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Backdating of stock option

backdating of stock option-67

The Wall Street Journal (see discussion of article below) pointed out a CEO option grant dated October 1998.The number of shares subject to option was 250,000 and the exercise price was $30 (the trough in the stock price graph below.) Given a year-end price of $85, the intrinsic value of the options at the end of the year was ($85-$30) x 250,000 = $13,750,000.

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Backdating does not violate shareholder-approved option plans.Further, at-the-money options are considered performance-based compensation, and can therefore be deducted for tax purposes even if executives are paid in excess of $1 million (see Section 162(m) of the Internal Revenue Code).However, if the options were effectively in-the-money on the decision date, they might not qualify for such tax deductions.Remy Welling, a senior auditor at the IRS, was asked to sign the deal in late 2002.Instead, she decided to risk criminal prosecution by blowing the whistle.A 2004 NY Times article describes this case in greater detail (the article is available here), and so does a 2006 article in Tax Notes Magazine (available here).

In a 2004 CNBC interview, Remy Welling said that "this particular -- well, it's called a 30-day look-back plan, is even widespread in Silicon Valley and maybe throughout the country."The terms "spring loading" and "bullet dodging" refer to the practices of timing option grants to take place before expected good news or after expected bad news, respectively. This is what Professor Yermack hypothesized in his article discussed above, though he never used these terms.

Any remaining pattern is concentrated on the couple of days between the reported grant date and the filing date (when backdating still might work), and for longer periods for the minority of grants that violate the two-day reporting requirements.

We interpret these findings as strong evidence that backdating explains most of the price pattern around ESO grants.

Furthermore, the pre-and post-grant price pattern has intensified over time (see graph below).

By the end of the 1990s, the aggregate price pattern had become so pronounced that I thought there was more to the story than just grants being timed before corporate insiders predicted stock prices to increase.

Thus, if backdating explains the stock price pattern around option grants, the price pattern should diminish following the new regulation.