FAQ: What you need to know about stock options and backdating

A quick guide to what it is and why it matters

In recent months, the U.S. Securities and Exchange Commission has been looking at the stock-options practices of more than 100 companies. A variety of technology vendors, including Apple Computer Inc., Comverse Technology Inc., Foundry Networks, Intuit Inc., McAfee Inc., Progress Software Corp. and Quest Software Inc., have been conducting internal reviews and responding to SEC inquiries about the practice.

Just last month, the former CEO of Comverse Technology was arrested in Namibia on charges related to stock-options backdating. Last week, a member of Apple's board stepped down after a probe of options problems at that company. And earlier today, two executives at McAfee and the CEO of CNet left their jobs in the wake of options probes.

Here's a quick look at what options backdating is, what it means for companies and why the SEC is interested in the practice.

Just what is stock options backdating? In a sense, it's pretty much what it sounds like. Stock options are often given as an incentive to new hires at a company or to executives who have done well and can later be used to by company stock at a price lower than the stock's current market value. The value of the option is set on the day it's issued.

Backdating of a stock options occurs when a company changes the date on which the stock option was granted to a date on which the per-share price was lower, according to the SEC. At a lower price, more shares can be purchased for the same amount of money, inflating the options' value. Stock options are typically offered by a company to executives and other employees to give them the right to buy stock shares at a specific price, called the exercise price. Stock options can't be used until after a specific amount of time has elapsed.

Why is backdating in the headlines now, and is it illegal? Backdating a stock-option purchase date, or grant date, essentially allows the owner to get a discounted stock price. That is not necessarily illegal, according to existing SEC rules. But any backdating has to be reported and accounted for in tax filings and earnings reports.

By not properly reporting instances of backdating, companies are now running into potential trouble with the SEC. Backdating of stock-options grants can cause underpayment of taxes, which is why the government has been looking into these matters more closely in recent months.

How does backdating affect corporate earnings and shareholders? Many companies hit by stock options backdating questions have found out that they need to restate their corporate earnings, which negatively affects shareholders and stock prices. In some cases, back taxes and penalties for the purchases have to be paid by the companies, which hurts shareholders, according to Institutional Shareholder Services Inc., a Rockville, Md.-based group that provides proxy voting and corporate governance help to member institutions (download PDF).

How has the Sarbanes-Oxley Act of 2002 affected these purchases? One important change was that Sarbanes-Oxley tightened the requirements for stock-options reporting by companies. Previously, companies had 45 days to report such transactions, which left more time for backdating to occur. Now, reports must be made within two business days. Also, officers and directors of companies previously had until the end of the fiscal year to disclose their receipt of the grants, but that was changed by Sarbanes-Oxley to two business days.

Copyright © 2006 IDG Communications, Inc.

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