With complete hindsight, we can now all agree that this purpose was not achieved." This change in the tax law tilted compensation practices away from salary and other forms of cash compensation in favor of stock options and other types of non-cash compensation to which the cap did not apply.
In addition, companies turned more and more to options as a form of compensation because they believed they helped align the incentives of shareholders and managers.
Unlike the abusive corporate tax shelter ploys which often involve complex manipulation of a transaction to achieve tax results that are inconsistent with the economic reality of the deal, stock option backdating is a relatively crude device: A corporation merely changes the date that a stock option was actually granted to an earlier time when the stock price was lower.
Thus, the option becomes "in the money", meaning there was a built-in profit on the underlying stock, on the grant date.
(For more insight, see ) Although it may appear shady, public companies can typically issue and price stock option grants as they see fit, but this will all depend on the terms and conditions of their stock option granting program.
However, when granting options, the details of the grant must be disclosed, meaning that a company must clearly inform the investment community of the date that the option was granted and the exercise price. In addition, the company must also properly account for the expense of the options grant in their financials.
A quick examination of the cases against Brocade clearly identifies why backdating is synonymous with fraud, even though no U. The practice involves using hindsight to assign a stock-option contract an earlier date than its actual grant date.
By pushing the date into the past, to a time when the underlying stock traded at a lower price than it did the day the grant was issued, the option holder is, in effect, being given the promise of cash.
I am pleased to testify with Acting IRS Commissioner Kevin Brown today and to share with you the Securities and Exchange Commission's perspective and insights on this form of compensation, which has become a significant component of executive pay among today's public companies.
The cascading litany of alleged charges is not likely to stop with the Brocade case.
Indeed, with more than 80 companies being reviewed by the SEC for potential illegal backdating practices, and one academic study claiming that more than 2,000 companies have engaged in the practice, civil and criminal charges will probably mushroom in the next few months. The purpose of backdating is straightforward: it gives options holders an immediate paper gain, and a real gain once the option is exercised.
If the company sets the prices of the options grant well below the market price, they will instantaneously generate an expense, which counts against income.
The backdating concern occurs when the company does not disclose the facts behind the dating of the option.
Stock option backdating has erupted into a major corporate scandal, involving potentially hundreds of publicly-held companies, and may even ensnare Apple's icon, Steve Jobs.