For several years, Micrel allowed its employees to choose the lowest price for the stock within 30 days of receiving the options.
After these stock option terms came to the attention of the IRS in 2002, it worked out a secret deal with Micrel that would allow Micrel to escape million in taxes and required the IRS to keep quiet about the option terms.
Unfortunately, these conditions are rarely met, making backdating of grants illegal in most cases.
The Wall Street Journal (see discussion of article below) pointed out a CEO option grant dated October 1998.
The number of shares subject to option was 250,000 and the exercise price was $30 (the trough in the stock price graph below.) Given a year-end price of $85, the intrinsic value of the options at the end of the year was ($85-$30) x 250,000 = $13,750,000.
ESOs are usually granted at-the-money, i.e., the exercise price of the options is set to equal the market price of the underlying stock on the grant date.
Because the option value is higher if the exercise price is lower, executives prefer to be granted options when the stock price is at its lowest.
The graph below shows the dramatic effect of this new requirement on the lag between the grant and filing dates.
To the extent that companies comply with this new regulation, backdating should be greatly curbed.
Unless corporate insiders can predict short-term movements in the stock market, my results provided further evidence in support of the backdating explanation.
In a second study forthcoming in the Journal of Financial Economics (available at Randy Heron of Indiana University and I examined the stock price pattern around ESO grants before and after a new SEC requirement in August of 2002 that option grants must be reported within two business days.
Most shareholder approved option plans prohibit in-the-money option grants (and thus, backdating to create in-the-money grants) by requiring that option exercise prices must be no less than the fair market value of the stock on the date when the grant decision is made. For example, because backdating is used to choose a grant date with a lower price than on the actual decision date, the options are effectively in-the-money on the decision date, and the reported earnings should be reduced for the fiscal year of the grant.
(Under APB 25, the accounting rule that was in effect until 2005, firms did not have to expense options at all unless they were in-the-money.
Furthermore, the pre-and post-grant price pattern has intensified over time (see graph below).