Backdating and Spring Loading Stock Options – The Dark Side

In the last year, numerous cases of backdating stock options have come to light. Apple has been the most high profile company to be embroiled in the scandal. Apple CEO, Steve Jobs, was recently cleared by an internal investigation, but the former CFO and General Counsel were not so lucky. What is “backdating”? It is the practice of issuing stock options or grants to employees and artificially picking a past date. The implications are clear. When a company picks a date when the stock price is lowest, the option has more value. Unfortunately, it circumvents the law and the original intent of the option. A recent ruling in the Delaware courts indicated that companies and their board directors would be liable if options were wrongly issued. Furthermore, the IRS has decided that employees who cashed in on backdated options may have increased tax liabilities and face significant financial penalties. Not a pretty picture.

The Judge in the Delaware decision, Chancellor William B. Chandler III, made it clear that backdating is illegal and that corporate boards need to act swiftly to rectify the wrong doing. What surprised many was his further discussion on “spring loading”. Spring loading options is the practice of granting options just prior to issuing good news (financial performance, merger/acquisition, positive news regarding a regulatory approval and so forth). If spring loading is deemed to be illegal, it could cause an even worse situation, as spring loading has been common practice in corporate America. In his decision, Chancellor Chandler stated, “It is difficult to conceive of an instance, consistent with the concept of loyalty and good faith, in which a fiduciary may declare that an option is granted a “market rate” and simultaneously withhold that both the fiduciary and the recipient knew at the time that those options would quickly be worth much more”. This puts a spotlight on compensation committees that determine executive compensation and their own compensation as directors.

The answer to these scenarios is the practice of granted stock at more frequent intervals and in smaller amounts. We have for years encouraged companies to implement a theory similar to risk-averse investing (predetermine amounts and dates each month, quarter or year). We have proven that over time, executives are actually better off using this process. Trying to time the market is a risky endeavor and manipulating it is even worse. Board Directors better get ahead of this wave or risk lawsuits and personal liability.