
In addition to backdating, three other types of timing manipulation should be noted.86 First,
spring-loading and bullet-dodging concern the timing of option grants to coincide with public 87
announcements by the issuing company. Spring-loading occurs when stock options are issued in
advance of a positive public announcement by the issuing company, which is expected to drive up
the market value of the stock. Because the recipients of the stock options knew that the public
announcement would be positive, but other investors did not, the recipients of the stock options
received a “windfall” gain. Bullet-dodging is the reverse of spring-loading. Stock options are
issued shortly after a negative public announcement by the company. Investors are surprised by
the negative announcement, may overreact, and may temporarily reduce the market value of the
stock, at which point the stock options are issued. Subsequently, if the price recovers, recipients
of these stock options will have received a favorable exercise price. Spring-loading and bullet-
dodging can also be applied to the timing of option repricing. When a company’s stock price falls
significantly below the exercise price of its stock options, some companies reprice the option’s
exercise price. The justification for repricing stock options is to restore their incentive effect.
Second, the timing of corporate announcements can be manipulated in relation to known dates for
the granting of options. For example, a high tech firm could delay the announcement of a
technological breakthrough until after the date of the granting of stock options.
Third, some executives have changed the exercise date without disclosure in order to reduce their 88
tax liability. By backdating the exercise date on their stock options to when the stock price was
lower, executives can convert regular income into capital gains, which are taxed at a much lower 89
marginal tax rate.
In some cases more than one form of timing manipulation may occur, and it may be difficult to
empirically separate the relative magnitude of these different forms of manipulation.
Review, vol. 90, no. 2, May 2000, pp. 197-202.
86 Whether or not the first two forms of timing manipulation are illegal has not been determined by the SEC or the
87 The SEC has not decided whether or not to pursue cases of spring-loading and bullet-dodging. Rachel McTague,
“More Stock-Options Backdating Cases Expected in Near Future, SEC Officials Says,” p. A9.
88 Dash, “Dodging Taxes Is a New Stock Options Scheme,” p. 1.
89 Mark Maremont and Charles Forelle, “How Backdating Helped Executives Cut Their Taxes, Wall Street Journal,
Dec. 12, 2006, pp. A1, A13.
Two types of stock options qualify for the special tax treatment provided in IRC Section 421:
incentive stock options and employee stock purchase plans. Both types require that the recipient
be an employee of the company (or its parent or subsidiary) from the time the option is granted
until at least three months before the option is exercised. The option may cover stock in the
company or its parent or subsidiary.
Both types of qualified stock options receive some tax benefit under current law. The employee
recognizes no income (for regular tax purposes) when the options are granted or when they are
exercised. Taxes (under the regular tax) are not imposed until the stock purchased by the
employee is sold. If the stock is sold after it has been held for at least two years from the date the
option was granted and one year from the date it was exercised, the difference between the
market price of the stock when the option was exercised and the price for which it was sold is
taxed at long-term capital gains rates. If the option price was less than 100% of the fair market
value of the stock when it was granted, the difference between the exercise price and the market
price (the discount) is taxed as ordinary income (when the stock is sold).
Companies generally receive no deduction for qualified stock options, so the tax advantage
accrues to the employee, not the employer. Companies that would not be taxable anyway, such as
start-up companies not yet profitable, would care little (if at all) about the tax deduction and
would be expected to use this method of compensation. Many companies that are taxable grant
qualified stock options, however, so these options must have some advantage that outweighs the
tax cost. In some cases, the companies no doubt find that rewarding their employees with
qualified stock options is worth the cost; in other cases, perhaps, the officers and employees who
receive the options exercise special influence over the companies’ compensation policies.
If the stock is not held for the required two years from the granting of the option and one year
from its exercise, special rules apply. The employee is taxed at ordinary income tax rates instead
of capital gains rates on the difference between the price paid for the stock and its market value
either when the option was exercised or when the stock was sold, whichever is less. The company
is then allowed a deduction just as if the employee’s taxable gain were ordinary compensation
paid in the year the stock is sold.
Imposing the alternative minimum tax on incentive stock options reduces their tax advantage; for
persons paying the AMT, the tax treatment is similar to the regular tax treatment of nonqualified 90
options. In some cases, individuals have incurred a significant tax liability from exercising their
incentive stock options but had not sold their stock before the price dramatically declined. The
alternative minimum tax in combination with other rules could cause a large tax liability that 91
could not be offset with an offsetting loss when the stock price fell. On December 20, 2006, this
“unfair” situation was solved by passage of the Tax Relief Act and Health Care Act of 2006 (H.R.
90 For a description of the alternative minimum tax, see CRS Report RL30149, The Alternative Minimum Tax for
Individuals, by Steven Maguire.
91 For a full explanation of this issue, see CRS Report RS20874, Taxes and Incentive Stock Options, by Jane G.
Incentive stock options (IRC Section 422) must be granted in accordance with a written plan
approved by the shareholders. The plan must designate the number of shares to be subject to the
options and specify the classes of employees eligible to participate in the plan. The options must
be exercised within 10 years from the grant date. The market value of the stock for any incentive
stock options exercisable in any year is limited to $100,000 for any individual. This is the limit on
the amount that receives favorable tax treatment, not on the amount that may be granted; options
for stock exceeding $100,000 in market value are treated as nonqualifying options. There are
additional restrictions for options granted to persons owning more than 10% of the outstanding
stock. The value of incentive stock options is included in minimum taxable income in the year of
The tax code (IRC Section 422) states that “the option price is not less than the fair market value
of the stock at the time such option is granted.” But the code (IRC Section 422) also states the this
requirement is met if there are “good faith efforts to value stock.”
An employee stock purchase plan (IRC Section 423) must also be a written plan approved by the
shareholders, but this type of plan must generally cover all full-time employees with at least two
years of service (or all except highly compensated employees). It must exclude any employee
who owns (or would own after exercising the options) 5% or more of the company’s stock. The
option price must be at least 85% of the fair market value of the stock either when the option is
granted or when it is exercised, whichever is less. The options must be exercised within a limited
time (no more than five years). The plan must not allow any employee to accrue rights to
purchase more than $25,000 in stock in any year.
Literature about backdating can be divided into academic studies and Wall Street Journal (WSJ)
articles. The academic work provided the statistical verification of the hypothesis of backdating.
Initially, the academic work did not specific any particular corporations involved in backdating.
Articles in the Wall Street Journal named specific corporations that had backdated their stock
options. Furthermore, these WSJ articles provided widespread publicity for the backdating issue
to both the business community and the general public.
Professor Erik Lie, currently on the faculty of the University of Iowa, initially formulated the
hypothesis that some companies, without disclosure, backdated dates for grants of options to 92
times when prices of their stock were low. Dr. Lie wrote an article titled “On the Timing of CEO
Stock Options Awards,” which included an empirical analysis supporting his backdating 93
hypothesis, and sent a copy of this article to the SEC in 2004. In May 2005, his article was 94
published in Management Science.
Dr. Lie indicates that “the board of directors of a company generally assigns the administration of 95
the [stock option] grants of the stock option plan to the compensation committee.” Executives,
however, may be able to influence the decisions of the committee because executives often
propose parameters of stock option grants, executives often have close personal friendships with
some committee members, and executives may influence the timing of compensation committee 96
meetings. Using a sample of almost 6,000 stock option grants to chief executive officers (CEOs)
between 1981 and 1992, he conducted several statistical analyses and concluded “that the 97
abnormal stock returns are negative before the award dates and positive afterward.” These
findings were consistent with his hypothesis of backdating of stock options without disclosure.
The publication of Dr. Lie’s article led to SEC investigations of the timing of the granting of stock
options by certain companies.
In their forthcoming article in the Journal of Financial Economics titled “Does Backdating
Explain the Stock Price Patten Around Executive Stock Option Grants?,” Professor Randall A.
Heron and Professor Erik Lie examined the frequency of backdating of stock options since 98
August 29, 2002, when the Sarbanes-Oxley Act (P.L. 107-204) mandated that the SEC change
92 Steve Stecklow, “Options Study Becomes Required Reading,” Wall Street Journal, May 30, 2006, p. B1.
94 Erik Lie, “On the Timing of CEO Stock Option Awards,” Management Science, vol. 51, no. 5, May 2005, pp. 802-
95 Ibid., p. 803.
97 Ibid., p. 810.
98 The Sarbanes-Oxley Act was passed on July 30, 2002.
the reporting regulations for stock option grants.99 Before the change, executives receiving stock 100
options had up to 45 days after the end of the company’s fiscal year to report them to the SEC.
After August 29, 2002, recipients of stock options must report them to the SEC within two
business days of receiving the grant. One day after receiving this information, the SEC makes it
public, and now firms with corporate websites are required to post this information on the day
after they disclose it to the SEC. The authors stated that
if backdating produced the abnormal return patterns around executive option grants, we
hypothesize that the new reporting requirements should substantially dampen the abnormal 101
return patterns that previously had been intensifying over time.
Heron and Lie utilized a large sample of stock option grants to CEOs between August 29, 2002,
and November 30, 2004, and compared this sample with a large sample from January 1, 2000, to
August 28, 2002. The authors concluded that
Overall, we find evidence suggesting that backdating is the major source of the abnormal
stock return patterns around executive stock option grants. Our evidence further suggests that
the new reporting requirements have greatly curbed backdating, but have not eliminated it.
To eliminate backdating, it appears that the requirements need to be tightened further, such
that grants have to be reported on the grant day or, at the latest, on the day thereafter. In 102
addition, the SEC naturally has to enforce the requirements.
Thus, the authors found that while the undisclosed backdating of stock options still occurs, it was
far more prevalent before new reporting regulations took effect on August 29, 2002.
On July 14, 2006, Professor Randall A. Heron and Professor Erik Lie published a working paper
based on a sample of 39,888 stock option grants of 7,774 companies to top executives, which 103
were dated between January 1, 1996 and December 1, 2005. (Top executives consisted of
CEOs, Presidents, and Chairmen of the Board.) The authors estimated that before August 29,
grants were backdated. But from August 29, 2002 through December 1, 2005, only an 105
estimated 10.0% of this type of stock option grants were backdated. The authors estimated that
99 Randall A. Heron and Erik Lie, “Does Backdating Explain the Stock Price Pattern Around Executive Stock Option
Grants?,” Journal of Financial Economics, vol. 83, no. 2, pp. 2-3. This article is available at http://www.biz.uiowa.edu/
faculty/elie/GrantsJFE.pdf, visited Jan. 2, 2008.
100 Ibid., p. 3.
101 Ibid., p. 3.
102 Ibid., p. 30.
103 Heron and Lie, “What Fraction of Stock Option Grants to Top Executives Have Been Backdated or Manipulated?”,
Working Paper, College of Business, Univ. of Iowa, pp. 4-5.
104 Ibid., p. 13.
106 Ibid., p. 4.
In January 2005, Professors M.P. Narayanan and H. Nejat Seyhun published a University of
Michigan working paper titled “Do Managers Influence Their Pay? Evidence from Stock Price 107
Reversals around Executive Option Grants.” The authors tested their hypothesis that managers
influence the grant date stock price for their stock options. They used a data base of 605,106
option grant filings by insiders between 1992 and 2002. The authors found that the abnormal
stock return reversals on the grant date were consistent with the influence hypothesis. They found
that “the market-adjusted return for the 90 days preceding the grant date is about—3.6% and the 108
return for the 90 days following the grant date is about 9.4%.” The authors concluded that the
much smaller absolute value of the return before the grant date than after the grant date suggested
that the firms were engaged in behavior that went beyond controlling the timing of the grants and 109
the timing of corporate information disclosures. The authors also advanced the hypothesis “that
grant dates are set on a ‘back-date’ basis, that is in many cases, the lowest stock price during a 110
window is picked as the grant date ex-post.” They found statistical evidence that was consistent 111
with their backdating hypothesis.
Professors M.P. Narayanan, Cindy A. Schipani, and H. Nejat Seyhun wrote an article titled “The 112
Economic Impact of Backdating of Executive Stock Options,” in the Michigan Law Review.
discuss four consequences of misdating that can adversely impact shareholder value: 1)
Legal issues: There are legal consequences arising from backdating or forward-dating
without complete disclosure. In addition, the ethical issues raised might have economic
consequences as they undermine the investors’ confidence in the top executives; 2) Tax
issues: The tax treatment of in-the-money options with implications for both the company
and its executives; 3) Corporate disclosure issues: Disclosure of misdating practices can lead
to restatement of earnings as the camouflaged pay is recognized as compensation expense.
The reduced earnings can result in a downward reassessment of shareholder value; and 4)
Incentive issues: Misdating amounts to stealth compensation. If this is done because
executives have captured the compensation process, then the managers are being 113
inefficiently compensated, resulting in incorrect incentives.
The authors computed that the upper bound of the average benefit from potential backdating was
$3 million for executives based on a sample of 39,864 option grants from 43 firms listed on a 114
Wall Street Journal website. In comparison, these firms experienced an average loss of $510
107 M.P. Narayanan and H. Nejat Seyhun, “Do Managers Influence Their Pay? Evidence from Stock Price Reversals
around Executive Option Grants,” Working Paper No. 927, Ross School of Business, University of Michigan, Jan.
2005, 52 p.
108 Ibid., p. 30.
109 Ibid., p. 24.
110 Ibid., p. 4.
111 Ibid., pp. 25-27.
112 M.P. Narayanan, Cindy A. Schipani, and H. Nejat Seyhun, “The Economic Impact of Backdating of Executive
Stock Options, Michigan Law Review, June 2007, available at SSRN: http://ssrn.com/abstract=931889.
113 Ibid., p. 4.
114 Ibid., p. 40.
million in the value of their outstanding stock as a result of being implicated in backdating of 115
Professors Lucian Bebchuk, Yaniv Grinstein, and Urs Peyer, examined what they called “lucky”
grants, which they defined at stock option grants given at the lowest price of the stock during the 116
month. They found that during the period 1996-2005, about 1,150 lucky grants to 850 CEOs
(about 10% of all CEOs) and provided by about 720 firms (about 12% of all firms) involved 117
opportunistic timing, primarily backdating. The percentage of “lucky grants” declined from 118
The authors identified links between the manipulation of the timing of granting stock options and
business governance. The authors state that
Lucky grants are more likely to occur when the firm lacks a majority of independent
directors and when the CEO has longer tenure, both factors associated with greater CEO
influence on the company’s pay-setting and governance processes. Relatedly, we [the
authors] find that CEOs receiving lucky grants also receive total compensation from other
sources that is higher relative to peer firms, thus finding no evidence that extra gains from 119
grant timing manipulation was used by firms as a substitute for other compensation forms.
The authors also found links between the manipulation of the timing of stock options and the
potential gains from this manipulation.
Not only is manipulation more common in firms with higher stock price volatility, but it is
also more likely to occur, for a given CEO and firm, in months in which the potential gain
from it is higher relative to other times. Our analysis also highlights the existence of serial
luck. Luck is persistent with CEOs more likely being lucky in their next grant when their 120
prior grant was lucky.
Finally, the authors concluded that “by providing estimates of the substantial incidence of lucky
grants, firms, and CEOs in old economy firms, ... [their] analysis dispels the impression that grant 121
manipulation is concentrated in new economy firms.”
Professors Lucian Bebchuk, Yaniv Grinstein, and Urs Peyer analyzed whether or not outside
directors received option grants involving opportunistic timing; that is, timing manipulation.
Their sample consisted of “all grants given to directors of the about 6,000 public companies in the
115 Ibid., p. 48.
116 Lucian Bebchuk, Yaniv Grinstein, and Urs Peyer, “Lucky CEOs,” Working Paper, Harvard Law School, Last
revision: Nov. 16, 2006, 55 p. Available at http://www.law.harvard.edu/faculty/bebchuk/.
117 Ibid., p. 2.
118 Ibid., p. 36.
119 Ibid., p. 35.
120 Ibid, p. 36.
121 Ibid., p. 36.
Thompson database during the decade of 1996-2005.”122 The authors found that 804 grant events
during this period were due to opportunistic timing rather than mere luck, and 457 firms (7.1% of 123
all firms) were involved. The percentage of these lucky grant events was 35.7% before SOX 124
and 25.4% after SOX. An estimated 1,389 directors (or 4.6% of all directors) received one or 125
more opportunistically timed grants. Several statistical tests were consistent with the
hypothesis that backdating played a significant role in opportunistic timing grants of options that 126
benefitted directors. The authors acknowledge that their methodology does not measure timing 127
manipulation of stock options that occurred in “small look-back periods.” In contrast, some
other studies measure all timing manipulation of options regardless of the time period.
Furthermore, the authors state that their analysis “does not show what role, if any, outside 128
directors played in the opportunistic timing of their own grants.”
Professor Gennaro Bernile, Professor Gregg Jarrell, and Howard Mulcahey analyzed the effect of 129
the options backdating scandal on the stock-price performance of 110 companies. They
examined the stock prices of 110 companies involved in the options backdating scandal that were
named on a web page posted by the Wall Street Journal. The authors estimated that the
cumulative abnormal return for these 110 companies over a period of 140 trading days was
negative 25.86%, which equaled a loss in the value of stock of over $100 billion. These 140
trading days consisted of 60 days before and 80 days after the first company disclosure about
option-backdating. For the period of May 16, 2005 through November 15, 2006 (100 trading days
before and 380 trading days after Erik Lie’s initial backdating article), the authors calculated a
cumulative abnormal return for the companies of negative 54.14%, which equaled a loss in the
value of stock of approximately $250 billion.
Dr. Lie’s articles did not mention any company by name, but his hypothesis of backdating of
stock options without disclosure was tested for five corporations by Charles Forelle and James 130
Bandler in an article in The Wall Street Journal on March 18, 2006. These authors examined
the timing of stock option grants for five corporations. In each case, stock options were granted
on dates when prices were extremely low. The authors concluded that the likelihood of this 131
“happening by chance was extraordinarily remote.” For example, one CEO received six stock-
122 Bebchuk, Grinstein, and Peyer, “Lucky Directors,” p. 3.
123 Ibid., pp. 15-16.
124 Ibid., p. 15.
125 Ibid., p. 16.
126 Ibid., p. 19.
127 Ibid., p. 7.
128 Ibid., p. 8.
129 Gennaro Bernile, Gregg Jarrell, and Howard Mulcahey, “The Effect of the Options Backdating Scandal on the
Stock-Price Performance of 110 Accused Companies,” Working Paper, Simon School at Univ. of Rochester, Dec. 21,
2006, 18 p. Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=952524.
130 Charles Forelle and James Bandler, “The Perfect Payday; Some CEOs Reap Millions by Landing Stock Options
When They Are Most Valuable; Luck—or Something Else?,” Wall Street Journal, March 18, 2006, p. A1.
option grants from 1995 to 2002, which occurred at dates when the stock price was unusually 132
low. The author found that the probability of these dates being selected by chance was around
one in 300 billion.
On May 22, 2006, Charles Forelle and James Bankler wrote a second article in The Wall Street 133
Journal concerning backdating of stock options without disclosure. The authors identified five 134
more companies “with highly improbable patterns of options grants.”
133 Charles Forelle and James Bandler, “Matter of Timing: Five More Companies Show Questionable Options
Pattern—Chip Industry’s KLA-Tencor Among Firms with Grants before Stock-Price Jumps—A 20 Million-to-One
Shot,” May 22, 2006, p. A1.
This appendix briefly summarizes several significant studies of other forms of the timing of stock
Professor David Yermack wrote the first article concerning the manipulation of the timing of 135
stock options. He formulated the hypothesis that some CEOs arranged for the award of the
stock option to occur shortly before public announcements of positive information about their
companies. This concept was later called spring-loading. In order to test his hypothesis, he used a
sample of 620 stock option awards to CEOs of Fortune 500 companies between 1992 and 1994.
At a 1% level of significance, he found that the average abnormal increase in option award value 136
was $30,000 after 20 trading days and $48,900 after 50 trading days.
Professors Keith W. Chauvin and Catherine Shenoy analyzed abnormal stock price decreases 137
prior to executive stock option grants. They developed the hypothesis that executives cause bad
news to be released prior to the time that options are granted in order to set the strike price of the
options at a lower level. This negative information could be in the form of a formal public
announcement, or else insiders “can put a more negative ‘spin’ on information than otherwise,
speak ‘off the record’ to analysts, or strategically use rumor and innuendo to ‘leak’ information.”
The authors statistically analyzed a sample of 783 stock option grants from May 1991 to February
Professors David Aboody and Ron Kasznik investigated their hypothesis “that CEOs manage
investors’ expectations around fixed dates of scheduled awards for their stock options by delaying 139
good news and rushing forward bad news. The authors tested their hypothesis by using a 140
sample of 2,039 stock option awards made between 1992 and 1996 to the CEOs of 572 firms.”
The authors concluded that “overall, our findings provide evidence that CEOs of firms with
135 David Yermack, “Good Timing: CEO Stock Option Awards and Company News Announcements,” Journal of
Finance, vol. 52, no. 2, June 1997, pp. 449-476.
136 Ibid., p. 458.
137 Keith W. Chauvin and Catherine Shenoy, “Stock Price Decreases Prior to Executive Stock Option Grants,” Journal
of Corporate Finance, vol.7, no. 1, March 2001, pp. 53-76.
138 Ibid., p. 74.
139 David Aboody and Ron Kasznik, “CEO Stock Awards and the Timing of Corporate Voluntary Disclosures,”
Journal of Accounting and Economics, vol. 29, no. 1, Feb. 2000, pp. 73-100.
140 Ibid., pp. 73-74.
scheduled awards make opportunistic voluntary disclosures that maximize their stock option 141
Professors Sandra Renfro Callaghan, P. Jane Saly, and Chandra Subramaniam investigated the
hypothesis that executive stock option repricings were systematically timed to coincide with 142
favorable movements in the company’s stock price. If the exercise price of the stock options
falls well below the market price of the stock, some executives maintain that the stock options 143
should be repriced in order to “retain valued employees and to restore incentives.” The authors
used a sample of 236 repricing of options for 166 companies from the period 1992 through 144
conjunction with the release of corporate news. Executives who anticipated favorable earnings
reports repriced their option prior to the public announcement of the report. Conversely,
executives who anticipated negative earnings reports repriced their options after the public release
James M. Bickley Gary Shorter
Specialist in Public Finance Specialist in Financial Economics
firstname.lastname@example.org, 7-7794 email@example.com, 7-7772
141 Ibid., p. 98.
142 Sandra Renfro Callaghan, P. Jane Saly, and Chandra Subramaniam, “The Timing of Option Repricing,” Journal of
Finance, vol. 59, no. 4, Aug. 2004, pp. 1,651-1,676.
143 Ibid., p. 1,651.
144 Ibid., p. 1,654.
145 Ibid., p. 1,674.