The Options Backdating Scandal – Could it Happen in the UK?

The options backdating problem stems from a number of practices adopted when granting employee stock options.

Stock options are generally granted to executives as an incentive. They tie executive pay to shareholder returns by allowing executives to earn compensation equal to the difference between the stock price at the date of the grant, the strike price, and the stock price at the date the option is exercised. The executive therefore has an incentive to increase the company's stock price so that the option can be exercised for a profit.

'Backdating' occurs when the price at which the stock option is granted reflects a date in the past, upon which the stock price was lower than on the date that the options are actually granted. This pricing methodology allows the option holder to take advantage of an opportune date, with a low stock price, to build in an immediate unrealised profit and/or increase the prospects of a more profitable sale when the options are exercised.

Backdating has come to be used as an umbrella term, encompassing a number of activities, including:

• 'Spring-loading', which involves timing the grant of an option so as to pre-date the release of good news likely to increase a company's stock price
• 'Bullet-dodging', which involves timing the grant shortly after the release of bad news

The practice is not necessarily illegal. If the company granting the stock options properly discloses the backdating at the actual time of the grant then no problem arises.

However, the grant is referred to as a 'discounted grant' and will not qualify for the same beneficial tax treatment as standard, fair market value, options grants. In light of this, some companies seek to conceal the backdating by misrepresenting the position or falsifying documents, which is likely to be regarded by the regulatory authorities as an act of fraud.

THE SCANDAL IN THE US

The scandal broke when the Wall Street Journal discovered from Securities and Exchange Commission (SEC) filings that options grants were occurring in unusual numbers on days when the stock price was much lower than normal, and in particular on the day with the lowest stock price in the fiscal year.

This precipitated a wide-ranging investigation, which has so far led to as many as 120 public US companies coming under SEC scrutiny. The numbers of businesses announcing internal investigations or the receipt of subpoenas from regulators continues to increase. Several senior executives have already had their contracts terminated or been forced to resign.

It appears that prior to the introduction of the Sarbanes-Oxley legislation and prior to the renewed focus on corporate governance which arose in the aftermath of Enron, the practice of backdating was rife in the US and only now are the problems being addressed.

THE POSITION IN THE UK

The position is rather different in the UK. Strict governance rules, in particular in relation to the disclosure of stock option grants, have seemingly prevented problems on the scale seen in the US.

Listed businesses have a 42-day period following results announcements to grant options packages, leaving little room to interfere with grant dates, while the requirement for better disclosure of stock option packages and exercise conditions for issuers in the UK has made the sort of manipulation seen in the US difficult.

However, it is still possible for UK companies to manipulate stock option grants and the consequences could be as serious as those in the USA. Such action could lead to a company being found guilty of breaching the UKLA disclosure rules, insider dealing, market abuse or false accounting.

With this in mind, it is important for companies to heed the lessons provided by the US scandal and to ensure that they are careful to avoid complacency when it comes to proper documentation and disclosure in relation to the granting of stock options. Best practice is rarely an absolute concept, but there are certain steps which companies can take in order to protect themselves and their executives from erring. Such steps may include the following:

• First, it is advisable for companies to document internal procedures which prescribe defined windows throughout each year during which grants can be made and which stipulate requirements for punctual and appropriate disclosure following those windows
• Secondly, companies should avoid tying their rewards policy too closely to performance indicators that are overly focused on short-term price movements or which can easily be manipulated for short-term gain
• Thirdly, companies should ensure that their remuneration committees act independently of their boards in establishing and implementing remuneration policies

In summary, the type of corporate irregularity seen in the US when granting stock options is less likely to be a problem in the UK. The UK regulatory environment is, and has been for some time, stricter than the regime which persisted in the US prior to the introduction of the Sarbanes-Oxley legislation and which appears to have allowed illegitimate options backdating to flourish.

Companies in the UK should, however, remain mindful of the need for good governance in all aspects of remuneration policy and of the potential pitfalls which the American experience so clearly illustrates.