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The Demise Of Backdating
by Winter Casey
Increased scrutiny by regulators and the media has forced most companies to end the practice of backdating stock options, experts say. Yet the legal ramifications of backdating are expected to go on for many years and have resulted in significant costs for the companies found to be involved in the practice.
Backdating involves marking a stock option document with a date that precedes the date when the decision to grant the option was actually made without adequately reflecting the resulting compensation on financial statements. According to experts, factors that have contributed to the demise of backdating include legal regulation and the attention drawn to the subject by the media, investor groups and accounting advisers, as well as the threat of civil and criminal litigation.
How exactly the legal system will punish those found to have been involved in backdating is not yet known. Other factors that remain unknown include how much the practice will eventually cost the technology sector and how many companies will be investigated.
Awareness of the backdating phenomena is largely credited to the research of academics from the University of Iowa, Indiana University, and a series of Wall Street Journal articles.
The research firm Glass Lewis found that as of March 16, at least 257 companies have announced internal reviews, Securities and Exchange Commission inquiries, or Justice Department subpoenas related to their stock-option granting practices.
Among the tech companies currently under investigation for the practice include Affiliated Computer Services, Apple, Broadcom, Cablevision, Mercury Interactive, and VeriSign, according to The Wall Street Journal. And Indiana University business professor Randall Heron said he expects a significant number of new investigations to be launched.
According to a July 10 Journal story, 10 executives at six companies have been charged with criminal offenses related to backdating. Five of the executives have pleaded guilty, one has fled the country and three are awaiting trial.
It is not yet known whether courts will consider backdating to be a criminal offense, The Mercury News reported Friday. U.S. District Judge Charles Breyer has not indicated when he will decide whether to dismiss the first criminal stock-option backdating trial of former Brocade Communications Systems Chief Executive Gregory Reyes, the paper said. The judge has given the case to a jury.
Reyes was charged last summer with misleading investors and regulators and failing to disclose from 2000 to 2004 the impact of granting discounted options on Brocade's financial documents.
"Actions against individual executives largely has been limited to people who intentionally backdated options in egregious circumstances," said Michael Stevens, a partner who specializes in executive compensation at Alston & Bird's Atlanta office. Patrick Conroy, vice president at the economic consulting firm NERA, said it would be many years before all of the litigation related to backdating is resolved.
Why Did Companies Backdate?
In some backdating cases, the attempt to deceive or defraud was blatant, while in others it is less clear whether there was a strong intention to do wrong, legal experts said. Iowa University accounting professor Daniel Collins said that in certain cases a company might have made its backdating practices known but still failed to account for it properly.
Still, Stevens said there are cases of both intentional and unintentional backdating.
"Intentional backdating involves purposely selecting a date when the stock price was low and maintaining that an option was granted 'as of' that prior date," he said. "This is not illegal or inherently wrong provided that the financial statements adequately reflected the resulting compensation charge, the public disclosures accurately reflected the practice, and issuing a below-market priced option was permitted by the terms of the applicable plan. As a practical matter, this confluence of circumstances would have been rare."
Stevens added that unintentional backdating "could result from lax corporate procedures, such as using unanimous consent actions for granting options but not having all directors sign on the same day, or the compensation committee failing to set all material terms on the intended date of grant."
Collins said some companies did not account for backdating properly in order to hide the practice from shareholders. Some firms have argued that backdating was beneficial for the company as another way to attract and retain talent by increasing the financial gains of executives who were the recipients of stock option grants, Heron said.
The Corporate Library, a research firm, said in the fall of 2006 that the backdating phenomena could have been spread through directors sitting on the boards of multiple companies.
Stevens said backdating was a particularly difficult issue for the tech community because of the widespread use of options, the rapid stock gains during the dot.com boom, and the lack of rigorous grant practices in certain companies. However, backdating certainly was not universal in the technology industry and most companies were doing the right thing, he added.
Backdating Storm Spurs Accounting Changes
New accounting rules and awareness of the issue have drastically decreased if not eliminated backdating, experts said.
Stevens said research has indicated that the backdating phenomenon was especially prevalent during the stock market boom of the 1990s and largely stopped with the adoption of the accounting law known as the Sarbanes-Oxley Act in 2002, which amended a section of the Securities Exchange Act of 1934 to require two-day reporting of option awards. "These new legal requirements drastically diminished the opportunities for bad actors to intentionally backdate options," he said.
A June 2007 paper published in the Financial Analysts Journal found that the recent changes in reporting requirements associated with the Sarbanes-Oxley law have improved the transparency of executive compensation practices and removed some of the incentives to backdate options. The research also noted, however, that through the end of 2005, stock option forms were still filed late with the SEC and backdating was still going on, despite the two-day reporting requirement. The SEC has increased its enforcement to reduce this problem, Heron said.
The journal paper, co-authored by Heron, Erik Lie of Iowa University and Tod Perry of Indiana University, said the implementation of a requirement to expense option grants at the fair value price has minimized the incentive to backdate. The SEC also has adopted changes to executive compensation disclosure rules that have reduced the practice of backdating, Heron said.
"Many companies have adopted option grant policies which provide for regular grant dates and are intended to avoid the allegation that the company has backdated options" to take advantage of non-public information, Stevens said.
While the federal government and businesses have looked to strengthen accounting standards and legal requirements, experts contend that only time will tell whether the United States will see more accounting scandals of the magnitude of the past decade.
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