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Backdating Probe Strikes Fear in Boardrooms

SMG’s Wenli Huang says current scandal just tip of iceberg

In recent weeks, news stories have reported the resignations or demotions of more than 40 executives from 20 companies, and whiffs of scandal in the boardrooms of several solid, high-profit companies such as Apple Computer, McAfee, SafeNet, and Sapient. The menace is the suspicion that these companies have backdated stock options, a questionable practice that gives executives maximum profit at the expense of ordinary investors. At the moment, the Securities and Exchange Commission (SEC) is looking closely at nearly 100 companies that are suspected of  backdating.

Stock options are offered to employees in the hope of motivating them to work harder to improve the company’s share price. A stock option may allow an employee to purchase, for example, 1,000 shares of company stock at the market price of $30 a share on the day the option is offered. If, in a year, the stock’s price has risen to $42 a share, the employee can purchase it for $30, making a $12 profit. When options are backdated, the grant date is set to an earlier time when the stock price was lower, rather than the day the options were actually granted, which gives the employee an automatic profit on the options.

BU Today spoke with Wenli Huang, a School of Management assistant professor of accounting, on why companies are in trouble and the extent of the scandal.

BU Today: Backdating stock options isn’t necessarily illegal. What did companies do that was illegal?

Huang: While backdating is not illegal per se, in many cases it could be. The SEC sees backdated options as at least problematic —especially if not properly accounted and disclosed — since these options are effectively in-the-money on the decision date.

Wenli Huang, SMG
assistant professor

Accounting rules require that such “discount options” be expensed on the company’s financial statements. The U.S. tax code disqualifies them from certain corporate deductions and exemptions. Because backdating is typically not properly reflected in accounting earnings and tax forms, some companies may have to restate their earnings and pay tax penalties for past years to rectify disclosure omissions. Companies that didn’t disclose the backdating — or implied in their filings that they didn’t backdate — can face serious securities violations. Board members and senior executives could be personally liable if they approved options in violation of the company’s plan or did not make full disclosures to shareholders.

How common was this practice of backdating options without properly reporting them and why did so many companies do it if they knew the practice wasillegal?

Backdating can be hard to identify. The SEC and federal prosecutors have launched a widespread investigation into option grant practices. Currently more than 100 companies are under scrutiny. The list likely will continue to grow, and yet what we are witness to is but the tip of an iceberg.

In the past, we attributed the practice of granting options at a date when the stock price is particularly low to managers’ perfect forecast of the future price movements. It was not discovered until recently that managers may have chosen lower stock prices in hindsight, which is what backdating is all about.

Backdating has become a convenient way to allow these options to receive favorable accounting treatment and enrich the option holders. Lack of tight internal control on how to grant options and loose SEC rulings on this matter exacerbate this practice. Until the Sarbanes-Oxley Act of 2002, companies were allowed to report option grants within 45 days after their fiscal year end. That gives companies more room to select preferential grant dates.

A recent study shows that, of the companies that have been implicated in the scandal, many of them have shared board members with each other, suggesting that the idea to backdate options as a compensation mechanism may have spread via word of mouth from company to company.

Do you have an estimate of the scope of this scandal? Will it blow over or will even more companies become implicated?

According to some recent studies, nearly 19 percent  of option grants to top executives from1996 to 2005 may have been backdated; backdating is more common among technology firms, small firms, and firms with more volatile stock prices.  

The SEC is expanding its investigation into the option grant practice. Federal prosecutors have brought criminal charges against former executives of two companies, Brocade Communications Systems, Inc. and Comverse Technology, Inc. Regulators and prosecutors haven’t the resources to conduct full-blown forensic probes of every company. They often rely on companies’ own internal inquiries to do the initial digging that helps authorities decide whom to pursue most vigorously. 

There is also a growing pressure on prosecutors to go after CEOs who cut corners to enrich themselves or others at their companies. So far, more than 40 executives and directors from 20 companies have stepped down or have agreed to step down. On October 16, for instance, one of corporate America’s most successful CEOs, William McGuire of United Health, agreed to step down amid revelation of backdating problems.

Is the backdating scandal more evidence of corporate mismanagement or has it been blown out of proportion because of other recent scandals, such as those involving Enron and WorldCom?

Similar to the Enron and WorldCom scandals, some of the blame of the backdating scandal can be laid at the human-nature tendency toward greed. Whenever there is an opportunity, there is more chance for fraud to occur.

The timing questions of option grants, however, are potentially a much bigger issue than backdating. The scandal raises questions about a lack of board oversight, weak internal controls, faulty external and internal audit practices, and poor accounting.

I believe that a policy or procedure requiring more transparency in option practice (and other forms of compensation) is needed. I expect that the problem will be mitigated by the SEC’s new disclosure requirements on executive compensation.

How do these events affect the average investor?

Backdating certainly hurts average investors. Backdating involves artificially changing the grant dates to give option recipients extra profits. But (in a zero-sum game) these extra profits come from the shareholders’ pockets. Also, backdating makes it more likely that the options will be profitable even if the company doesn’t do very well, thereby undermining the incentive they are supposed to provide. 

Investors are reacting in various ways to the unfolding scandal. Some have filed lawsuits against over 20 companies; others tend to shy away from companies under investigation.

I think corporate officials need to work really hard in order to restore financial credibility and public trust. More transparent disclosure rules are demanded to enable investors to hold boards accountable for improper behavior.