Options backdating possible in Canada

Stricter disclosure period lessens the likelihood, but income tax rules raise the incentive

Stricter disclosure rules in Canada in recent years may have made it more difficult for companies to backdate stock options granted to executives. But that doesn’t mean the practice doesn’t happen on this side of the border, some experts say.

“Is there some evidence that it’s happening? No, there are no specific cases yet. But it’s like asking how common is fraud? You don’t know until you find out,” said Neil Brisley, assistant professor in finance at the Richard Ivey School of Business who’s doing research on stock options-related issues.

In the United States, the Securities and Exchange Commission (SEC) announced this summer that more than 80 companies are under investigation. The SEC has also laid charges against former executives at two companies, Comverse Technology and Brocade Communications Systems.

When companies grant stock options as a form of compensation, they give the recipient a right to buy company shares at a pre-determined price. Typically, companies fix the price of the option at the same price that shares are trading at on the day the option was granted. That’s when the options are said to be “at the money.”

However, the company can also choose to fix the option price at a lower price than the share price on the day it’s granted. In that case, the options are said to be “in the money.”

Companies that backdate the options, however, are offering “in the money” options via yet another route — by saying they granted the options at some date in the past.

The incentive to backdate options, said Brisley, has much to do with tax rules in the U.S.

“By finding a date in the past, you’re pretending it’s at the money. And that meant until very recently that you did not expense the stock option. It did not hit the income statements, which is false accounting.”

The use of backdated options instead of straight salary also allows a company to get favourable tax treatment, he added. According to section 162(m) of the U.S. tax code, companies can deduct executive pay from their tax bill if the pay is $1 million or under. Beyond that $1 million, only performance-related compensation is tax-deductible.

Larry Moate, Toronto-based senior consultant specializing in executive compensation at Watson Wyatt’s Human Capital Group, said the backdating practice itself is, “to my knowledge, not illegal.

“What is illegal is if you’re not open and transparent in doing that. It certainly has bad optics. But when you go back and change the date of board meetings when there was no board meeting, that’s the part that’s fraudulent.”

In the case of Brocade, the SEC and the FBI allege that former CEO Gregory Reyes and former vice-president of human resources regularly granted in-the-money options to new and current employees. They also allege that Jensen created or told others to create paperwork to make it look like the options were granted on an earlier date.

In Brisley’s view, backdating options is out-and-out cheating.

“It’s false accounting. It’s pretending to the shareholders that you’re giving people less money than you are.”

To Moate, the main concern with the use of backdated options is it in effect guts the performance-based compensation program of its true spirit. The reason organizations grant executives and senior managers part of their compensation in the form of stock options is to align their interests with those of the company. The CEO has an added incentive to manage well, because then his own stock prices will go up.

But by granting options that are guaranteed from the start to give the CEO a profit margin, said Moate, “it makes the compensation arrangement less of an incentive arrangement and more of a retention bonus.”

Also potentially problematic is what’s called “spring-loading” — when the board knowingly gives executives stock options before the price goes up.

“The whole issue in both practices is with unscheduled options grants where you have these ad hoc grant arrangements. Where you get into less trouble is where there are regular scheduled option grants each year,” said Moate.

To make backdating more difficult, as of 2002, the Sarbanes-Oxley Act (SOX) requires directors and officers in the U.S. to report stock options to the SEC within two days, instead of 45. (Since 1999, the time frame for reporting in Canada has been 10 days.)

However, according to two finance professors at the University of Michigan’s business school, 24 per cent of stock option grants are reported late. “Backdating and camouflaged timing appear to be practised even after SOX, especially by smaller firms,” they concluded.

Plus in Canada, there’s an added incentive to cheat, Brisley noted. When the executive exercises an option, any gains he makes is treated as capital gain, and only half the amount is subjected to income tax.

However, “if it’s an in the money stock option, you lose that favourable tax treatment. So that’s an incentive for cheating in Canada,” said Brisley.

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