BACKDATED STOCK OPTIONS
 

What Are Backdated, Spring Loaded, And Bullet Dodging Stock Options And Why Are They Illegal?

Stock option backdating occurs when a stock option’s exercise price is not the stock’s actual closing price on the date the option was granted, but rather is set at a lower price which corresponded to the stock’s closing price on a previous date.  For instance, if a stock option is granted on July 1, when the stock price closed at $5.00 per share, then the option exercise price should be $5.00 per share.  However, if the option was backdated, it might be assigned the exercise price of $3.00 per share, which might correlate to the stock’s closing price on June 1, one month earlier.   

Backdating an option in this way ensures that the option is “in the money” on the date of its grant, thereby increasing not only the likelihood that the option will be exercised at a profit by the executive to whom the option was granted, but also increasing the amount of the profit that its exercise would yield.  This benefit to the executive being granted stock options comes at the direct expense of the corporation, which runs a greater risk of having the options it has granted be exercised in a manner that generates less money for the corporation (due to the lower exercise) than had the option not been backdated.  Thus, backdated options unjustly enrich the officer or director to whom they are granted, causing him or her to breach their fiduciary duties of care, loyalty, and good faith.   

Backdating an option so as to be “in the money” on the date of its grant also creates accounting improprieties.  Under generally accepted accounting principles (GAAP), options that are “in the money” when granted are the equivalent of compensation and therefore must be treated as an expense by the corporation.  If the corporation fails to properly account for the “in the money” options as an expense in its public filings with the Securities and Exchange Commission (SEC), it overstates profits.

Spring loaded and bullet dodging options likewise are granted so as to artificially manipulate the option grant price at the expense of the corporation.  Spring loaded options are granted to executives before the release of material information reasonably expected to drive the market price of company stock higher when disclosed.  Conversely, bullet dodging options are granted to employees after the release of materially adverse information that causes a decline in the market price of the company stock.  Both spring loading and bullet dodging have the effect of ensuing that the options granted have lower exercise prices than they would have had the option grants been made without reference to material information not known to the market.

In the cases investigated by our firm to date, corporate officers, directors, and executives have used backdated, spring loaded, and bullet dodging stock options to create for themselves tens, or even hundreds, of millions of dollars in profit and unrealized gain at the expense of their corporations.   

Many companies avoid the pitfalls described above by simply granting their stock options at the same time each year, a sound policy which eliminates the potential for surreptitious backdating by providing predetermined dates for the granting of options and, effectively, dates on which the their exercise price would be set.  This practice is entirely permissible.
 

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