The Chartered Accountant

of the option is changed, and the option appears to have
been awarded earlier. Instances were brought to light where
the option, instead of being based on the stock price when
an executive joined the company, was based on an earlier
(invariably lower) stock price. “Thus the option is “from
that manipulated date of issuance”. This implies that an
executive is rewarded for the performance of his seniors/
predecessors, which is just not fair. The practice has been
considered unethical because the company management
started looking ‘back over stock price performance and pick
the most advantageous date’ to award the option. (This is
like a Mutual Fund Company advertising that selected pick
Stock prices have gone up over last six months and hence if
you put your money in its fund it will multiply your money
as seen in the graph shown in the pamphlet. Obviously the
MF managers are showing others performance as theirs to
attract your money!). Thus earnings and taxes were reported
wrongly and unfair means were used to window dress
accounts and tax filing. Since the exercise is complicated,
even revised returns were not filed properly. The practice
led investors to believe in a different but false corporate picture,
and very rightly invited the wrath of the Regulator and
investor public. Assuming the proportions of a scandal,
it also affected stock prices in the market. According to a
pioneering research published by Prof Narayanan and others
(ref: http://sitemaker. umich.edu/options-backdating/
home) “Two types of games are possible: Backdating and
Forward dating.” The researchers thus stated:
Backdating: If executives report that the options they
received were granted on a date before the actual date
on which the decision was made, it is called backdating.
For example, the company's board of directors decides
to grant options to the CEO on June 13, 2006. The executive
subsequently reports to the SEC that the options
were granted on May 14, 2006. This results in a backdating
of about one month.
Forward dating: Executives who wish to give their grant
date to influence their compensation may not resort to
backdating if the company stock price had been falling
before the board decision date. In such cases, executives
may resort to forward dating to increase their compensation.
It works like this:
Suppose the board meets on June 15 to approve the compensation
parameters (essentially, the number of options to
be granted). The board intends June 15 to be the grant date
and expects the strike price of the options to be the closing
stock price on that day. Since the stock price has been falling,
the executive decides to wait and see if it goes further
down. Suppose the stock price continues to fall till June 22
and then starts rising. On June 24, the executive designates
June 22 as the grant date and reports the grant immediately
(electronically), thus getting a lower strike price than what
prevailed on June 15, and meeting the SEC deadline of
reporting within two business days of the grant date. Has
any company been targeted for forward dating? The only
one we know is Brocade Communications, which forward
dated their employee stock options (see WSJ article on July
13, 2006.
BANKING AND FINANCE
How Did the Backdating Disease Spread?
It is reported that over 150 big Corporations (only the tip
of the iceberg), which include Apple Computers, McAfree,
CNET, United Health group, Broadcade Communications
Systems, and Converse Technologies have practiced backdating.
The Corporate Library has published that about 51
directors who were common to the 120 out of 150 companies
spread the back dating practice by word of mouth! Since
in US, the executive salaries over $1 million are not eligible
for deduction from employers income, (U/S 162(m) of the
IRC since 1993) Options were found a way out, more as a
substitute salary package to start with and thereafter were
realized as a ‘build and gain’ management concept to the
executive in Software industry, since initially most of them
were cash starved but technically highly qualified. Granting
shares in place of options has also emerged as a new pay
out to tide over controversies. This is due to the introduction
of Sarbanes-Oxley in 2002 that was started for cleaning
up the Enron pollution in Corporate Governance. The
backdating of options has brought to light its ‘twin-sin’ of
‘spring-loading options’ which was also not considered illegal
in the US. In this, the option delivery date is deliberately
scheduled to occur just in advance of the announcement
of favourable information such as above (more than expected)
estimate earnings! It amounted to scheduling an
award based on privileged information and since it is illegal
for an executive to buy shares in advance based upon privileged
information, it is difficult to reconcile to any logic that
spring-loading options are legal. Thus granting of shares
rather than options has come to be a safer practice. Granting
of shares provides less temptation to manipulate how
and when those shares are awarded.
Since in UK and Europe, options have never been important
for compensating executives and more recently granting
of shares rather than options were found to be more
practiced to compensate for performance, the backdating
disease seems to have not spread across these countries.
But how about the state of affairs in respect of options
management in India where Sarbanes has not taken any
deep roots? Since Software boom is of recent origin in India
and the technology sector has long been an extensive
user of stock options across the globe, partly because of
the entrepreneurial and high-growth nature of the market
in this sector, options have been selectively practiced in
India too. Although the culture of options-based pay was
hit by the dotcom and technology crash of the early part
of 2K in US, ‘options use’ is more prevalent in the technology
sector than in other sectors, even in India. Moreover,
the introduction of FBT in India has raised many
eyebrows all over and possibly Indian corporate is lured
into practicing backdating.
How Do Shareholders View Backdating
Game?
It is reported that in the US, shareholders have filed 265
class action lawsuits against more than 70 companies,
claiming that they have been defrauded by companies
THE CHARTERED ACCOUNTANT 1027 DECEMBER 2008