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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Backdating

What it is:

In the finance world, backdating usually refers to the practice of changing the dates of option grants to one that is earlier than the actual grant date in order to place a lower exercise price on the options and thus enhance the potential profits from the exercise of those stock options.

The practice sometimes also occurs in the insurance industry, whereby policy issuers make the effective date of a policy (or claim) earlier than the application date in order to obtain a lower premium for the customer (or obtain better claim results).

How it works (Example):

For example, let's assume that John Doe is the CEO of Company XYZ. When he was hired, the Company XYZ board of directors offered John an attractive salary as well as an annual grant of 1,000 Company XYZ stock options. Those options give John the right but not the obligation to purchase 1,000 shares of Company XYZ stock at the market price on the date of the grant. The board formally grants the stock options to John every year at its January board meeting.

Typically, the grant date of the stock options is the same as the date of the board meeting. This is important to note, because the grant date is what determines the exercise price on the options. For instance, if the board meeting is on January 3, 2012, and Company XYZ stock closes at $45 per share that day, then the exercise price of John's 2012 stock option grant is $45 per share. That is, he has the right but not the obligation to purchase 1,000 shares of Company XYZ stock for $45 per share.

If, however, Company XYZ decides to backdate the options, it could change the paperwork to state that it actually granted those stock options to John on, say, June 15, 2008, when the stock was only trading at $15 per share. This would mean that John's 2012 stock option grant would have an exercise price of $15 per share instead of $45 per share.

Let's say that John now decides to exercise his stock options. On the day he decides to exercise his options, Company XYZ shares are trading at $50. Under normal circumstances, he pays the $45 per share exercise price and can turn around and sell those shares on the exchange for $50 each, netting a profit of $5 per share, or $5,000 total.

But if John's options are backdated, then his exercise price is only $15 per share. He pays the $15 per share exercise price and can turn around and sell those shares on the exchange for $50 each, netting a profit of $35 per share, or $35,000.

Why it Matters:

Granting stock options to employees is a generally accepted and perfectly legal form of compensating employees. Backdating the options is not. Critics of backdating argue that the practice is difficult to detect and thus encourages boards and executives to use it to synthesize more creative compensation packages.

In our example, backdating the options is the same as giving John Doe a check for $35,000 -- without recording that $35,000 on the income statement as compensation. That, in turn, understates the company's expenses and overstates its profits, which is a violation of generally accepted accounting principles and has been the grounds for a variety of fraud and miscellaneous charges from federal, state and local regulators. As a result, regulations in the Sarbanes-Oxley Act require companies to report option grants to the Securities and Exchange Commission within two business days.

In addition to being illegal, backdating isn't always a sure thing. The general reason companies backdate options is to create a lower exercise price, which in turn increases the probability that exercising the options will make more money for the optionee. Stock prices change, however, and there is no guarantee that any stock price will ever be above the exercise price.

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