Option Backdating: A New Study Dictates a Proactive Approach

A new study by finance professors suggests that the backdating of stock options may be a much more wide-spread practice than once thought.  Initially, many believed that stock option backdating might have been concentrated in the high tech area.  Later, many thought that the practice occurred predominately during the period before the passage of the Sarbanes-Oxley Act in 2001.  Now, however, a new study by Professor John Bizjak of Portland State University and Michael Lemmon and Ryan Whitby of the University of Utah entitled “Option Backdating and Board Interlocks” suggests that as many as fifty percent of the companies that issued options during the 1990’s engaged in backdating.  This conclusion would clearly make the practice much more wide-spread than anyone had initially thought. 

The study also suggests that the practice may have proliferated as a result of directors who held positions on more than one board.  Overlapping board memberships may have facilitated the transmission of the practice from one company to another through the small and exclusive club of corporate directors.  This suggestion is also contrary to the current wisdom that the practice was management driven – at least that is the inference from the two cases the SEC and DOJ have filed.  This finding also undermines the theory that outside directors will serve as a watchdog on improper management practices.  If correct, it means the watchdog is the source of what may –backdating is not illegal in and of itself – be an improper practice. 

The study should clearly cause everyone to rethink the issues surrounding option backdating.  It also significantly changes the stakes for corporate boards and officers.  Previously, companies understandably could have thought that questions about backdating were limited to a handful of companies and, thus, no action was required.  Now the stakes are different.  The new study suggests that the problem is so prolific that it cannot be ignored, particularly in view of the stakes. 

If a company discovers a problem it has the opportunity to take control of the situation and expeditiously resolve it.  If, however, the SEC, another regulator, or even a whistleblower discovers a problem the company will loose the opportunity to control the situation and guide it to a chosen resolution.  Prudence dictates that companies take a proactive approach, conducting an internal investigation into its past option granting practices followed by taking any necessary corrective steps.  The alternative is to gamble that the company is in the fifty percent of companies that did not backdate any option grants.  In view of the high stakes and the impact of being wrong, that would be a bad gamble.

Bizjak , John M., Lemmon, Michael L. and Whitby, Ryan J., “Option Backdating and Board Interlocks” (November 2006). Available at SSRN: http://ssrn.com/abstract=946787.  A discussion of the report is contained in the New York Times, January 21, 2007 at BU-5.