Backdating Stock Options: Accounting, Tax, and Legal Risks

Backdating stock options is a practice where the grant date of a stock option is retroactively set to a day in the past when the company’s stock price was lower. This action immediately makes the option more valuable to the recipient, as it is already “in-the-money.” While not always illegal, the failure to properly account for and disclose backdated options has significant consequences. The core issue is the misrepresentation of the option’s value and the associated compensation expense, which can distort the purpose of stock options as a tool to align employee and shareholder interests.

The Mechanics of Backdating

A stock option gives the holder the right to buy a company’s stock at a predetermined “strike” price. This strike price is the fair market value of the stock on the day the option is officially granted. This creates an incentive for the recipient to work towards increasing the company’s stock price, thereby making their options more valuable over time.

Backdating manipulates this process by using hindsight. For example, a company might formally approve an option grant on April 1st when the stock is trading at $30 per share. Instead of using that date and price, they might look back and select March 15th as the grant date, a day when the stock price was at a low of $22. The option paperwork is then drawn up with the March 15th date and the $22 strike price, instantly creating an $8 per-share gain on paper.

This practice is often motivated by a desire to make compensation packages more attractive in competitive markets for executive talent. By providing an immediate, built-in gain, the company can offer a more lucrative package without an immediate cash outlay. Methods can range from falsifying grant documents to allowing executives to choose their grant date from a window of time after the grant was approved.

Another scenario involves authorizing a pool of options at a specific price but delaying the allocation to individual employees until the stock price has risen. This also creates an “in-the-money” situation. Regardless of the method, the result is that the option’s exercise price does not reflect the stock’s true market value on the date the grant decision was actually made.

Accounting and Financial Reporting Consequences

The primary accounting issue with backdating is the misrepresentation of compensation expenses on a company’s financial statements. Under Generally Accepted Accounting Principles (GAAP), stock options are a form of compensation whose value must be recorded as an expense. A backdated option is an “in-the-money” grant because it uses a historical, lower stock price as its strike price.

Accounting Standards Codification (ASC) Topic 718 requires companies to recognize a compensation expense for the fair value of stock options. For an “in-the-money” option, this expense is the difference between the market price on the actual grant date and the backdated, lower strike price.

The problem in past scandals was that companies engaging in undisclosed backdating failed to record this required compensation expense. They treated the backdated options as if they were standard “at-the-money” grants, which under previous accounting rules often resulted in no recognized expense.

By omitting this cost, companies artificially inflated their net income and earnings per share (EPS), presenting a misleading picture to investors. When these practices were uncovered, companies were forced to conduct internal investigations and restate financial statements. These corrections often led to drops in stock price and a loss of investor confidence.

Taxation Implications

Backdating stock options has tax consequences for both the company and the employee. For the company, the ability to take a tax deduction for compensation expenses can be jeopardized. Backdating may disqualify the options from certain favorable treatments, leading to the disallowance of the corporate tax deduction for that compensation.

For the employee, the ramifications are governed by Section 409A of the Internal Revenue Code, which oversees nonqualified deferred compensation. A stock option granted with a strike price below the fair market value on the actual grant date is considered a form of deferred compensation under these rules. This classification triggers immediate tax consequences.

With non-qualified stock options (NSOs), an employee is taxed on the “bargain element”—the difference between the market price and the strike price—at the time of exercise. If the option violates Section 409A, the employee faces taxation when the option vests, not when it is exercised. This means the employee must pay taxes on income they have not yet received in cash.

On top of this early taxation, Section 409A imposes a 20% federal penalty tax on the amount of income recognized. Interest penalties may also be assessed on the underpayment of taxes from previous years. This combination of penalties can turn a valuable benefit into a financial burden for the recipient.

Regulatory and Legal Scrutiny

Backdating stock options attracts attention from regulatory bodies like the U.S. Securities and Exchange Commission (SEC). The legal issue is not granting a discounted option, but the failure to properly disclose and account for it. This lack of transparency can constitute securities fraud because it misleads investors about executive compensation and company profitability.

The SEC can take several enforcement actions against companies and individuals for undisclosed backdating. These actions include levying monetary penalties, forcing executives to disgorge gains from the options, and barring individuals from serving as officers or directors of public companies. A regulatory change now requires companies to report option grants to the SEC within two business days, reducing the opportunity for backdating.

Beyond SEC enforcement, undisclosed backdating can lead to civil litigation. Shareholders may file derivative lawsuits against a company’s board and management, alleging breaches of fiduciary duty, corporate waste, and unjust enrichment. These lawsuits seek to recover the financial harm caused by the improper option grants and subsequent financial restatements.

In cases with evidence of intentional deception, the Department of Justice (DOJ) may launch criminal investigations. These investigations can lead to charges of securities fraud, wire fraud, or mail fraud against the individuals involved. Such actions demonstrate the potential for criminal liability in these matters.