Federal prosecutors, the SEC, and now private litigants are looking carefully at the corporate practice of backdating stock options. Typically, stock options are granted “at-the-money,” which means that the exercise price of the option equals the market price of the underlying stock on the grant date. Because the value of the option increases as the spread between the exercise price and the current market price increases, executives prefer to be granted options when the stock price is at its lowest. However, if the options are granted retroactively, then the difference between the exercise price and the stock price becomes an expense that may reduce earnings and be taxable income to the recipient.

To avoid the impact on earnings and the tax implications for the recipient, some firms have engaged in the practice of “backdating.” In this practice, the firm decides to give the options to the employee on one date, but the specified grant date is chosen with hindsight so as to minimize the exercise price. That is, on the day the employee receives the options, the stock price for that day exceeds the exercise price, which is the stock price on the specified grant date. Thus, the options are “in the money” as soon as granted because the employee could exercise the options immediately and profit. This practice may be improper if the firm fails to disclose the discrepancy between the issue date and the grant date in its financial statements.

In a similar practice, known as spring-loading, a firm chooses the grant date in advance of the disclosure of information that will increase the stock price. Thus, the firm grants the options and appears to comply with accepted accounting practices, but because the company possesses inside information not yet disclosed to the market, it knows that the options will be in the money once the information is released. This practice may also be viewed as improper.

Applied Economics Partners has teamed with Stanford Professor Steven Grenadier to work on cases involving stock options backdating. Professor Grenadier is eminently qualified to testify on the likelihood that a firm has engaged in the backdating of employee stock options as well as the damages to shareholders. He has consulted with firms about the probability that a firm may have engaged in backdating for purposes of valuing a firm as part of merger discussions. In addition, he has testified on numerous occasions about the valuation of employee stock options. In particular, he has testified on the appropriateness of different methodologies for valuing employee stock options.

Professor Grenadier is Professor of Finance and Chairman of the Finance Department, Stanford University. He has written extensively about options and teaches options theory to both MBA and Ph.D. students. Professor Grenadier received his Ph.D. from Harvard University where his thesis advisor was Professor Robert C. Merton, who won a Nobel Prize for his work in option theory.

In conjunction with Professor Grenadier, AEP provides the following services with respect to stock options backdating and spring-loading:

• investigating and determining the likelihood of backdating or spring-loading
• estimating the impact to the firm’s financial statements as a result of backdating or spring-loading
• estimating damages to shareholders

Professor Grenadier's biography is located here.