Question

After Enron, WorldCom, and other major corporate scandals that rocked America in the recent past, it seemed that nothing would surprise investors or regulators. However, almost everyone was shocked by revelations that as many as 20 percent of all public corporations may have allowed their officers and directors to “backdate” their stock option awards and account for the awards improperly. For a time, hardly a day went by without another public company’s fraudulent stock option practices being revealed.

A stock option is an award granted under which key employees and directors may buy shares of the company’s stock at the market price of the stock at the date of the award. As an example, assume that Company A’s stock price is $15 per share on January 1, 2007. Further assume that the company’s CEO is awarded 200,000 stock options on that date. This means that after a certain holding (vesting) period, the CEO can buy 200,000 shares of the company’s stock at $15 per share, regardless of what the stock price is on the day he or she buys the stock. If the stock price has risen to, say $35 per share, then the CEO can simultaneously buy the 200,000 shares at a total price of $3 million (200,000 times $15 per share) and sell them for $7 million ($35 per share times 200,000 shares), pocketing $4 million. Stock options are a way to provide incentives to executives to work as hard as they can to make their companies profitable and, therefore, have their stock price increase.

Until 2006, if the option granting price ($15 in this case) were the same as the market price on the date the option was granted, the company reported no compensation expense on its income statement. (Under accounting rule FAS 123R, effective in 2006, the required accounting changed.) However, if the options were granted at a price lower than the market share price (referred to as “in-the-money” options) on the day the options were granted, say $10 in this example, then the $5 difference between the option granting price and the market price had to be reported as compensation expense by the company and represented taxable income to the recipient.

The fraudulent stock option backdating practices involved corporations, by authority of their executives and/or boards of directors, awarding stock options to their officers and directors and dating those options as of a past date on which the share price of the company’s stock was unusually low. Dating the options in this post hoc manner ensured that the exercise price would be set well below market, thereby nearly guaranteeing that these options would be “in the money” when they vested and thus provided the recipients with windfall profits. In doing so, many companies violated accounting rules, tax laws, and SEC disclosure rules. Almost all companies that were investigated “backdated” their options so that they would appear to have been awarded on the low price date despite having actually been authorized months later.

Would a good system of internal controls have prevented these fraudulent backdating practices?

Why would executives and directors of so many companies have allowed this dishonest practice in their companies?

Would a whistle-blower system have helped to prevent or reveal these dishonest practices?

Answer 1