Options backdating is the practice of granting an
employee stock option that is retroactively dated to increase its value. This practice raises a number of legal and accounting issues. The practice of backdating itself is not illegal, nor is granting of discounted stock options. What is illegal is the improper disclosures, both in financial records and in filings with the
United States Securities and Exchange Commission (SEC). Options backdating effectively transfers wealth from existing shareholders to management by diluting the EPS. (earnings per share)
In 1992 the SEC imposed a rule requiring companies to report executive stock options in detail. Even after the rule, some executives could legally delay reporting option grants for so long that it was virtually impossible to figure out whether any individual grant had been backdated.
Since the Enron scandal, the U.S. Congress enacted Section 409A of the Internal Revenue Code to deal with such non-qualified deferred compensation. Backdated stock options would be considered discounted stock options triggering additional taxes and penalties at vesting or exercise. Most of the legal issues arising from backdating are a result of the grantor falsifying documents submitted to investors and regulators in an effort to conceal the backdating.
In 1995, New York University finance professor David Yermack studied data that companies were obligated to publish, under a 1992 SEC decree, in connection with the exact dates of options grants in proxy statements. Previously, dates were disclosed within often ignored filings. Yermack found a pattern that the stock prices often declined in value just prior to the time of the grant of the options, and rose thereafter. He theorized that the executives were timing the awards of the options so that the issuances would precede good news and would follow bad news. In 1997, his findings were published in the Journal of Finance.