First service backdating stock options
If the compensation expense is not properly reflected in earnings, the company’s financial statements will be inaccurate and restatement of the financials may be required.
The discovery of past backdating practices may raise issues as to the adequacy of the company’s internal controls and disclosure controls and procedures.
Options granted at less than fair market value or without proper board or committee approvals may violate the terms of the applicable option plan, with the result that options could be invalid.
Exceeding the authority set forth in a shareholder-approved plan may also run afoul of stock exchange rules requiring shareholder approval of equity-based compensation.
Finally, an option granted at less than fair market value that either vests in whole or in part after December 31, 2004 or granted or modified after October 3, 2004 raises issues under the new deferred compensation rules set forth in Section 409A of the Code.
Under Section 409A, the recipient could be subject to acceleration of taxable income and additional taxes and penalties, and the company could be subject to special tax withholding and reporting requirements.
Several companies have expressed their intent to restate financial statements due to option timing issues, and opportunistic attorneys have already filed derivative and class action lawsuits.
The author of the academic study who is credited with focusing regulators on this issue estimates that at least 10% of “at-the-money” grants of options to CEOs between 19—before Sarbanes-Oxley shortened the reporting period for option grants—were backdated.
Options granted as of the commencement of employment based on the market price as of the date of acceptance may be problematic if the plan does not permit below-market grants or the grant is not treated as a discounted option for accounting and tax purposes.
Another scenario involves the allocation of grants to employees from an authorized pool.
If the exercise price is set when the pool is authorized by the board or committee but the allocation and actual grants occur later (when the stock price has increased), backdating issues may arise.
It could also lead to delays in filing financial statements while the magnitude of the problem is determined.
Adverse tax consequences may result from option backdating practices.