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The problem with this practice, according to the SEC, was that stock option backdating, while difficult to prove, could be considered a criminal act.
One of the larger backdating scandals occurred at Brocade Communications, a data storage company.
Since the advent of stock option backdating, corporate policies have moved first toward a posture of encouraging backdating as a standard business practice, but then toward a posture of avoidance as public scandals emerged and investigations into fraudulent or dishonest business practices increased despite a commonly held belief that backdating was an acceptable and legal practice.
In the modern business world, the Sarbanes-Oxley Act has all but eliminated fraudulent options backdating by requiring companies to report all options issuances within 2 days of the date of issue.
To avoid having to pay higher taxes, many companies adopted a policy of issuing “at the money” stock options in lieu of additional income, with the idea that the executive or employee would benefit through the option by working to increase the value of the company without exceeding the one million dollar deductibility cap for executive income.
Many companies' stock option plans provide that stock options must be granted at an exercise price no lower than fair market value on the date of the option grant.
However, if the company granted options with an exercise price below fair market value, there would be a compensation expense that had to be recognized under applicable accounting rules.
If a company backdated its stock options, but failed to recognize a compensation expense, then the company's accounting may not be correct, and its quarterly and annual financial reports to investors may be misleading.
If a company grants options on June 1 (when the stock price is 0), but backdates the options to May 15 (when the price was ) in order to make the option grants more favorable to the grantees, the fact remains that the grants were actually made on June 1, and if the exercise price of the granted options is , not 0, it is below fair market value.
Thus, backdating can be misleading to shareholders in the sense that it results in option grants that are more favorable than the shareholders approved in adopting the stock option plan.
There is a five-year statute of limitations for securities fraud, and under the Sarbanes-Oxley Act of 2002, option grants to senior management must be reported within two days of the grant date.