Options backdating occurs when companies grant options to their executives that correspond to a day where there was a significantly lower share price. It is suspected that these situations are not a coincidence and that the board or executives were granted options based on a past date in order to make these options more profitable.
At first glance, call options represent the perfect way to tie an executive’s level of compensation to the company’s performance because as the company’s share price increases, so does the payoff the executive will receive. However, this concept is not perfect and there are ways that executives can take advantage of the way that options are granted in order to earn money. An option’s strike price is usually chosen by taking the stock’s closing price on the day that the option was granted, calculating an average of the day’s high and low prices or by taking the closing price from the previous day’s trading.
For example, suppose that it is August 16, 2006, and the closing share price of XYZ Corp. is $45. On June 1, 2006, XYZ Corp.’s stock price was at a six-month low of $25. Technically, any options granted today should bear a strike price of $45. In a backdated situation, however, the options would be granted today (August 16), but their listed day of granting would be June 1 in order to give the options a lower strike price. Options backdating defeats the purpose of linking an executive’s compensation to the company’s performance, because the bearer of the options will already have experienced a gain.
In the past, granted options were only required to be disclosed to the Securities and Exchange Commission (SEC) within two months of the options being granted, which gives companies a window for backdating. Due to the implimentation of the Sarbanes-Oxley Act of 2002, the rule has been changed and companies are now required to report the granting of options within two business days, which effectively has removed this loophole.
The act of granting options with strike prices that are lower than the current market share price is technically legal, but the act of backdating the options may be in breach of the company’s option plan, a shareholder-approved document that highlights the company’s options policy. In some cases, backdating can be considered an act of fraud and an SEC investigation may result.
To lean more about options, see Options Basics Tutorial and Option Spread Strategies.