Options Backdating

Fifty-two companies currently under criminal investigation. Two indictments. Multiple guilty pleas. All stemming from the practice known as "options backdating."

Fifty-two companies currently under criminal investigation. Two indictments. Multiple guilty pleas. All stemming from the practice known as “options backdating.”

Options backdating occurs when a company issues stock options on one date, but reports in its financials an earlier issue date to create a “strike” or exercise price equal to the earlier date’s lower price. As a consequence, the option is immediately profitable, or “in the money,” to the option holder. Moreover, the company avoids having to expense the options as current compensation, thus increasing earnings in the near term. Another consequence is that the company underrepresents the real nature of an executive’s compensation, perpetuating the myth that options are performance-based incentive compensation.

The backdating problem was first highlighted by Professor Erik Lie of the University of Iowa, who published his initial study in 2004. Professor Lie concluded that the robust profitability of so many options was statistically impossible absent some artificial influence such as backdating.1 His study received wide publicity and even provoked lawsuits.2 Subsequently, the Securities and Exchange Commission (SEC) took an interest, followed by the securities plaintiffs’ bar and many corporations.

Cracking Down

The SEC brought no backdating cases prior to 2006. The practice of options backdating, apparently widespread from 1996 through 2002, is widely believed to have been short-circuited by the enactment of Sarbanes-Oxley in 2002. Although backdating had not yet been recognized as a problem, the provisions of Sarbanes-Oxley requiring that insiders report the acquisition of securities, including options, within two days of receipt greatly hindered the ability of corporations to backdate options. Under previous regulations, corporations could wait 45 days or, in some cases, over a year to report options, thus providing ample time for backdating.

Other similar practices are being reviewed by government officials as well. “Spring loading” involves the issuance of options immediately prior to the announcement of favorable financial news expected to have a positive impact on the underlying share price, thereby providing an immediate profit to the option holder.3 “Bullet dodging” describes the generating options shortly after the release of bad news that cause the stock price to take a temporary dip, which increases the probability that the option will become profitable in the short term.

With its attendant investigation, legal actions and executive fallout, the practice of options backdating is expected to have a short shelf life. But while options backdating may have a truncated life expectancy, its current impact is robust. The SEC is investigating many companies, ranging from small to Fortune 500 companies, for options irregularities.4

Similarly, the FBI has reported that it has 52 companies under criminal investigation. Two indictments have been issued and multiple guilty pleas have been entered in the most egregious cases.

In addition to the governmental investigations, more than 200 companies have completed, or are conducting, internal investigations — either because they want the comfort of knowing that they have not engaged in options backdating or they have an inkling that they did and want to be proactive in addressing the problem.

The problem is indeed widespread. In a follow-up study to his earlier work, Professor Lie estimated that 29 percent of 7,774 companies he surveyed backdated option grants to executives between 1996 and 2002. That is almost 2,300 companies.5


What are the consequences of options backdating? To a public corporation, the potential consequences of engaging in options backdating are manifold and can range from none whatsoever to having founders and CEOs going to prison.

In general, the U.S. Department of Justice has said it will bring criminal charges where defendants falsify corporate books and records; issue false financial statements; lie to boards of directors, auditors or the SEC; or file false reports. For example, in the case involving Brocade Communications, the SEC charged the former CEO and the former Vice President of Human Resources with criminally violating the securities laws.6 The facts of that case as set forth in the indictment were egregious.

Likewise, in a case involving Comverse Technology Inc., the U.S. Attorney charged the former CEO, the former CFO, and the former General Counsel with violating securities laws.7 In that case, corporate officers inserted backdated option grant dates into board of directors’ unanimous written consents that were transmitted to the compensation committee. Options were also backdated for new employees to dates prior to the date employment actually commenced. In addition, hundreds of thousands of backdated options were issued to fictitious employees and parked in a slush fund to be awarded at the CEO’s discretion. Not surprisingly, the defendants themselves earned millions of dollars from backdated options.

More than 200 companies have announced internal investigations, and the SEC is investigating many of them as well. The involved companies range from small to Fortune 500 companies.

Another troublesome outcome for a corporation is that the SEC will bring civil fraud charges stemming from options backdating in all cases where criminal charges have been filed. But even if no criminal charges are filed, the SEC still can bring a civil fraud action in federal court. This sort of case can be brought against the corporation and its officers and directors and can result in the disgorgement of profits, stiff monetary penalties, and prohibitions against officers and directors serving any public company in those capacities in the future. As in other enforcement areas, the SEC has a penchant for pursuing through civil actions matters that involve blatant and intentional misconduct.8

Of course, the imposition of an officer and director bar against those who are intimately involved with the backdating process can result in a corporation losing its founder or other key management personnel. And in addition to officer and director bars imposed by government authorities, internal investigations have led to numerous officer resignations from at least 25 companies including Quest Software, KB Homes, United Health Group, Inc., McAfee, Inc., CNET Networks, Inc., and Monster Worldwide. Even Apple Computer CEO Steve Jobs was implicated by an internal investigation into backdating, although he apparently did not receive, or otherwise benefit from, the backdated grants.

The Internal Revenue Service has also joined a number of investigations due to the tax implications of options backdating, both with respect to the individuals who received the backdated options as well as the corporations that failed to account properly for the options when they were granted.

Of course, disparity between a reported grant date and the actual grant date is not always intentional. Fortunately, the government appears to appreciate the difference between backdated options that involve the “intentional alteration of documents or faulty internal control and dating issues arising from ministerial or logistical delays.”9 Unfortunately, the plaintiffs’ bar is not so discerning.

Private Litigation

Public announcements that a company or the SEC is investigating possible backdating issues have spawned a rash of civil suits. Plaintiffs’ lawyers have seized upon this issue as yet another opportunity to bring cases against corporations and their officers and directors. Such cases are brought under the guise of both class actions and shareholder derivative proceedings.

Class actions ostensibly are brought on behalf of the shareholders of the company who have been impacted by the option grants. Shareholder claims typically are grounded in some allegation of misrepresentation. However, the fact of the option grants, their strike price and their eventual profitable exercise are in most instances disclosed. Thus, in the context of options backdating, substantial doubt exists as to the viability of shareholder claims.

Shareholder derivative claims, which are more common, are brought directly against the officers and directors on behalf of the corporation. Recovery in derivative suits inure to the benefit of the corporation. The theory here is that the company’s officers and directors breached their duties to the corporation — specifically, the duties of care and loyalty — by placing their personal interests before that of the corporation, with the corporation suffering economic damages as a result.

As of press time, reported decisions construing the metes and bounds of these particular type of suits are just beginning to be issued.10 One difficulty that plaintiffs will have is that options backdating is not per se illegal. Backdated options that are allowed by a corporation’s option plan, approved as backdated by the appropriate committee of the board of directors, and properly accounted for on the company’s financial statements and fully disclosed in the company’s filed reports, are not illegal. Illogical perhaps, but not illegal.

Regardless, the nondisclosure of backdating and other accounting issues raised by improperly backdated options are grist for the plaintiffs’ mill. However, other than seeking disgorgement from individual option grantees of improper option profits, it is difficult to predict precisely what damage theories plaintiffs can pursue in either a derivative or class-action setting that would make their claims viable. In addition, to the extent that plaintiffs pursue their cases on an unjust enrichment theory against beneficiaries of improper options backdating, they encounter the problem that such disgorgement is considered disgorgement of an ill-gotten gain and thus is not covered by directors and officers liability insurance policies. In addition, if a civil case is conducted parallel to an SEC enforcement action, there is the question of whether the benefiting officer or other person can be made to disgorge purported ill-gotten gains twice — once to the government and once to private plaintiffs for the benefit of the corporation. Of course, all these down-the-road theoretical difficulties that could be encountered by plaintiffs are cold comfort to a company that is sued and must endure the years of uncertainty and high defense costs that inevitably accompany such suits.

Indeed, the high costs of running internal investigations, coping with SEC investigations, and defending strike suits may have a major economic impact on companies with backdating issues. In addition to generating significant professional fees, a backdating problem can divert management and cause a corporation to lose focus.

It is not known whether the backdating “scandal” has crested. The Wall Street Journal has kept a backdating scorecard and, as of December 31, 2006, 135 companies had been impacted by backdating, with a majority of those companies being investigated by the government and being sued by shareholders.11

Given that most responsible companies hopefully have internally reviewed their options-grant practices, it is expected that this scandal will eventually taper off. However, as there is no statute of limitations that totally bans the SEC from suing companies, it may be difficult to determine with certainty when the risk has finally passed.


  1. Erik Lie’s original study: biz.uiowa/edu/faculty/elie/grants-ms.pdf. 
  2. See, e.g., Ryan v. Gifford, No. 2213, 2007 WL 416162 (Del. Ch. Feb. 6, 2007). 
  3. See In re Tyson Foods, Inc., No. 1106, 2007 WL 416132 (Del. Ch. Feb. 6, 2007). 
  4. Remarks of SEC Enforcement Director Linda Chatman Thomsen, July 20, 2006, 
  6. U.S. v. Reyes, No. 3-06-70456 (N.D. Cal., filed July 20, 2006), 
  7. U.S. v. Alexander, No. 06-CV-3844 (E.D.N.Y., filed Aug. 9, 2006). 
  8. Remarks of SEC Enforcement Director Linda Chatman Thomsen, Oct. 30, 2006, 
  9. Remarks of SEC Commissioner Paul S. Atkins, July 26, 2006, 
  10. See supra, nn.2-3. 
  11. See Perfect Payday: Options Scorecard, WALL ST. J. ONLINE, Dec. 31, 2006, 
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