A quick guide to options backdating
Until recently, only techies paid attention to Brocade Communication Systems, a San Jose, Calif., company that makes routers and other networking equipment. But after yesterday's filing of civil and criminal charges against former Brocade executives, the company has become a poster child for the latest corporate controversy: options backdating.
Securities and Exchange Commission Chairman Christopher Cox indicated this week that the Brocade charges may be just the start of an enforcement wave that could engulf dozens of better-known companies. He told reporters that the federal agency is now examining options-granting practices at 80 firms. Among those under scrutiny are several likely to be included in many investors' portfolios: Analog Devices, Applied Micro Circuits, Caremark, CNet, HealthSouth, Juniper Networks, Sepracor, and United Health.
Options backdating may seem outrageous to investors, who, after all, are not given the opportunity to backdate buy orders and purchase stock at old, cheap prices. But backdating isn't a slam-dunk for prosecutors and regulators because it is not necessarily illegal for companies to give such a sweet deal to their employees. Here are answers to frequently asked questions about options backdating:
What are stock options?
An option is the right (or option) to buy a share of stock for a predetermined price at some future point. Companies typically give options dated several years in the future to executives and other employees free of charge as a part of their compensation packages. Investors have to pay for options. For example, investors can today pay $4 for an option to purchase Microsoft shares next month for $20. (Microsoft is currently trading just below $24.)
Why do companies give employees stock options?
Companies argue that giving employees the right to buy stock at a set price in, say, three years makes them more interested in making sure the stock price goes up over that period. In other words, options are supposed to make employees think the way investors do and thus be eager to help the company by keeping costs low, raising sales, and so on. Of course, companies could similarly motivate employees by using cash bonuses. But companies may be short on cash or prefer to use cash for other purposes.
What is backdating?
Many companies, it now appears, allowed executives, board members, and other employees to look back over the history of their company's stock price movements and pick a date in the past on which they wanted their options to be granted. Thus, the executives could, and did, guarantee themselves a profit by selecting a date on which the stock price was very low. The options allowed the executives to buy stock in the future at the old, low stock price.
What are the rules governing backdating of options?
Companies are free to give employees the right to purchase stock at whatever price the company wants, but they are supposed to reveal those actions to investors and deduct the costs of the options from profits. Until the Sarbanes-Oxley Act of 2002, companies were free to give employees options, and not deduct the cost from profits, as long as the price at which the employee could buy future stock was the price set by the market on the day the option was granted. Now, companies must deduct even the costs of those options from their profits.
If companies are free to backdate options, why are companies coming under SEC scrutiny?
Many companies, it turns out, hid the backdating from investors and failed to subtract the costs from their profits. Lying to investors can be grounds for criminal prosecution by the Justice Department and civil penalties by the SEC. These actions may also mean the companies filed inaccurate tax forms, which could cause the Internal Revenue Service to demand fines and penalties.
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