Backdated stock options can be particularly lucrative for the executives who receive them. However, companies must be careful about how they award them. It is fraud when options are backdated without telling shareholders or when companies change documents such as board meeting minutes or board approvals to support the backdating.

In the money

Companies have historically granted stock options ‘at the money,’ meaning the exercise price is equal to the stock’s fair market value on the grant date. If properly structured, at-the-money grants offer certain tax and financial advantages over ‘in-the-money’ — more commonly known as ‘discounted’ — stock options, where the exercise price is lower than the stock’s fair market value on the grant date.

Options have value only when the underlying stock’s price is higher than the exercise price, allowing executives to purchase the stock at a discount. Companies engaged in backdating wait for stock prices to rise and then grant executives at-the-money options that are dated earlier, when prices were lower. Executives can enjoy instant profits, and they and the company can avoid some of the negative consequences typically associated with in-the-money options.

Not necessarily illegal

Stock option backdating is not necessarily illegal, but it is a problem if you do not:

• Disclose the practice to investors
• Record the appropriate compensation expense in your company’s financial statements
• Report the transaction properly for tax purposes

Regulators recognize that legitimate discrepancies may exist between the date an option is granted and the date it is finalized due to innocent administrative delays. However, companies must report their option grants within two days of their issue and list all stock options as expenses. To avoid backdating problems, be sure that your option-granting practices are consistent and well documented.

Potential consequences

Backdating can be permissible if it is transparent, but improper backdating may require restatements of earnings. In addition, public companies guilty of backdating may violate federal securities disclosure and reporting requirements, exposing themselves to regulatory or criminal investigations as well as securities fraud litigation. If you decide to award backdated stock options, contact us about how to do it correctly.