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In the mid-2000s, an investigation by the U.S. Securities and Exchange Commission (SEC) resulted in the resignations of more than 50 senior executives and CEOs at firms ranging from restaurant chains and recruiters to homebuilders and healthcare. Apple Inc. (AAPL), UnitedHealth Group Inc. (UNH), Broadcom Inc. (AVGO), Staples, The Cheesecake Factory Inc. (CAKE), KB Home (KBH), Monster Beverage Corp. (MNST), Brocade Communications Systems, Vitesse Semiconductor, and dozens of lesser-known technology firms were implicated in the scandal.
What was it all about? Options backdating.
Read on to find out how the scandal emerged, what brought it to an end, and what we can learn from it now.
Key Takeaways
- Options backdating involved executives falsifying stock option grant dates to increase their compensation illegally.
- The practice exploited accounting rules and tax code loopholes, allowing companies to avoid properly reporting executive compensation.
- Academic studies and investigative journalism ultimately exposed the widespread nature of options backdating.
- The scandal resulted in many executive resignations, company restatements, and an estimated $10 billion in investor losses.
- New regulations were put in place requiring prompt reporting of option grants and proper expense accounting to prevent future abuses.
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Options Backdating
The options backdating scandal revealed a widespread practice of executives manipulating stock option grant dates to increase their compensation while deceiving regulators, shareholders, and the IRS. The roots of this scandal were in a 1972 accounting rule that allowed companies to avoid recording executive compensation as an expense on their income statements. This loophole applied to stock options granted at the market price on the day of issue, known as “at-the-money” grants. As a result, companies could offer substantial compensation packages to senior executives without disclosing them fully to shareholders.
While these grants gave executives significant stock holdings, the share price had to appreciate before they could profit. A 1993 amendment to the tax code inadvertently created an incentive for executives and their employers to engage in backdating. This amendment classified executive compensation exceeding $1 million as unreasonable and not tax-deductible for the company. However, performance-based compensation remained deductible.
At-the-money options qualify as performance-based compensation since share prices have to go up to be profitable. This made the options eligible for corporate tax deductions. Executives soon realized they could retroactively choose a date when their company’s stock was at its lowest price and pretend that was the grant date. This practice guaranteed in-the-money (profitable) options.
In fact, the manipulation allowed executives to cheat the IRS twice: once for themselves, as capital gains are taxed at a lower rate than ordinary income, and once for their employers, who could claim larger tax write-offs. The practice became so widespread that some investigators believe 10% of nationwide stock grants were issued under these pretenses.
The Scandal Comes to Light
A series of academic studies brought the backdating scandal into the public eye. The first was in 1995, when a professor at New York University reviewed option-grant data that the SEC forced companies to publish. The study, published in 1997, identified a strange pattern of extremely profitable option grants, somehow perfectly timed to coincide with dates on which the shares were trading at a low.
A series of two follow-up studies by professors elsewhere suggested that the uncanny ability to time options grants could only have happened if the granters had known the prices in advance. A Pulitzer Prize-winning story published in the Wall Street Journal finally blew the lid off the scandal.
As a result, firms restated earnings, fines were paid, executives lost their jobs, and the corporate world appeared to the public to be going to any lengths to hide the many millions it pays its executives. The SEC reported that investors suffered more than $10 billion in losses because of share price declines and stolen compensation.
Unsung Role of Academic Researchers in Uncovering Corporate Malfeasance
Academics have played a crucial role in uncovering several other financial scandals. Here are just a few notable examples:
Enron Scandal (2001): Academic researchers, particularly graduate students and their professors at Cornell University, questioned Enron’s accounting practices and financial statements long before the company’s collapse. Their analysis of public filings raised red flags about the company’s use of special purpose entities and off-balance-sheet financing.
Mutual fund market timing scandal (2003): Finance professors at Stanford and the University of Virginia uncovered widespread illegal late trading and market timing practices in the mutual fund industry. Their research led to a major investigation by New York Attorney General Eliot Spitzer.
LIBOR manipulation Scandal (2008-2012): Academics from Bocconi University and Pompeu Fabra University published papers suggesting manipulation of the London Interbank Offered Rate (LIBOR) as early as 2008, years before regulators took action.
Volkswagen emissions scandal (2015): The scandal was initially uncovered by researchers at West Virginia University who discovered discrepancies between Volkswagen’s stated emissions and actual performance during road tests.
These examples highlight the critical role that academic research can play in identifying and exposing corporate malfeasance, often before regulators or journalists become aware of the issues.
What Are Options?
Options are financial contracts that give the buyer the right, but not the obligation, to buy options for a specific asset, such as a stock, at a preset price (known as the strike price) within a set time frame. For example, a call option on Apple stock with a strike price of $150 and an expiration date of three months from now would allow the holder to buy 100 shares of Apple at $150 each, regardless of the market price, at any time before the option expires.
Investors often use options to speculate on price movements or hedge against potential portfolio losses.
What Are Executive Stock Options (ESOs)?
ESOs are call options that give the employee the right to buy the company’s stock at a specific price for a finite period. Terms of ESOs are fully spelled out for an employee in an employee stock options agreement. Typically, ESOs can’t be sold, unlike standard listed or options.
Why Didn’t Regulators Catch the Backdating Scandal?
In the end, academics and the media broke the scandal, not the regulators tasked with overseeing the market. The SEC, IRS, et al., didn’t detect options backdating for several years, first of all, because the practice exploited a regulatory blind spot created by the intersection of accounting rules and tax laws, making it difficult to identify without detailed scrutiny. Second, companies were not required to disclose option grants immediately, often reporting them months or even years later, which obscured suspicious patterns. Third, the sheer volume of options grants across thousands of public companies made comprehensive oversight challenging with limited regulatory resources.
In addition, the practice was often hidden within complex financial statements and executive compensation packages, requiring specialized knowledge to uncover.
The Bottom Line
In the early 2000s, new accounting provisions were enacted that required companies to report their option grants within two days of their issue and required that all stock options be listed as expenses. These changes reduced the likelihood of future backdating incidents.
