Backdating Scandal Explained

The mid-2000s options backdating scandal allowed senior executives to evade taxes and employers to claim options as a tax write-off. Studies uncovered the scandal, leading to fines, restated earnings, and job losses. Accounting provisions were put in place to restore trust.

Basics

Over 50 senior executives and CEOs from various companies resigned due to an investigation by the Securities and Exchange Commission in the mid-2000s, impacting a wide range of industries including restaurant chains, recruiters, home builders, healthcare, and technology. The scandal implicated high-profile companies such as Apple, UnitedHealth Group, Broadcom, Staples, The Cheesecake Factory, KB Home, Monster, Brocade Communications Systems, Vitesse Semiconductor, and several lesser-known technology firms.

Options Backdating Scandal

The Accounting Rule Loophole

The roots of the options backdating scandal can be traced back to 1972 when an accounting rule allowed companies to avoid recording executive compensation as an expense if stock options were granted at the market price on the grant day, known as an at-the-money grant. This loophole enabled companies to provide large compensation packages to senior executives without informing shareholders.

The Tax Code Amendment

In 1993, a tax code amendment created an incentive for executives and employers to engage in illegal activities. Compensation exceeding $1 million was deemed unreasonable and not tax-deductible, except for performance-based compensation, which included at-the-money options that relied on share price appreciation.

Retroactive Selection

Senior executives discovered that by retroactively selecting a low trading price date as the grant date, they could secure in-the-money options and instant profits. This allowed them to evade taxes, as capital gains are taxed at a lower rate than ordinary income, and also enabled their employers to claim the options as a corporate tax write-off. This deceitful practice became so widespread that some investigators estimate that 10 percent of nationwide stock grants were issued based on pretenses.

Exposing the Scandal

Academic studies played a crucial role in uncovering the backdating scandal. The first study, conducted in 1995 by a professor at New York University, analyzed option-grant data made public by the SEC. Published in 1997, the study revealed a suspicious pattern of highly profitable option grants that coincided with low share prices. Subsequent studies by other professors confirmed that the granters must have possessed advanced knowledge of the prices. The scandal was finally exposed through a Pulitzer Prize-winning story published in The Wall Street Journal.

Consequences ensued, with firms restating their earnings, paying fines, and executives losing their jobs and credibility. According to the SEC, investors suffered losses exceeding $10 billion due to declines in share prices and illicit compensation practices.

Conclusion

Engaging in insider trading by exploiting advanced knowledge of stock prices is dishonest and undermines trust. To address this issue, accounting provisions in the early 2000s required companies to promptly report option grants and treat them as expenses, reducing the likelihood of backdating incidents.