Stock Options: The Backdating Games

While backdating of options is not necessarily illegal, it can lead to a welter of problems.

Following a yearlong investigation, it appears the Securities and Exchange Commission is finally beginning to crack down on companies with questionable policies governing stock-option grants. In November, management at Analog Devices Inc. agreed to pay $3 million to settle an SEC investigation into the company’s handling of stock-option awards. And three senior managers at software maker Mercury Interactive Corp. recently resigned after an SEC probe uncovered problems with the reporting of stock-option issuances. Published accounts say the commission is looking at about a dozen companies, and appears to be zeroing in on the backdating of grants.

The commission apparently became interested in the topic when academic research showed that the share price of scores of companies dropped just prior to the granting of options. The research also indicated that — surprise, surprise — share prices often rose immediately after the pricing of options. “Timing of option grants is a very systematic and widespread practice,” says Patrick McGurn, an executive vice president of Institutional Shareholder Services Inc., in Rockville, Md. “But backdating is a whole other issue.”

While backdating is not necessarily illegal, McGurn notes that it can lead to a welter of problems, including violation of securities laws. In the case of Mercury Interactive, an internal company investigation (triggered by the SEC probe) uncovered 49 instances of backdating of options during a 10-year period. Ultimately, three top executives at the Mountain View, Calif., company resigned, including CEO Amnon Landan and CFO Douglas Smith. While the two executives admitted they “benefited personally” from the manipulation of stock-option grant dates, both denied knowingly doing anything wrong.

It’s uncertain just how common backdating of options has been. But Andrew Liazos, a partner at McDermott Will & Emery LLP in Boston, believes that accelerated reporting requirements now make backdating more difficult. Section 403 of the Sarbanes-Oxley Act now requires that directors and officers report option grants to the SEC within two business days, instead of weeks (or even months), as allowed under prior law. “For executives with these reporting requirements,” says Liazos, “it’s harder to see how backdating will occur [now].”

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