Why Options Backdating is Wrong

Mark Stein has an excellent

overview today of exactly what is wrong with options backdating (and I’m

not just saying that ‘cos he’s my editor at Portfolio). Suddenly, after the

vast amount of ink spilled on the topic, it all makes sense to me now.

There’s a simple reason why this issue is hard to understand, and it’s this:

options backdating is not illegal. In fact, there’s really no reason

why options shouldn’t be backdated. Historically, when executives have

been given options grants, they’ve been given at-the-money options: the option

to buy stock at the price the shares are trading at on the day the option is

granted. That way, if the share price goes up, then the executive makes money;

if the share price goes down, the executive makes nothing.

But there are other types of option, too: they can be out of the money, or

they can be in the money. If an executive is granted out-of-the-money options,

a tiny rise in the share price isn’t enough for him to start making money. But

a large rise in the share price can be very profitable. A grant of $1 million

in out-of-the-money options is actually much more valuable if the share

price goes up a lot than a grant of $1 million in at-the-money options would


Alternatively, executives can be granted in-the-money options. These options

have value even if the share price goes down a little, although they lose their

value if the share price goes down a lot.

The different types of options create different types of incentive for executives.

An executive with out-of-the-money options has every incentive to take big risks,

because only if the share price rises a lot does he get the big payout. An executive

with in-the-money options, on the other hand, has an incentive to prevent the

share price from falling. That’s one reason to grant in-the-money options. Another

reason to grant in-the-money options is to reward executives for increases in

the share price which have already happened, under their watch, in the recent


Backdated options are a form of in-the-money option. And if there are good

reasons to award in-the-money options, what’s wrong with backdated options?

Up until now, the best answer I’ve received to that question is that it’s all

about taxes. The tax implications of an options grant which is at-the-money

or out-of-the-money are different from the tax implications of an options grant

which is in-the-money. And if a company backdates an options grant instead of

simply awarding an in-the-money option at today’s share price, it’s essentially

trying to pull one over on the IRS, and get away with paying at-the-money taxes

on an in-the-money options grant.

So is this just a question of tax accounting? It turns out that in

fact it’s bigger than that: the people currently being indicted are guilty not

only of scamming the taxman, but also of fraudulently deceiving their own shareholders.

Carole Argo of SafeNet, in fact, is accused of deceiving not

only the company’s shareholders but even its directors as well. When the options

grants were announced, they were accompanied by a public statement that "no

gain to the options is possible without stock price appreciation, which will

benefit all shareholders." Which is fraudulently deceptive, if you ask


Similarly, shareholders of KLA-Tencor were never informed that options grants

to CEO Kenneth Schroeder were in the money when they were made.

Reports Stein:

Over all, KLA-Tencor, a semiconductor-equipment maker, used backdating to

hide more than $200 million in stock-option compensation. The S.E.C. said

it did so to avoid reporting the expenses to investors…

"Corporate executives who deliberately backdate options grants and skew

their books to hide compensation expenses are misleading shareholders and

investors about the earnings of the company and painting a false picture of

executive pay," U.S. Attorney Michael J. Garcia said in a statement.

That’s what’s wrong with backdating. Companies can incentivize their

executives any way they like. But they can’t lie about it to shareholders.

This entry was posted in pay. Bookmark the permalink.