Criminal and Civil Charges Brought in Stock Option “Backdating” Scheme — The SEC and DOJ Get Serious!

On July 20, 2006, the Department of Justice and the Securities Exchange Commission filed criminal and civil charges against former executives of Brocade Communications Systems, Inc., one of the more than eighty companies currently under investigation for backdating stock options. One of the executives charged in the Brocade litigation is the former vice president of human resources. If found guilty of the criminal and civil charges, the former executives may be required to pay heavy fines and could face time in prison. The Department of Justice (the “DOJ”) and the Securities Exchange Commission (the “SEC”) have suggested that executives at other companies will be similarly charged.

Stock Option Backdating

Stock option backdating is the act of documenting a stock option with a grant date that is prior to the date that the necessary corporate action was taken to grant the option. There are various forms of stock option “backdating.” In some cases, option backdating is done intentionally to guarantee the option holder the lowest possible exercise price. In other cases, however, option backdating is primarily the result of poor recordkeeping or loose corporate governance controls.

Government agencies are also investigating “springloading” and “bullet-dodging” practices. Spring-loading is the act of granting an option immediately prior to the public announcement of good news that is expected to result in an increase in the company’s stock price. Bullet-dodging is the act of granting an option immediately following the public announcement of bad news that has resulted in a decrease in the stock price. Although these practices have few issues in common with backdating, and thus will not be discussed in this article, they could potentially result in securities law violations. For instance, a securities law violation may arise if the Board granted itself options at a time when it had favorable inside information about the company.

For the purposes of this article, we will assume that if an option was backdated, the stated “grant” date of the option is a date preceding the date on which all necessary corporate action was taken, with the result that the option holder received an in-the-money option—although the option was reported as being granted at fair market value.

Grant Date.

Option backdating is focused on the grant date of the stock option. For corporate and tax law purposes, the grant date of the option is generally the date that the Board of Directors (or other authorized committee or persons) took all of the necessary actions to award the stock option. In many cases, the date of grant is the date of the Board of Directors or Compensation Committee meeting. (We note that FASB Statement 123(R) [“FAS 123(R)”] defines the grant date for accounting purposes as the date on which both the employer and the employee reach a mutual understanding of the key terms and conditions of the award.)

Fair Market Value.

The grant date of the option is of primary importance in determining whether a stock option is granted “at fair market value.” As we will discuss below, for a number of important reasons companies want to grant options so that the exercise price of the option is equal to the fair market value of the underlying stock on the date of grant. Companies must be clear on the date of grant of the option in order to determine the exercise price of the option.


There are a number of factual scenarios under which stock options may be backdated. Some of the common scenarios suggest premeditated thought or, as the SEC might say, a “scheme to defraud.” At the other end of spectrum, innocent human error may result in unintentional backdating. Listed below are a few of the circumstances that can result in or lead to backdated stock options.

  • Corporate documents, including minutes of Board of Director meetings, may be altered to reflect a favorable grant date and exercise price.
  • Offer letters may be dated incorrectly, or hire dates manipulated to secure the lowest exercise price for the newly-hired employee.
  • Delayed communication of the terms of the option may result in manipulation of the terms of the option, including the grant date and exercise price, between the date corporate action was taken to grant the option and the date the award is communicated to the option holder.
  • Poor or sloppy recordkeeping may result in the preparation of erroneous stock option grant notices.

Backdating Prior before 2002.

The ability of a public company to manipulate the grant date of stock options has been curtailed since 2002, primarily by the passage of the 2002 Sarbanes-Oxley Act (“SOX”). SOX has resulted in tighter regulation of public companies with respect to their reporting and disclosure obligations and the way that companies maintain their internal controls. Under SOX, officers and directors of public companies are required to report on a Form 4 any change in the beneficial ownership of company stock within 2 business days of the change. This requires officers and directors to file a Form 4 with the SEC within two business days of the date of grant of the option, thus eliminating the ability to backdate an option more than two days and still comply with the Form 4 requirements. Prior to SOX, stock option grants were disclosed on a Form 5 within 45 days after the end of the end of the company’s fiscal year. SOX also requires public companies to set up internal controls that should both eliminate circumstances under which documentation can be manipulated and decrease the instances of the poor or sloppy recordkeeping. Keep in mind, however, that option backdating is not only a public company issue. Privately- held companies that grant stock options should review their internal procedures and set up systems to minimize instances of backdating.

All Necessary Corporate Action.

As we discussed above, for most purposes the grant date of the option is the date that all necessary corporate action has been taken to grant the option. There are two particularly troubling methods of granting options that can lead to option backdating. First is the use of the unanimous written consent for board actions and board committee actions. Section 141(f) of the Delaware General Corporation Law states that unless otherwise restricted by the certificate of incorporation or bylaws, any action that may be taken by the board of directors (or any committee thereto) at a meeting, may be taken without a meeting if all members of the board (or the committee) consent to such action in writing and the writing is filed with the minutes of the board (or the committee). The corporation laws of many other states contain similar provisions. If a stock option is granted pursuant to this Section 141(f), all necessary action to grant the option does not occur until all of the board or committee members have signed the unanimous written consent and the document is filed with the minutes. Confusion can arise (or the grant date of the option can be manipulated) when, for example, two of the members of the Compensation Committee sign the consent at the beginning of the month, the remaining two members sign the consent at the end of the month and the consent is returned to the secretary of the committee in the middle of the following month. The date of grant could be the date the consent is returned to the secretary; however, many corporate legal advisors would likely determine the date of grant to be the date the last committee member signed the consent. In the past, companies have elected any one of the possible dates (first signed, last signed, filed with the minutes) as the date of grant, or, more problematically, dated the consent after obtaining the signatures to match the date of the lowest possible exercise price.

The second method of granting options that can be problematic when pegging the option grant date is the delegation of the granting authority from the board of directors or the compensation committee to a committee of one (often the chief executive officer or the senior vice president of human resources). When this type of delegation occurs, no formal meeting is held to signify the date of grant nor is there typically a written record such as “minutes” of the one person committee meeting. Or, if minutes are drafted, they are not formally filed with the books and records of the company. A committee of one is a structure ripe for backdating because the executive granting the option can act on his or her own to manipulate the grant date; there is no check or balance. In addition, a committee of one can lead to inadvertent backdating through poor or sloppy recordkeeping or failure to accurately communicate the actions of the committee of one to those persons charged with documenting the options.

Potential Consequences

There are tax, legal and accounting issues that can arise from an option that was treated as granted at “fair market value” but was actually granted at a price lower than the fair market value at the date of grant. Below is a list of some of those potential issues.

Financial Accounting.

Prior to the effective date of FAS 123(R), companies were not required to recognize a compensation expense under APB Opinion 25 (APB 25) with respect to stock options if, among other factors, the exercise price of the option was equal to or greater than the fair market value of the underlying stock on the date of grant. However, an option that has been backdated would be considered a discounted stock option for financial accounting purposes, and the company would be required to take a charge to earnings with respect to the option. If enough stock options have been subject to backdating and the charge to earnings is significant, companies may be required to restate their financial statements to reflect the accounting consequences of granting discounted stock options.

Companies generally now report stock option expense on their financial statements under FAS 123(R), which requires that companies report a charge to earnings on their financial statements equal to the fair value of the option determined on the date of grant. Under FAS 123(R), the date of grant is the date that the company communicates the grant to the option holder. The accountants are still discussing how to reconcile the communication date and the date that all corporate action has been taken with respect to the option (the corporate law standard discussed above). Needless to say, this is an area ripe for confusion.

Companies should contact their independent financial accounts for accounting advice.

Incentive Stock Options.

An option is an Incentive Stock Option (“ISO”) if it is granted to an employee and has an exercise price equal to or greater than the fair market value of the underlying stock on the date of grant. (Special rules apply to employees who are ten percent stockholders of the employer.) If an option is an ISO, no income or employment tax withholding is required at the time of exercise. On the other hand, if an option subject to backdating fails to qualify as an ISO because the option was granted at a discount, then the option is taxed as a nonstatutory (or nonqualified) stock option at the time of exercise and income and employment tax withholding is required. If the company has failed to withhold applicable taxes on the exercise of the nonstatutory stock option, the company may be subject to penalties. If a person at the company knowingly fails to withhold applicable taxes, that person may be subject to personal liability for the amounts not withheld.

Internal Revenue Code Section 409A.

Internal Revenue Code Section 409A governs the taxation of nonqualified deferred compensation including stock options with an exercise price that is less than the fair market value of the underlying stock on the date of grant. Code Section 409A imposes penalties on service providers (including employees, officers, directors and consultants) who hold unvested, discounted stock options on or after January 1, 2005 that do not meet the requirements of Code Section 409A. Thus, service providers holding unvested, backdated options could be subject to penalties under Code Section 409A beginning in 2005 unless some action is taken to amend the option and bring it into compliance with Code Section 409A. Any action taken to bring discounted options into compliance with Code Section 409A must be done on or before December 31, 2006. (Please watch our newsletter for updates — this deadline may be extended.)

Internal Revenue Code Section 162(m).

Internal Revenue Code Section 162(m) limits the compensation deduction of public companies for amounts paid to certain executive officers to $1 million per year. Certain performance-based compensation is disregarded when applying the $1 million limit, including options granted with an exercise price equal to or greater than the fair market value of the underlying stock on the date of grant (so long as the other requirements of 162(m) are met). If the option has been backdated to manipulate the exercise price, the option likely will not qualify as performance-based compensation. In this case, any ordinary income recognized by the option holder may not be deductible on the company’s corporate tax return. If the company previously recognized the deduction, the company may be required to file amended tax returns and to restate its tax liability on its audited financial statements.


Officers and directors of public companies must report on Form 4 the grant of any option within two days of the grant date. Backdating would likely result in a missed or late Form 4 filing, which must be reported in the company’s proxy statement.

Other legal and regulatory issues.

Backdating stock options may result in the company’s failure to comply with the terms of the written stock option plan. For example, many stock option plans require that all options be granted with an exercise price equal to or greater than the fair market value of the underlying stock on the date of grant — or at not less than 85% of the fair market value of the underlying stock on the date of grant. Options that are backdated may fail to comply with the terms of the plan. This failure may mean that the option is invalid or that the employee has a rescission right against the company with respect to the option. If the option is deemed to be granted outside of the plan and the option has not been approved by the stockholders of the company, the option grant may cause the company to be in violation of NYSE or NASDAQ listing rules. Again, if the option is deemed to be invalid, and the option was previously accounted for in calculating compensation expense, the company may be required to restate its financial statements.

Next Steps

Companies (public and private) that grant stock options should conduct an internal audit of the stock option grant and documentation procedures. This investigation, if not already undertaken, should begin immediately. We recommend that the investigation include all outstanding stock options (whether vested or unvested) granted in the last ten years.

Internal audit — look for red flags.

  • Examine the exercise price of outstanding stock options and grant dates:
    • Is the exercise price the lowest reported price for the week of grant, the month of grant or the fiscal quarter of grant?
    • Are options granted on the same date annually, quarterly, or monthly or are options granted on various random dates?
    • Are there one or more grant dates where a mega-grant was made? For this purpose, a mega-grant might be a very large grant to one person, or the grant of stock options to very large group of service providers.
    • Did the grant date of any option precede the option holder’s hire date?
    • Do the dates of the Board of Directors or Compensation Committee meetings coincide with the grant dates of the options?
  • Report to the audit committee to determine whether an investigation should be made by an independent third party (a law firm with expertise in the area or a forensic accountant).

Establish grant procedures for stock option grants that are impervious to backdating.

  • Consider whether options should be granted on the same date each year, each fiscal quarter or each month.
  • Develop a system of checks and balances so that no one person is responsible for all of the steps in granting or documenting stock options.
  • Consider granting stock options to new-hires on the next regularly scheduled grant date instead of making hire date grants.
  • Review the security of official corporate documents (board and committee meeting minutes, offer letters, stock option grant notices), whether such documents are kept in hard copy or are stored electronically.
  • Perform mini-audits of the grant procedures on a regular basis.

Potential actions to be taken if violations are found by the internal audit.

While each case will need to be looked at individually and a specific plan designed for that case, the following are actions that a company may want to consider if violations are discovered (after consulting with its legal and financial accounting advisors):

  • Document the internal audit process of reviewing the nature of the violation, the extent of the violations and the origins of the violations.
  • Remediate any misconduct discovered, to the extent able.
  • Consider self-reporting violations to the SEC.