A Crackdown on 'Perfect' Timing

SEC Chairman Christopher Cox, shown after giving a speech June 7 in New York, says that the practice of backdating, when done improperly, can erode the very performance incentives that stock options are is supposed to encourage.
SEC Chairman Christopher Cox, shown after giving a speech June 7 in New York, says that the practice of backdating, when done improperly, can erode the very performance incentives that stock options are is supposed to encourage. (By Daniel Acker -- Bloomberg News)
By Kathleen Day
Washington Post Staff Writer
Wednesday, June 14, 2006

Federal regulators plan to crack down on an increasingly popular corporate practice that boosts executive compensation by guaranteeing profits on stock-option awards.

The Securities and Exchange Commission is to issue a statement, possibly as early as next month, clarifying the agency's view of when current law allows backdating of stock options -- picking a date when the stock was at a low point to be the date of the award, thereby immediately guaranteeing a profit. Companies need the permission of directors, consistent with company policy, and full disclosure to investors, including properly counting the added costs against earnings.

"We will issue guidance on the backdating of stock options that will more clearly circumscribe the bounds of acceptable conduct," SEC Chairman Christopher Cox said in an interview yesterday.

The action stems from a widening federal probe by the SEC and the Justice Department into whether several dozen companies backdated stock options illegally, making them more valuable by changing the date on which they were said to have been issued without telling shareholders and without recording the additional compensation cost as an expense against the bottom line.

More than three dozen companies have said they are being investigated by federal regulators for possible illegal backdating. While the SEC has been investigating backdating abuses for several years and more intensively in the past 12 months, most of the company announcements have been made since March, after the Wall Street Journal began publishing articles that focused public attention on the issue.

Stock options give an executive the right to buy a company's stock at a set price sometime in the future. Options are supposed to be valued on the date they are issued. The idea behind options is to give executives a non-cash incentive to improve the company's performance and, thus, its stock price. The executive would then profit from the difference between the cost of the stock under the option grant and the price at which it is sold after holding it for at least six months, as federal law requires.

Company officials backdate options to maximize an executive's profit. If a person buys 1 million shares for $25 a share and sells them for $30 a share, that executive will pocket $5 million, before transaction costs and taxes. If the executive backdates the option to a day when the stock was valued at a low point, say $20, then the seller will make $10 million profit by selling the shares at $30.

For the past six years or so, as stock options gained in popularity, regulators and the investment community began to notice that a company's stock price often rose after the company awarded executives stock options. That led to concerns that companies might be timing announcements to give stocks a boost after options awards were made.

In 2003, the SEC began to notice another wrinkle in possible improper manipulations of option awards, backdating. The agency brought one case citing backdating, and the head of the agency's enforcement division opened 2004 with a speech warning about a possible trend.

In the past 18 months several academic researchers have found a correlation between stock options being awarded and periods when shares were trading at their lowest point in a given time frame, usually several months but sometimes up to a year.

Under a law Congress adopted after a series of high-profile accounting scandals, beginning with Enron Corp., executives must file statements with the SEC within two days of a buying or selling a company's stock or being awarded options. The law, which took effect in the fall of 2002, shortened the period from 40 days with the intent of giving investors fresher information and preventing situations like those leading to the fall of Enron in 2001, when Enron's then-chairman, Kenneth L. Lay, was promoting the company's stock to investors while he was quietly selling his own shares in the company.

As the potential problem of backdating caught regulators' attention, they anticipated the shorter two-day filing period would make it harder for companies to backdate options and hide what they were doing.

A team of University of Michigan professors recently analyzed 569,000 SEC filings on option grants in the two years after the shorter filing period took effect, from August 2002 to August 2004, and found that 24 percent of such notices were filed late, with 10 percent more than a month late. They found smaller firms tended to be more likely to have a longer filing lag.

The professors said the delays suggest backdating and concluded that the new, shorter filing period has failed to thwart stock-option manipulation. SEC spokesman John Nester disagreed, saying the evidence the agency has seen so far suggests the "vast majority" of backdating occurred before the shorter filing deadline took effect.

Even so, the agency clearly thinks it needs to act soon. The clarifying statement Cox envisions the agency making next month probably will be issued at the same time the agency votes on a final set of new rules requiring companies to disclose more information about executive compensation, including how stock options are awarded, when company policy permits backdating, and what is the added cost of backdating.

Backdating has also caught the eye of powerful members of Congress. "It's one thing for an executive to make big profits because he's improved his company, but it's a whole different thing to make big profits because he's playing fast and loose with the dating of stock options," Senate Finance Committee Chairman Charles E. Grassley (R-Iowa) said yesterday, after his committee held a hearing on backdating and other practices that can lead to lost tax revenue for the federal government.

"Outside the corporate suite, Americans don't get to pick and choose their dream stock price," he said. "The market dictates the price. It's bothersome to think that after the corporate scandals of recent years, some executives are still looking for ways to cook the books for personal gain."

Several pension funds are suing companies over the timing of options grants. Cox said that when done improperly, the practice of backdating can erode the very performance incentives that options are is supposed to encourage.

"What makes the option work as a powerful motivational tool is, that unlike a bonus, it isn't so much a reward for prior performance as it is an incentive for future performance," Cox said in a speech last week. "That's why the undisclosed backdating of options is such a serious potential problem. By giving the recipient of options an undisclosed paper gain right from the start, it cuts the direct connection to future performance. And in the process, what investors might otherwise view as a shareholder-friendly way to align their interests with those of the company's executives becomes instead a more expensive way for the firm to structure its compensation program."

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