On the Use (and Abuse) of Stock Option Grants

Recently, a significant number of companies have come under public and regulatory scrutiny for backdating stock option grants. This article discusses factors that influenced the dramatic increase in stock option compensation and summarizes the academic research that led to the discovery of backdating. The information gained in this early stage of investigation provides some insight into the number of companies and potential costs of option backdating. Increased transparency and timely disclosure should curtail grant-date manipulation, but the credibility of the disclosure system requires active enforcement of the rules and standards. Investors need accurate, complete disclosures of executive compensation to hold boards of directors accountable for executive compensation.The structure and form of compensation for executive officers of publicly traded companies have changed dramatically since the early 1990s; the number and value of stock options granted to executive officers exploded during this period. Stock options can be used to align the financial interests of managers and shareholders, provide retention incentives, and compensate employees without any immediate cash outflow. Critics of stock options, however, have argued that the historical accounting treatment of stock options and the possible tax advantages for stock options relative to cash-based compensation have contributed to an excessive use of option-based compensation.Although companies are now required under Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS 123R) to expense stock options by using option-pricing methodologies designed to capture the underlying economic, or “fair,” value of the option grant, a new controversy over stock option grants has arisen as a significant number of companies have been identified as likely to have backdated stock option grants.Backdating is the practice of selecting option grant dates on a retroactive basis to reflect a lower stock price than the stock price on the date the actual granting decision occurred. With the benefit of hindsight, we can see that companies that grant backdated options are effectively granting in-the-money options. The accounting rules in place prior to SFAS 123R did not require companies to expense stock options as long as the options were not granted in the money.We present summary data that illustrate how the structure of CEO pay packages changed during the 1996–2005 period and the increased emphasis on options. We then discuss the academic research leading to the discovery that executive option grants were being backdated and provide graphs demonstrating the return patterns around the time of option grants prior to and following the adoption of SOX. We also discuss how the backdating scandal surfaced in the media and was followed by an explosion of interest in 2006.Although the industry is in the early stages of learning about backdating practices, we provide some evidence as to the breadth of the practice and the potential economic costs for companies involved in it. By November 2006, more than 170 companies had been mentioned as having potential backdating problems, and that number is likely to substantially increase. Also, from early information, we find that the costs of investigating and fixing backdating problems are likely to be material for many companies.We conclude with a discussion of additional measures that are being taken and should be taken to prevent or limit abuses of option granting, such as backdating, in the future. Companies are now required to expense option grants at fair value for accounting purposes, and new U.S. SEC rules for compensation disclosure require companies to provide greater details regarding the timing of option grants than were required in the past. Increased transparency combined with timely disclosure should curtail manipulation of option grant dates, but the credibility of the disclosure system still requires active enforcement of the rules and standards in place. Ultimately, investors need to use the more accurate and complete disclosure of executive compensation in general, and option grants in particular, to hold boards of directors accountable for the compensation paid to executives.