Backdated Options Scandal Khuderchuluun Batsukh Kim Dignan

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

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

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

History Obviously, the pattern of share prices rising after options granted had not gone unnoticed. But, wasn’t a scandal until now…why?  Enron and Arthur Anderson  Public’s outrage over top management’s compensation level  In late 2005, many financial analysts compiled lists of companies whose actions were deemed “suspicious”

I-Clicker Question Is backdating options illegal? A. Yes B. No C. It Depends on the circumstances

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

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

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

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

Grant Date Selection

Firms that Backdate their Options Backdating practice takes place mostly in : - Publicly traded corporations (1990) - Tech Firms - Small Firms - Firms with High Stock Price Volatility

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

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

Why Do Firms Practice Back-Dated Options? Exploits a lower stock price. Reduces the risk of share price going down.

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

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