What it is:
Options backdating occurs when a company grants an option that is dated prior to the date the company granted the option.
How it works/Example:
For example, let's assume Jane Smith is the CEO of Company XYZ. When she was hired, Company XYZ's board of directors offered Jane an attractive salary as well as an annual grant of 1,000 Company XYZ stock options. Those options give Jane 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 Jane 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 because the grant date is what determines the exercise price on the options. For instance, if the board meeting is on January 3, 2020, and Company XYZ stock closes at $45 per share that day, then the exercise price of Jane's 2020 stock option grant is $45 per share. That is, she 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, then it could change the paperwork to state that it actually granted those stock options to Jane on, say, June 15, 2019, when the stock was only trading at $15 per share. This would mean that Jane's 2020 stock option grant would have an exercise price of $15 per share instead of $45 per share.
Let's say Jane now decides to exercise her stock options. On the day she decides to exercise her options, Company XYZ shares are trading at $50. Under normal circumstances, she 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 Jane's options are backdated per the example above, then her exercise price would be only $15 per share. She 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 total.
Why it matters:
Granting stock options to employees is a generally accepted and perfectly legal form of compensating employees, and typically companies grant stock options with an exercise price that is equal to the market price of the shares on the date of the grant. But backdating options allows companies to set an exercise price that's lower than the current value of the company's stock. This makes the options in-the-money for the grantee (Jane Smith, in our example), basically giving her options that are instantly profitable.
In our example, backdating the options is the same as giving Jane Doe a check for $35,000. If the company does so without recording that $35,000 on the income statement as compensation, it understates its expenses and overstates its profits, which is a violation of generally accepted accounting principles (GAAP) and has been the grounds for a variety of fraud and miscellaneous charges from federal, state and local regulators.
The Securities and Exchange Commission (SEC) previously allowed companies to report the issuance of stock options up to two months after the options were granted. That allowed companies to essentially pick the lowest stock price during that two-month period and report that as the exercise price on the options, giving companies a way to grant instantly profitable options to employees. Today, regulations in the Sarbanes-Oxley Act require companies to report option grants to the SEC within two business days.