Backdated Options Scandal

1
Backdated Options Scandal

• Khuderchuluun Batsukh
• Kim Dignan

2
I-Clicker Question

• What is a backdated option?
• A. An option granted to an employee, which has
  a date prior to the issuing date printed on
  it.
• B. An option that is past its expiration date.
• C. An option whose expiration date is adjusted
  in favor of an executive.
• D. I have no idea

3
What is backdating?

• The practice of marking a stock option with a
  date that precedes the actual date.
• These backdated options given to employees (often
  top level) of company
• Essentially, the option recipient chooses the
  date which would be most profitable

4
History

• In 1992, the SEC obligated all companies to
  disclose the exact dates of option grants
• NYU professor David Yermack studied data in 1995,
  and noticed a peculiar pattern.
• In 2004, University of Iowa professor Erik Lie
  noted that many option grants were timed to
  exploit market-wide price decreases (that no one
  could have predicted!)
• Concluded that some of the options must have been
  retroactive.

5
History

• Obviously, the pattern of share prices rising
  after options granted had not gone unnoticed.
• But, wasnt a scandal until nowwhy?
• Enron and Arthur Anderson
• Publics outrage over top managements
  compensation level
• In late 2005, many financial analysts compiled
  lists of companies whose actions were deemed
  suspicious

6
I-Clicker Question

• Is backdating options illegal?
• A. Yes
• B. No
• C. It Depends on the circumstances

7
Legal Issues

• The act of backdating options, itself, is not
  illegal.
• The practice only becomes illegal when a
  companys shareholders have been mislead as a
  result.
• For example, many public companies grant stock
  options according to formal stock option plans
  approved by shareholders at annual meeting.
• If issue is listed with a strike price lower than
  the current stock price, then it goes against
  policy

8
Legal Issues

• Backdated options may also lead to accounting
  errors.
• If a company grants a stock option to an employee
  with a price below fair market value, then they
  must put it on the books as a compensation
  expense.
• If compensation not accounted for, can lead to
  misleading quarterly and annual statements.

9
Legal Issues

• Majority of options backdating took place in the
  1990s
• In 2002, the Sarbanes-Oxley Act was passed
• Required that option grants given to senior
  management must be reported within 2 days
• Short time frame leaves little room for
  backdating

10
Recognition of Backdated Options

• Strange movements of stock prices around
  executive stock options.
• Stock prices tend to increase shortly after the
  grant date.
• Stock prices tend to decrease unusually before
  the grant date.
• Can be hard to identify.

11
Grant Date Selection
12
Firms that Backdate their Options

• Backdating practice takes place mostly in
• - Publicly traded corporations (1990)
• - Tech Firms
• - Small Firms
• - Firms with High Stock Price Volatility

13
Statistical Facts

• Analysis, conducted by Professor Erik Lie and
  Randall A. Heron of Kelly School of Business,
  estimates that
• - 29.2 of companies have used backdated
  options between 1999 and 2005.
• - 13.6 of options granted to top executives
  from 1996 to 2005 were backdated or otherwise
  manipulated.

14
Home Depot

• Admitted to backdating options from 1981-2000
• Practice stopped after new CEO came to the
  company in 2000
• Led to an understatement of compensation expense
  of more than 200 million
• Just one of many well-known companies involved in
  backdating

15
Why Do Firms Practice Back-Dated Options?

• Exploits a lower stock price.
• Reduces the risk of share price going
  down.

16
In Reality

• If you were an executive of a firm,
• would you participate in backdating?
• A. Yes
• B. No
• C. Maybe

17
In Reality

• According to the analysts, only a minority of
  firms that have engaged in backdating of option
  grants will be caught. In other words, we will
  never see the full iceberg.