The current SEC and DOJ investigations into the backdating of stock options may have, in part, been prodded by news articles, primarily those in the Wall Street Journal. In this regard, these investigations would not differ markedly from those into the so-called “market timing” and “late trading” practices at mutual funds, which were spurred in part by wide spread press coverage. In fact, both scandals share common threads. Backdating stock options is not in and of itself illegal as SEC Commissioner Paul Atkins noted in a July 2, 2006 speech. Similarly, market timing is not in and of itself a violation of the federal securities laws and late trading is, at best, only arguably a violation of those statutes. All of these practices may, however, violate the federal securities laws when combined with other activity such as non-disclosure or improper accounting in the case of backdating options or violation of specific representations in a prospectus or other disclosure documents in the case of market timing and late trading.

Now consider stock option spring-loading and bullet dodging. The former refers to timing the issuance of an option just before a company announces good news, while the latter is the opposite, timing the grant to avoid a downward movement in the stock price from bad news. Neither practice is considered a best practice in corporate governance. Rather, these practices may be forms of insider trading that differ from backdating. Insider trading is based on the theory that insiders should not use company information for their personal benefit. If, however, the company uses the information is there an abuse? Many would say no because the company is permitted to use its information as it sees fit. These points are discussed in a recent New York Times article. Despite recognition of the at best dubious legal theory on which spring-loading and bullet dodging may be based, the article ends by suggesting it would be regrettable if government prosecutors chose not to prosecute these cases.

Why? If these practices are not insider trading or if the basis of the legal theory is dubious at best, what would be regrettable is for the government to try and prosecute those cases. Government enforcement actions, whether civil when brought by the SEC, or criminal when brought by the DOJ, carry terrible consequences for those accused. That accusation can cause significant harm to a company and severely damage, if not end, the a career of an executive or professional. In many ways the power to charge is the authority to convict because the accusation whether proven or not never goes away – it lingers for years to sully what may have otherwise been a good reputation built over the years. So here is hoping that in this case publicity may not spur more action by government prosecutors and that great care is taken in bringing option enforcement actions.

A great deal has been written about executive compensation in the wake of the SEC’s new rules on the subject.  In many instances, articles on the subject are critical of the large amounts paid to senior executives.  The current stock option backdating scandal has fueled this debate.  In two enforcement actions, the DOJ and the SEC, respectively, have alleged criminal and civil violations in connection with the backdating of options issued at least in part to senior executives.  It looks like these executives profited plenty from such practices.  For example, in the Brocade case one executive got 500,000 backdated options that are described as having an immediate paper profit of $2.5 million.  But “paper” may be the key word there.  The question is what factors should be analyzed in determining how much the executive profited and how much shareholders may have lost?    

The answer is anything but clear.  The enforcement actions seem to talk about the profits to executives as if one can simply take the difference between the price the options should have been issued at and what the backdated price was as the profit.  Critics argue that this practice misaligns the interest of shareholders and the executive because options are suppose to be an incentive to improve the stock price in the future, not give an instant profit.  No doubt this is true. 

Backdating options, however, may not necessarily give any executive an “instant profit.”  Most options are not immediately exercisable.  If the options are not exercisable for a period of years, the executive may or may not make a profit depending on what happens to the stock price.  If the price goes down below the price at which the options were issued there will not be any profit.  Thus, the executive has an incentive to keep the stock price up to at least the issuance price and more – the greater the stock price the greater the profit. 

A working paper of Boston University Law School Professor David Walker argues that, in fact, the profits to executives are not as large as they appear and that profits cannot be determined by looking at the difference between the backdated stock price and the stock price on the actual date of issuance.  Rather, Professor Walker argues that actual profits from backdating are much smaller than the amount determined from this calculation. The paper is available at
Now this is not to say backdating is good.  But the question is, what did the executives get and what is the harm to shareholders?  One University of Michigan study reported in the New York Times on September 6, 2006, estimates that the average executive’s pay was sweetened by about 1.25% or about $600,000 per year.  At the same time, recent disclosures about option dating practices have caused shares to drop about $500 million, according to the study.  

On the other hand a Bloomberg study released on September 27,2006, estimates that investors have lost about $7.9 billion in market cap.  Loss of market cap, however, may be the impact of a temporary drop in share price based on market reaction.  Consider for example the report in the New York Times on September 29, 2006 about Research In Motion, maker of Blackberry wireless e-mail devices.  RIM disclosed that it had begun an investigation into its handling of stock options.  The company went on to report that it expected to restate its financial statements and reduce its net earnings since 1997 by $25 million to $45 million.  The news, according to the Times report, “did not faze investors.”  This may be because the market anticipates that the adjustments will be in the past and the news about RIM’s current earnings is good.  But that leaves the questions of what did the executives make from these practices and what did shareholders lose?