With the increasing focus on executive compensation, companies have been prosecuted for the manipulation of the timing of stock option grants and exercises. Two such practices, stock option backdating and spring-loading, are a significant target of the SEC and the Justice Department, as well as the subject of a growing number of derivative suits and private securities class actions.

The Securities and Exchange Commission and the Justice Department have recently sent a clear message that they will pursue unlawful stock option manipulation by prosecuting such conduct. For example, they recently charged two former executives of Brocade Communications Systems with civil and criminal violations for routinely backdating stock option grants to benefit employees. The SEC is currently investigating over 130 other cases involving stock options and is expected to bring more enforcement actions. It is anticipated that in the more egregious cases, there will also be additional criminal prosecutions.


In the 1990s, many companies began to issue stock options to their employees, on the theory that such options would allow companies to recruit and retain talented employees and provide them with the incentive to work for the benefit of the company. Additionally, accounting rules then did not require that companies treat such option grants as an expense on their books, so long as the strike price of the option was the same as the market price of the stock on the date of the grants. Some studies have estimated that as many as one-third of companies that issued stock options engaged in some form of unlawful stock option manipulation.

Stock option backdating is the practice of manipulating the timing of the grant or exercise date of the option. In the first instance, the grant of a stock option is recorded at a date that reflects a lower value of the stock than its market value at the time that the option was actually granted.

Typically, an option’s grant date is backdated to a date on which the market value of the company’s stock hit a low (or lower) point, and false documentation is created to suggest that the option was authorized on that date. The holder benefits by paying less for stock that is worth more. The effect of such backdating is that the options appear to be “at the money” (exercise price is the same as the market price), but in actuality are “in the money” (exercise price is lower than market price).

Under prior accounting rules, a company did not need to record “at the money” options as a compensation expense, but was required to record “in the money” options as such. With backdating, companies failed to properly book the amount of the options that was “in the money” as a compensation expense.

A related practice consists of exercising the option on a particular date, but reporting the market price from an earlier date when the market price was higher. This purchase often results in more favorable tax treatment for the employee, by converting ordinary income tax rates to capital gain tax rates.

Another form of stock option manipulation is known as “spring-loading.” This practice involves timing the granting of a stock option at a time prior to positive news or after negative news. For example, options may be granted before favorable corporate information is disseminated to the public that is likely to drive up the share price of that company, or the grant may be delayed due to an impending announcement of bad news.

Impact of Backdating

The end result is similar in each of these scenarios – the holders of the options pay an artificially low price for the company’s stock, and enjoy an immediate, or almost immediate, boost in the stock option’s value. Since backdating practices are often, but not always, the result of intentional manipulation and involve fraudulent documentation and reporting, it is not surprising that they are the newest target of federal investigation and regulation.

Regardless of the motivation behind stock option backdating, such practices are detrimental to the company and its shareholders. The end result of systemic backdating is that the company receives an artificially low amount of capital in return for its shares. More importantly, the discovery of these practices has caused companies significant expense in investigating these practices and taking corrective action, including restating earnings, a consequence that in turn can cause stock prices to decline and ultimately harm shareholders. Additionally, for many companies and their option holders, there can be severe tax consequences as a result of the correction of the backdating problems.

On July 26, the SEC adopted extensive new disclosure rules concerning corporate stock option grant practices in an attempt to address the growing problem of option backdating and to prevent further backdating. Companies are now required to disclose their stock option grant practices and to describe the methodology implemented. Companies are likewise required to disclose the grant date of each option issued, the fair value of each option at its grant date, the closing market price of the stock on the grant date, to the extent that the price is greater than the exercise price, as well as any discrepancy between the grant date and the date on which the board of directors took action to grant the option.

Practical Pointers

As these regulations are implemented and the investigations continue, and because of investor concerns over backdating practices, it is prudent that companies develop their own policies concerning such practices. As a primary matter, companies should immediately review past options grant practices and current procedures for awarding options. Auditors will be looking into these practices; consequently, issuers are well advised to do their own review first.

If suspicious practices are discovered, companies should consider investigation to further examine whether or not there was any intentional or inadvertent option backdating. If so, companies will need to determine whether or not to self report their findings to the SEC. Experienced SEC counsel can weigh the pros and cons of such a course of action and advise appropriately. Companies will then have to determine whether to disclose any accounting adjustments that need to be made, either as part of regularly scheduled SEC disclosures, or in a Form 8-K.

In most cases, the audit committee will oversee any investigation and be involved in any decisions based on its findings, with a team including independent counsel and forensic accountants. If the audit committee has any potential exposure due to its prior involvement in or oversight of the options granting practices, consideration should be given to forming some other, independent, and untainted committee to oversee the investigation.

Companies also may choose to analyze their rights and/or obligations to recover any ill-gotten gains from company executives who had received backdated options. Of course, consideration should be given as to whether the executive knowingly participated in the backdating scheme or was merely an innocent beneficiary. In order to head off derivative or class action lawsuits, companies may choose to hold compensation committees and/or members of management, including counsel, accountable for any improper stock option granting practices in which they were involved.

In addition to taking remedial action, companies are advised to develop preventive policies and strategies to preempt any potential issues that may arise in connection with stock option backdating, by taking into account the SEC’s latest rules in this area. For example, companies should consider establishing a fixed schedule of option granting to avoid backdating and spring-loading issues.

To the extent that companies have not yet taken measures to identify, rectify and prevent any unlawful practices in connection with stock option grants, they are well advised to do so in light of the increased scrutiny from the SEC and Department of Justice. Doing so will help companies to avoid or lessen the impact of any investigation and potential prosecution by the government, and the many costs associated with such a process.

JAY A. DUBOW is a partner in the litigation department of Wolf Block Schorr & Solis-Cohen. Prior to joining the firm, he was a branch chief in the division of enforcement of the SEC in Washington, D.C. His practice concentrates on securities litigation including defending SEC and other regulatory investigations and securities class actions. He can be contacted by calling 215-977-2058.
JUSTINE M. KASZNICA is an associate in Wolf Block’s business litigation practice group. She is also a lecturer in the department of politics at Princeton University, where she teaches for thecourse constitutional interpretation.