This is a practice that was once viewed as little more than
financial sharp practice but in 2006 exploded into major scandal
for some of Silicon Valley's biggest names. It is a phenomenon that
will never rock the UK markets as it has the US ones.
US technology employees may live on their salaries, but whether
they get truly rich or not depends on their share of the company.
While lucky early employees might get actual shares, most workers
will depend on stock options to cash in on the tech boom.
A stock option granted, for example, on the day you join the
company allows you the right to buy that share at that day's price,
but not until a fixed period – say a year – has elapsed. If the
price has risen in that time you can buy the share at the option
price, sell it and pocket the profit. If the price has fallen, you
simply don't buy the share.
Backdating is the practice of rewriting the agreement so that
the option appears to have been granted at an earlier time when the
share was even cheaper. That way you make even more money when you
sell the share at today's prices.
The practice is not actually illegal in US law, as long as you
tell the shareholders it is going on. Also, the backdating of
options brings with it accounting obligations: the backdating has
to be recognised as a compensation expense.
Academics had long recognised an odd phenomenon of share prices
appearing to rocket on the day after senior executives were given
stock options. One explanation was that options were being
backdated to before major rises.
That idea broke from academia into the business mainstream in
2006, and backdating scandals swept like wildfire in 2006,
involving companies as famous as Apple, Dell and Broadcom.
Reyes is the first executive to go on trial, though others have
settled cases with US financial regulator the Securities and
Exchange Commission and paid not only fines, but millions of
dollars of 'ill gotten gains' in some cases.
So why have we not seen such scandals in the UK? The simple
answer is that the practice has not taken hold because of the
quality of UK regulation.
It is simply not an option for publicly listed companies to
pretend that an option was granted days or even weeks ago. Publicly
traded companies must disclose any grants of options to directors
as soon as possible. In fully listed companies that includes people
discharging managerial responsibility.
This disclosure must come no later than the end of the following
trading day, effectively preventing any back-dating of option
grants.
Companies also have to have their own share dealing codes. When
they don't they simply adopt the stock exchange's own rules. These
rules say that options can't be granted when executives have access
to unpublished price-sensitive information.
Backdating option grants to, for example, just before an
announcement that had a positive share price effect would be
equivalent to granting the option in a prohibited period. Directors
are rightly highly sensitive about share dealing because they can
be censured by the stock exchange; prosecuted for abusing the
market by the Financial Services Authority; or even summarily
dismissed by the company itself.
Protections don't just apply to big listed firms, though. Even
for privately held companies the scope to backdate an option grant
is very limited indeed. Many privately held companies rely on an HM
Revenue and Customs-agreed valuation to fix a market value option
price, typically for Enterprise Management Incentive ("EMI")
option. These HMRC agreed valuations usually remain valid for 30
days only.
So the scandal and court intrigue in the US is unlikely to be
repeated here because tight regulation has ensured that a
backdating culture simply never developed in the first place.
By Rory Cray, a partner of Pinsent Masons, the law firm
behind OUT-LAW.COM. Rory has a decade's worth of experience in the
area of executive incentives and employee share plans.
Contact: rory.cray@pinsentmasons.com
