South-Western - Management  
Authorities Probe Improper Backdating of Options
Topic Ethics and Social Responsibility
Key Words SEC, stock option grants, backdating, strike price, Sarbanes-Oxley Act
News Story

The Securities Exchange Commission and business academics are taking a close look at company executives who may have improperly backdated stock option grants in order to receive financial benefit when selling their shares. Representatives from Mercury Interactive Corporation admitted to the practice, which resulted in the resignation of their CEO and two other top officials. The SEC is investigating approximately twelve companies in all.

In addition to the SEC, business academics have noticed an overall pattern of stock prices dropping ahead of reported dates of option grants, and then rising just afterward. Company executives purchase options at a preset strike price (the point where stock options can be converted to shares), and must retain the options for a set period before doing anything with them. By backdating, executives tie the strike prices to earlier, more favorable dates.

Therefore, the pattern shows stocks dipping sharply before the date of option grants, then rising immediately afterward. In other words, the executives changed the purchase date of buying shares when the price was low, which enabled them to sell their shares at a profit. Although backdating is legal, it does raise issues of disclosure. The Sarbanes-Oxley Act has been a significant influence on preventing the practice of backdating. Before the legislation, companies had weeks or even months to report option grants. After Sarbanes-Oxley, companies only have two days, which means less time for executives to find a more favorable grant date.

Although some experts are skeptical of the backdating theory, others believe the data is persuasive. In addition to Mercury, other companies involved in the investigation include Brocade Communications Systems, Siebel Systems, Nyfix and Analog Devices. No charges have been filed against any of these companies.

With Nyfix, its CEO stated the problem was that his company set grants for employees on certain dates, and when executives were given their grant options, they were set on an earlier date. Another issue is that the company sometimes set the price of options for new employees when they were hired, not on the set option date. However, another company sanctioned their grants just before the company released positive earning news, which is why the SEC continues to investigate.

Questions
1.

Research stock options in your text and online at nceo.org. What are the two principal types of stock option programs? How are stock options beneficial to the growth of a new company?

2.

Do you think the practice of backdating stock options is unethical or illegal? Justify your answer.

3.

Research the Securities Exchange Commission at sec.org. How does the organization protect investors from fraudulent activity?

Source “Authorities Probe Improper Backdating of Options,” The Wall Street Journal. Nov. 11, 2005. Page A1.
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