The backdating scandals
Backdating allows executives to choose a past date when the market price was particularly low, thereby inflating the value of the options.An example illustrates the potential benefit of backdating to the recipient.Disordered, untimely paperwork was cited as the cause in some cases of unintentional backdating.Initially, lax enforcement of the reporting rule was also blamed for allowing many companies to sidestep the rule adjustment that stemmed from Sarbanes-Oxley.Unfortunately, these conditions are rarely met, making backdating of grants illegal in most cases.(In fact, it can be argued that if these conditions hold, there is little reason to backdating options, because the firm can simply grant in-the-money options instead.)David Yermack of NYU was the first researcher to document some peculiar stock price patterns around ESO grants.Most shareholder approved option plans prohibit in-the-money option grants (and thus, backdating to create in-the-money grants) by requiring that option exercise prices must be no less than the fair market value of the stock on the date when the grant decision is made. For example, because backdating is used to choose a grant date with a lower price than on the actual decision date, the options are effectively in-the-money on the decision date, and the reported earnings should be reduced for the fiscal year of the grant.
Thus, an artificially low exercise price might alter the tax payments for both the company and the option recipient.
This included options backdating presented in offer letters to new hires.
Annual and quarterly reports filed by the company did not include the compensation costs that stemmed from the options backdating incidents.
ESOs are usually granted at-the-money, i.e., the exercise price of the options is set to equal the market price of the underlying stock on the grant date.
Because the option value is higher if the exercise price is lower, executives prefer to be granted options when the stock price is at its lowest.