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. Although many companies have been identified as having problems with backdating, the severity of the problem, and the consequences, fall along a broad spectrum.

At one extreme, where it is clear that top management was guilty of conscious wrongdoing in backdating, attempted to conceal the backdating by falsifying documents, and where the backdating resulted in a substantial overstatement of the company's profitability, SEC enforcement actions and even criminal charges have resulted. Toward the other extreme, where the backdating was a result of overly informal internal procedures or even just delays in finalizing the paperwork documenting options grants, not intentional wrongdoing, there is likely to be no formal sanction—although the company may have to restate its financial statements to bring its accounting into compliance with applicable accounting rules.

With respect to the more serious cases of backdating, it is likely that most of the criminal actions that the government intended to bring were brought in There is a five-year statute of limitations for securities fraud, and under the Sarbanes-Oxley Act of , option grants to senior management must be reported within two days of the grant date. This all but eliminated the opportunity for senior management to engage any meaningful options backdating.

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Therefore, any criminal prosecution is likely to be based on option grants made before Sarbanes-Oxley took effect, and the deadline facing the government for bringing those prosecutions has already passed. As of 17 November , backdating has been identified at more than companies, and led to the firing or resignation of more than 50 top executives and directors of those companies. Notable companies embroiled in the scandal include Broadcom Corp. Some of the more prominent corporate figures involved in the controversy currently are Steve Jobs and Michael Dell. Anderson and former Apple general counsel Nancy R.

Heinen for their alleged roles in backdating Apple options. According to Section 83 of the Code , employees who receive property from the employer must recognize taxable income in the year in which that property vests i. Such backdating may be construed as illegally avoiding income recognition because falsely under-reporting the market price of such stocks makes them appear to have no value in excess of the strike price at the time the option is granted. The Clinton tax increase amended the Code to include Section m which presumptively makes compensation in excess of one million dollars unreasonable for public companies.

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According to the September 5, Joint Committee on Taxation background briefing if the CEO or other top executive gets stock option grants with exercise price equal to market price, then the options granted would be presumed to be reasonable because they would be performance based. However, if the exercise price is below the market price so that the options are in the money , then the compensation will not be performance based, as the options would have intrinsic value immediately.

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See page 5 of the background briefing. As an economic and practical matter, backdating and cherry-picking dates with the lowest market price of the underlying stock may be evidence that the options granted were not reasonable compensation, because the grant of the options would not be performance based. In such a case, tax deductions would be denied.

Stock Option Repricing and Exchange Programs | Practical Law

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Is Backdating the New Corporate Scandal? Compensation Standards. Executive Press, Inc. Retrieved 11 December Investopedia Retrieved on Including officers and director awards in the repricing program may impact shareholder approval if required , and generally only options that are significantly out of the money should be included in the repricing. Management will need to consider the timing of the option repricing and continued market volatility and avoid the perception of capitalizing on a short-term dip in valuation or providing for outsized employee compensation rewards upon a quick market rebound.

Restoring Incentives of Underwater Stock Options

Modeling the impact of all strategies considered will be critical in making the appropriate decision and these decisions will likely impact the structure of equity awards to be issued in the future. Ultimately, the decision makers at your company will need to understand the impact of the strategies at their disposal.

Depending on the strategy selected your company may see an impact on dilution, stock-based compensation expense, or a combination of the two. Dilutive impact will occur with instances where additional awards are given as consideration. The dilutive impact will be in the increase of shares to your award pool in order to give out additional options.

If portions of your exiting option pool can be used to issue out additional consideration, the impact to your fully diluted shares can be minimized. Stock based compensation impact will occur in instances where options are repriced so that the exercise price is lowered to a price below the current exercise price. In accounting these are considered type 1 modifications where no previous expense recognized or projected will be reversed and there may be an incremental expense for the replacement grant.

The incremental expense is measured at the fair value of the grant directly before and after the application of the modification. In these instances, companies will likely recognize the greatest impact to additional stock-based compensation expense in the expense period the repricing occurs.

Then in future expense periods, the company will continue to recognize an additional incremental expense until the grant is fully vested. Modeling these scenarios accurately will be instrumental in arming your executives and board with the proper information to move forward. If you are fortunate enough to have your capitalization table on a software solution such as Carta, this process can be significantly more accurate and streamlined. As the economy looks beyond COVID and begins to reopen in the coming months, hopefully a clearer picture of the near-term economic outlook begins to form.

The Pay-to-Performance Link

If current valuations remain in the shadows of prior highs, it may be a good time for companies to start developing a strategy to address underwater stock options. Having knowledgeable partners to help guide management through the modeling, valuation and decision-making process, as well as an all-in-one equity system solution will help ensure a fully vetted strategy. ARC Consulting is a premier accounting advisory firm based in San Francisco, staffed with technical experts with a mix of practical industry experience. All material has been prepared for informational purposes only, and is not intended to substitute, and should not be relied on for tax, legal, or investment advice.

You should consult an independent tax advisor, lawyer, or financial advisor before engaging in any transaction. For more information, visit arcconsultingllc.

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Since its inception in , more than 14, companies, , shareholders and Venture Capital firms have trusted Carta to manage hundreds of billions of dollars in equity. Carta is an SEC-registered transfer agent.