Stock Options: The Backdating Issue
Congressional research reportJan 2, 2008
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Text
Order Code RL33926
Stock Options: The Backdating Issue
Updated January 2, 2008
James M. Bickley and Gary Shorter
Specialists in Economics
Government and Finance Division
Stock Options: The Backdating Issue
Summary
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 investigative journalists.
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.
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Illustration of Undisclosed Backdating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Types of Stock Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Nonqualified Stock Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Qualified Stock Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Growth of Stock Options in the 1990s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
The Omnibus Budget Reconciliation Act of 1993 . . . . . . . . . . . . . . . . . . . . . 6
Higher Marginal Individual Income Tax Rates . . . . . . . . . . . . . . . . . . . 6
“Excessive Remuneration” — Section 162(m) . . . . . . . . . . . . . . . . . . . 6
The Stock Market Boom of the 1990s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Cost Accounting Rules for Certain Stock Options . . . . . . . . . . . . . . . . . . . . 8
The Extent of Timing Manipulation of Options . . . . . . . . . . . . . . . . . . . . . . . . . . 9
The Potential Costs of Backdating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Costs to Shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Costs from Earnings Hits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Costs of Reduced Executive Performance . . . . . . . . . . . . . . . . . . . . . . 10
Costs from Delistings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Costs from the Actions of Bondholders . . . . . . . . . . . . . . . . . . . . . . . . 10
Costs of Additional Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Costs of Probes, Fines, and Lawsuits . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Employees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Bondholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Taxpayers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Key Legislative and Regulatory Developments . . . . . . . . . . . . . . . . . . . . . . . . . . 12
American Jobs Creation Act of 2004 (Section 409A) . . . . . . . . . . . . . . . . . 13
FASB Rule for Expensing Stock Options . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Sarbanes-Oxley Act: Stock Option Disclosure Reforms . . . . . . . . . . . . . . . 14
SEC’s 2003 Requirement of Approval of Compensation Plans . . . . . . . . . 14
SEC’s 2006 Executive Compensation Disclosure Rules . . . . . . . . . . . . . . . 14
Gatekeepers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Corporate Boards and Compensation Committees . . . . . . . . . . . . . . . . . . . 16
Outside Auditors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Securities and Exchange Commission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Late Filings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
The Question of the SEC’s Alertness to Misconduct . . . . . . . . . . . . . 23
Potential Policy Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Improve Enforcement of Timely Filing of Option Awards . . . . . . . . . . . . . 24
Require Same Day Filing of Option Grants . . . . . . . . . . . . . . . . . . . . . . . . . 24
Require Scheduling of Grants of Executive Stock Options . . . . . . . . . . . . . 25
Ban Equity-based Pay for Top Attorneys and Board Members . . . . . . . . . . 25
Increase Shareholder Roles in the Election of Board Members . . . . . . . . . . 26
Eliminate the Cap on Deduction for Executive Pay . . . . . . . . . . . . . . . . . . 27
Appendix A: Other Forms of Timing Manipulation . . . . . . . . . . . . . . . . . . . . . . 28
Appendix B: Qualified Stock Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Incentive Stock Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Employee Stock Purchase Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Appendix C: Literature about Backdating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Academic Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Erik Lie . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Heron and Lie (article) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Heron and Lie (working paper) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Narayanan and Seyhun . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Narayanan, Schipani, and Seyhun . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Bebchuk, Grinstein, and Peyer (Lucky CEOs) . . . . . . . . . . . . . . . . . . . 34
Bebchuk, Grinstein, and Peyer (Lucky Directors) . . . . . . . . . . . . . . . . 35
Bernile, Jarrell, and Mulcahey . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Wall Street Journal Articles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Appendix D: Literature about Other Types of Timing Manipulation . . . . . . . . . 37
Yermack (Spring-Loading) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Chauvin and Shenoy (Manipulation of Information Flow) . . . . . . . . . . . . . 37
Aboody and Kasznik (Manipulation of Information Flow) . . . . . . . . . . . . . 37
Callaghan, Saly, and Subramaniam (Timing of Repricing) . . . . . . . . . . . . . 38
Stock Options: The Backdating Issue
Introduction
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-themoney” (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 taxes — central concerns of the Internal Revenue Service (IRS).1
1
Eric Dash, “Dodging Taxes Is a New Stock Options Scheme,” New York Times, Oct. 30,
(continued...)
CRS-2
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 negative accounting and tax complications.2
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 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 tending to the formalities
that drive the setting of grant dates.3
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 potential financial fraud.4
On September 18, 2007, the deputy director of the SEC’s Division of Enforcement
stated that backdating continued to be a main focus area for his division in 2007.5
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 26 former executives associated with 15 firms and the
DOJ has reportedly brought at least 10 criminal filings against defendants for
backdating.7 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.
1
(...continued)
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.
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 at [http://online.wsj.com/public/resources/documents/infooptionsscore06-full.html].
7
Therese Poletti, “Buck Stops Here Rhetoric Doesn’t Wash,” MarketWatch, Dec. 13, 2007.
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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
previously surrendered.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. Securities and Exchange Commission related to the alleged
backdating.9 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 pending.
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/optionsbackdating.htm].
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,
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.
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the potential costs of backdating, key legislative and regulatory developments,
gatekeepers, and potential policy options.
Illustration of Undisclosed Backdating
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 been backdated.
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, 1998, when the stock price was at its low for
the year ($30).10 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 SEC.
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 exercising his options at any time until
December 31, 2008). He pays ABC $300,000 ($30 X 10,000). He has an immediate
gain of $450,000 ($45 X 10,000 shares) on paper. Assuming that these are
nonqualified stock options,11 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.
Types of Stock Options
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
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.
11
Nonqualified options are defined in the next section of this report.
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taxed to the employee as wage income when their value can be unambiguously
established (which IRS says is when they are no longer at risk of forfeiture and can
be freely transferred).12 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 Stock Options
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 gains.
Qualified Stock Options
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 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
12
Nonqualified options are not guaranteed; that is, they have no value if the company goes
bankrupt.
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value of incentive stock options is included in minimum taxable income in the year
of exercise.13
Growth of Stock Options in the 1990s
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 accounting rules.
The Omnibus Budget Reconciliation Act of 1993
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.
Higher Marginal Individual Income Tax Rates. 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 deficit, to improve tax equity, and to make the individual income
tax system more progressive.”14 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 marginal tax rate for 2007 is 35%.15
“Excessive Remuneration” — Section 162(m). 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 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 executives of publicly held
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.
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corporations is limited to $1 million per year.”16 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 outside directors.
!
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 that the performance goals and any other
material terms were in fact satisfied.17
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 relative importance of performance-related compensation
including stock options.18 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
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.
CRS-8
cheese-like rule. I want to know what went wrong and consider whether it makes
sense to make changes.19
SEC Chairman Christopher Cox testified that
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 consequences.20
The Stock Market Boom of the 1990s
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 been reduced.21
Cost Accounting Rules for Certain Stock Options
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 option grant awards.22
19
“Grassley Takes Aim at Stock Options Backdating, Executive Pay,” Press Release from
Senator Grassley’s Office, Sept. 6, 2006.
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.
CRS-9
The Extent of Timing Manipulation of Options
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.
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 companies.
The Potential Costs of Backdating
Corporate executives appear to have profited handsomely from undisclosed
backdating, although they may ultimately be faced with a number of costs related to
such actions.23 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.
Costs to Shareholders
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.
Costs from Earnings Hits. Firms where backdating is detected may have
to adjust to the accounting shortfall by downward restatements of previous earnings
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.
CRS-10
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 value
of the stock of 110 corporations by at least $100 billion.24
Costs of Reduced Executive Performance. 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.
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.
Costs from Delistings. 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 low and
volatile stock prices, and high trading costs.25
Costs from the Actions of Bondholders. 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
24
Bernile, Jarrell, and Mulcahey, “The Effect of the Options Backdating Scandal on the
Stock-Price Performance of 110 Accused Companies,” p. 11.
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.
CRS-11
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.
Costs of Additional Taxes. 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
immediate paper profits and are not treated like performance-based options, making
them ineligible for such deductions.
Costs of Probes, Fines, and Lawsuits. 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
significant fines.26 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.
Employees
Some employees may not be aware that their stock options have been backdated.
Consequently, they may be liable “for unanticipated tax as well as interest and
penalties.”27 Some companies distributed stock options to many levels of employees
without disclosing to these employees (or the public) that their options had been
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.
CRS-12
backdated.28 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 the higher regular income tax and the capital gains tax, plus interest.29
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 409A of the tax code applies, and tax is
due when options vest rather than when they were exercised. Thus, these employees
may also be liable for a 20% penalty and interest.30
Bondholders
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.
Taxpayers
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.
Key Legislative and Regulatory Developments
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.
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.
30
Ibid.
CRS-13
American Jobs Creation Act of 2004 (Section 409A)
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 response to perceived abuses by executive
employees in the recent wave of corporate scandals.”31 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
underlying stock on the date the stock appreciation rights are granted.32 Section
409A generally provides that
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 and not previously included in gross income,
unless certain requirements are met.33
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.
FASB Rule for Expensing 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 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 reduce the overall level of
option awards.35
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 [http://www.irs.gov/irb/200629_IRB/ar11.html].
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
(continued...)
CRS-14
Sarbanes-Oxley Act: Stock Option Disclosure Reforms
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 within the two day
period.36
SEC’s 2003 Requirement of Approval of Compensation Plans
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.
SEC’s 2006 Executive Compensation Disclosure Rules
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 future effect in this area.37 It consisted of a
package of rules designed to enhance the transparency 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
35
(...continued)
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. Seitzinger.
CRS-15
require companies to disclose whether they are timing options grants to make them
more lucrative to executives and other employees.38
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 generally?
!
What role did the compensation committee and executive officers
play in such a plan? and
!
Does a company plan to time, or has it timed, its release of material
nonpublic information for the purpose of affecting the value of
executive compensation?39
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 opportunities to get away with secretive options grants.”40
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 eliminated.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
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.
CRS-16
not insignificant level of option grant manipulation still persists, manipulation that
likely includes backdating.42
Furthermore, critics argue that the new proxy tables do not include all stock
options data because of two factors.43 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 from their books.44 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 granted to an
executive.”45
Gatekeepers
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.
Corporate Boards and Compensation Committees
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 committees.
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.
42
For example, see Lucien Bebchuk, Yaniv Grinstein, and Urs Peyer, “Lucky CEOs,”
Harvard Law School Working 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.
45
Ibid.
CRS-17
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, 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 backdating scandals.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 evidence of deliberate and opportunistic timing.47
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
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.”
CRS-18
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 were more likely
to award lucky grants to their board members.48
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 CEO’s tenure, the greater the prospect
of option manipulation, probably reflecting that executive influence over board
composition and behavior may tend to grow over time.49 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 backdated.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
backdating scheme.51
Outside Auditors
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.
48
Ibid. (Since 2004, firms listed on the NYSE and NASDAQ have been required to have
a majority of outside directors.)
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].
50
51
Ibid.
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.
CRS-19
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-compliance with GAAP.52 When such problems emerge, questions
are invariably raised about the role played by the outside auditors.53
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 to
confirm the documents’ veracity, at worst.54
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 firm gave its approval
to a form of backdating.55
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.”
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.
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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 option manipulation.56 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 disclosures that were
tardily filed, as well as unscheduled option grant awards,57 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 Accounting Oversight Board58 (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 selfserving 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.
To date, we are not aware of any auditors who have been implicated in option
backdating malfeasance.
Securities and Exchange Commission
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 additional resources for its work in this area, the
funds would be put to good use.59 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
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 auditors.
59
“U.S. Senator Richard Shelby Holds a Hearing on Stock Options Backdating, The
Political/Congressional Transcript Wire, Sept. 8, 2006.
CRS-21
costs, meaning that other regulatory or enforcement endeavors will have to be
sacrificed in order to shift resources to the backdating inquiries.60
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 actual and reported exercise
dates are consistent.61
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
undertake the probes.62
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 and get immunity for doing that. Otherwise
the DOJ will be doing these cases for a number of years.”63
60
Ibid.
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 2001and 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.
63
Carolyn Said, “Backdating Issue Moves to Forefront,” San Francisco Chronicle, July 22,
2006.
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Late Filings. 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 filing process) 13% of the insider option
grant award filings in 2005 were tardy.64 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 stock-options grants to executives
that had been tardily filed.65
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 was going to close the door on
backdating remains ajar....”66 Additionally, the analysts said the study raised the
prospect that “hundreds” of firms may have either knowingly or accidentally
backdated awards after the 2002 changes.67
Since August 2002, the SEC has pursued enforcement actions against six
delinquent filers, usually as part of larger investigations.68 Noting that the lateness
of the filings creates a greater opportunity for option grant abuse, Glass Lewis’
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/elie/Grants-11-01-2006.pdf].
65
As reported in: Therese Poletti, “Silicon Image Prompted to Review Stock Option
Grants,” The San Jose Mercury News.com, Oct. 31, 2006.
66
Ibid.
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.
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researchers described the agency’s enforcement as far too lax and thus lacking in
significance as a meaningful deterrent to tardy submissions.69
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
controls) compared to larger firms with market capitalizations of at least $750
million.70
The Question of the SEC’s Alertness to Misconduct. 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 market makers.
!
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 reforms.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.
69
Tiffany Kary and Kaja Whitehouse, “Late Form 4s May Suggest Backdating Continued
After SOX,” Dow Jones Newswires, Oct. 31, 2006.
70
Ibid, and Jessica Guynn, “Late Options Filings Proliferate Firm Says,” San Francisco
Chronicle, Oct. 31, 2006, p. D-1.
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.
CRS-24
Potential Policy Options
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 the need for additional measures at this
point.72 Yet, while it is almost universally agreed that 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.
Improve Enforcement of Timely Filing of Option Awards
Historically, the SEC has reportedly viewed enforcing tardily filed executive
grant award disclosures as a low priority, low payoff exercise.73 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 where needed.74 But late disclosures
provide greater opportunities for backdating and critics argue that lax enforcement
lowers deterrence, increasing the odds that firms may deliberately backdate.75
Require Same Day Filing of Option Grants
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 Lie has argued for the agency to institute such reform.76
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 some option grants are
already filed on the same day.77 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
sample of grants filed within the two day requirement were backdated,78 suggesting
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.
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.
77
Ibid.
78
Heron and Lie, “What Fraction of Stock Option Grants to Top Executives have Been
(continued...)
CRS-25
that the two day filing window has reduced but not totally eliminated the opportunity
to backdate option grants.
Require Scheduling of Grants of Executive Stock Options
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 of reform is the traditional province of corporate boards,
although some observers have suggested that the SEC might have authority to
intervene in this area.79
Ban Equity-based Pay for Top
Attorneys and Board Members
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 certain
measures of corporate financial performance.80
78
(...continued)
Backdated or Manipulated?” p. 3.
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.
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Increase Shareholder Roles in the
Election of Board Members
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 nominees for board membership included in a company’s
proxy materials.81 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 have been the beneficiaries of options manipulation — provides additional support
for such reform.
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
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://72.14.209.104/search?q=cache:S2ZazKrK5RIJ:www.sec.gov/rules/proposed/34-4
8626.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.
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considering proposals for revisions to its earlier shareholder proxy access initiatives
at a meeting on December 13, 2006, 82 which they also did not do.
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 intervene in this area
if the SEC does not act.83
Eliminate the Cap on Deduction for Executive Pay
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
use of stock options, thus limiting the supply of potentially backdatable stock
options.84 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 open question.”85
82
“Remarks Before the Willamette Securities Regulation Institute by SEC Commissioner
Roel Campos,” Oct. 19, 2006.
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 Review, vol. 90, no. 2, May 2000, pp. 197-202.
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Appendix A: Other Forms of Timing Manipulation
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 announcements by the issuing company.87 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 tax liability.88 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 marginal tax rate.89
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.
86
Whether or not the first two forms of timing manipulation are illegal has not been
determined by the SEC or the federal courts.
87
The SEC has not decided whether or not to pursue cases of spring-loading and bulletdodging. Rachel McTague, “More Stock-Options Backdating Cases Expected in Near
Future, SEC Officials Says,” p. A9.
88
89
Dash, “Dodging Taxes Is a New Stock Options Scheme,” p. 1.
Mark Maremont and Charles Forelle, “How Backdating Helped Executives Cut Their
Taxes, Wall Street Journal, Dec. 12, 2006, pp. A1, A13.
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Appendix B: Qualified Stock Options
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 options.90 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 could not be offset
90
For a description of the alternative minimum tax, see CRS Report RL30149, The
Alternative Minimum Tax for Individuals, by Gregg A. Esenwein and Steven Maguire.
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with an offsetting loss when the stock price fell.91 On December 20, 2006, this
“unfair” situation was solved by passage of the Tax Relief Act and Health Care Act
of 2006 (H.R. 6408), in Section 402.
Incentive Stock Options
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 exercise.
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.”
Employee Stock Purchase Plans
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.
91
For a full explanation of this issue, see CRS Report RS20874, Taxes and Incentive Stock
Options, by Jane G. Gravelle.
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Appendix C: Literature about Backdating
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.
Academic Studies
Erik Lie. 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 times when prices of their stock were low.92
Dr. Lie wrote an article titled “On the Timing of CEO Stock Options Awards,” which
included an empirical analysis supporting his backdating hypothesis, and sent a copy
of this article to the SEC in 2004.93 In May 2005, his article was published in
Management Science. 94
Dr. Lie indicates that “the board of directors of a company generally assigns the
administration of the [stock option] grants of the stock option plan to the
compensation committee.”95 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
meetings.96 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 abnormal stock returns are negative before the award dates and
positive afterward.”97 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.
Heron and Lie (article). 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 August 29, 2002, when
92
Steve Stecklow, “Options Study Becomes Required Reading,” Wall Street Journal, May
30, 2006, p. B1.
93
Ibid.
94
Erik Lie, “On the Timing of CEO Stock Option Awards,” Management Science, vol. 51,
no. 5, May 2005, pp. 802-812.
95
Ibid., p. 803.
96
Ibid.
97
Ibid., p. 810.
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the Sarbanes-Oxley Act (P.L. 107-204)98 mandated that the SEC change the reporting
regulations for stock option grants.99 Before the change, executives receiving stock
options had up to 45 days after the end of the company’s fiscal year to report them
to the SEC.100 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 return patterns that previously had been intensifying over
time.101
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 addition,
the SEC naturally has to enforce the requirements.102
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.
Heron and Lie (working paper). 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 were dated between
January 1, 1996 and December 1, 2005.103 (Top executives consisted of CEOs,
Presidents, and Chairmen of the Board.) The authors estimated that before August
29, 2002, when the new two-day filing took effect, 23.0% of unscheduled, at the
98
The Sarbanes-Oxley Act was passed on July 30, 2002.
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.
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money stock option grants were backdated.104 But from August 29, 2002 through
December 1, 2005, only an estimated 10.0% of this type of stock option grants were
backdated.105 The authors estimated that 29.2% of the 7,774 companies engaged in
timing manipulation for stock option grants to top executives.106
Narayanan and Seyhun. 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 Reversals around
Executive Option Grants.”107 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 return for the 90 days following the
grant date is about 9.4%.”108 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 the timing of corporate information disclosures.109 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 window is picked as the grant date ex-post.”110 They
found statistical evidence that was consistent with their backdating hypothesis.111
Narayanan, Schipani, and Seyhun. Professors M.P. Narayanan, Cindy A.
Schipani, and H. Nejat Seyhun wrote an article titled “The Economic Impact of
Backdating of Executive Stock Options,” in the Michigan Law Review.112 They
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
104
Ibid., p. 13.
105
Ibid.
106
Ibid., p. 4.
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].
CRS-34
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 inefficiently compensated, resulting in incorrect incentives.113
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 Wall Street Journal website.114 In comparison, these firms
experienced an average loss of $510 million in the value of their outstanding stock
as a result of being implicated in backdating of stock options.115
Bebchuk, Grinstein, and Peyer (Lucky CEOs). 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 month.116 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 opportunistic timing, primarily backdating.117 The
percentage of “lucky grants” declined from 15% before SOX to 8% after SOX.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 grant timing
manipulation was used by firms as a substitute for other compensation forms.119
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
113
Ibid., p. 4.
114
Ibid., p. 40.
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.
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also highlights the existence of serial luck. Luck is persistent with CEOs more
likely being lucky in their next grant when their prior grant was lucky.120
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 manipulation is concentrated in new economy
firms.”121
Bebchuk, Grinstein, and Peyer (Lucky Directors). 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 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 all firms) were involved.123 The
percentage of these lucky grant events was 35.7% before SOX and 25.4% after
SOX.124 An estimated 1,389 directors (or 4.6% of all directors) received one or more
opportunistically timed grants.125 Several statistical tests were consistent with the
hypothesis that backdating played a significant role in opportunistic timing grants of
options that benefitted directors.126 The authors acknowledge that their methodology
does not measure timing manipulation of stock options that occurred in “small lookback periods.”127 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 directors played in the
opportunistic timing of their own grants.”128
Bernile, Jarrell, and Mulcahey. Professor Gennaro Bernile, Professor
Gregg Jarrell, and Howard Mulcahey analyzed the effect of the options backdating
scandal on the stock-price performance of 110 companies.129 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
120
Ibid, p. 36.
121
Ibid., p. 36.
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].
CRS-36
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.
Wall Street Journal Articles
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 Bandler in an article in The Wall Street Journal on March
18, 2006.130 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 “happening by
chance was extraordinarily remote.”131 For example, one CEO received six stockoption grants from 1995 to 2002, which occurred at dates when the stock price was
unusually low.132 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 Journal concerning backdating of stock options without disclosure.133
The authors identified five more companies “with highly improbable patterns of
options grants.”134
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.
131
Ibid.
132
Ibid.
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.
134
Ibid.
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Appendix D: Literature about Other Types
of Timing Manipulation
This appendix briefly summarizes several significant studies of other forms of
the timing of stock options.
Yermack (Spring-Loading)
Professor David Yermack wrote the first article concerning the manipulation of
the timing of stock options.135 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 was $30,000 after 20 trading days and $48,900 after 50 trading days.136
Chauvin and Shenoy (Manipulation of Information Flow)
Professors Keith W. Chauvin and Catherine Shenoy analyzed abnormal stock
price decreases prior to executive stock option grants.137 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 1994 issued to 209 CEOs and found “a significant stock price decrease
prior to executive stock option grants.”138
Aboody and Kasznik (Manipulation of Information Flow)
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 good news and rushing forward bad news.139 The
authors tested their hypothesis by using a sample of 2,039 stock option awards made
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
139
Ibid., p. 74.
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.
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between 1992 and 1996 to the CEOs of 572 firms.”140 The authors concluded that
“overall, our findings provide evidence that CEOs of firms with scheduled awards
make opportunistic voluntary disclosures that maximize their stock option
compensation.”141
Callaghan, Saly, and Subramaniam (Timing of Repricing)
Professors Sandra Renfro Callaghan, P. Jane Saly, and Chandra Subramaniam
investigated the hypothesis that executive stock option repricings were systematically
timed to coincide with favorable movements in the company’s stock price.142 If the
exercise price of the stock options falls well below the market price of the stock,
some executives maintain that the stock options should be repriced in order to “retain
valued employees and to restore incentives.”143 The authors used a sample of 236
repricing of options for 166 companies from the period 1992 through 1997.144 Their
statistical analysis suggested that managers opportunistically timed repricings in
conjunction with the release of corporate news.145 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 of earnings.
140
Ibid., pp. 73-74.
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.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.