Accounting & Tax

SEC Looking at Backdated Options Grants

Backdating is not illegal, but it does boost gains and could signal disclosure problems.
Stephen TaubNovember 11, 2005

The Securities and Exchange Commission, which has been investigating the uncanny timing of some options grants, is now looking into whether companies improperly backdated the grants to provide recipients a nice windfall, according to The Wall Street Journal.

Reportedly, SEC officials are looking at about a dozen companies and investigating whether management engaged in backdating. One of the companies is Mercury Interactive Corp., which earlier this month announced that three top executives had resigned after an internal investigation found a long history of stock-option-grant manipulation.

The Journal noted that backdating is not illegal. However, it does boost gains. Furthermore, Alan Dye, a securities attorney at Hogan and Hartson LLP in Washington, told the paper that the practice could raise disclosure issues. For example, a company that reports in proxy statements that the strike prices for options are equal to the market value on the date of a grant could then select a different grant date to help option holders capitalize on a lower market value.

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The initial SEC probe into options-granting practices stems from academic studies that found that several companies had granted options to top executives shortly before the companies announced good news. This would almost instantly provide a paper gain for the recipients. If the stock goes up, it would also increase their real gain when the options are exercised, explained the paper.

“The whole point of a stock option is that you only profit if the stock goes up,” David Yermack, an associate professor at New York University’s Stern School of Business, told the Journal. Yermack is one of a handful of academics who have done research on option-grant timing. “If you fix it in advance so that it’s already deep in the money, it eliminates a lot of the risk,” he added.

In another study, Erik Lie, a finance professor at the University of Iowa’s school of business, and Randall Heron of Indiana University’s business school, found that the unusual timing essentially stopped after August 2002, thanks to the Sarbanes-Oxley Act, which requires executives to report option grants within two days, instead of the weeks or months previously allowed. With less leeway to choose a favorable grant date, “most of the effect disappeared,” said Lie.

Lie also said that any backdating likely occurred at only a small fraction of companies.

David Aboody, an associate professor at UCLA’s Anderson School of Management, discounted the Lie-Heron study findings, reported the Journal. Aboody, who has also studied option-grant timing, asserted that he would be “shocked” if backdating was a systemic practice, arguing that to get the large aggregate effect that Lie cited in another report, hundreds of companies would have had to engage in backdating, which Aboody thinks is absurd.

Companies that have disclosed SEC investigations of their options-granting practices in general include Mercury, Brocade Communications Systems Inc., Siebel Systems Inc., Nyfix Inc., and Analog Devices Inc. However, no charges have been filed against any companies related to the probe.