What Is Backdated Issue Premium?
A backdated issue premium refers to the illicit gain or advantage derived when a company's executive stock options are granted with a retroactive date that corresponds to a lower historical market price of the company's stock. This practice effectively makes the options "in-the-money" at the time of their actual issuance, providing an immediate, unearned intrinsic value to the recipient. This type of premium falls under the broader category of corporate governance issues and financial misconduct, as it typically involves a lack of transparency and can mislead shareholders regarding true executive compensation. A backdated issue premium distorts reported financials by understating compensation expense.
History and Origin
The practice of stock option backdating, which leads to a backdated issue premium, gained notoriety in the early 2000s, though its roots trace back further. For years, companies often had a window of time, sometimes up to two months, to disclose new stock option grants. This allowed executives to look back at past stock prices within that window and choose a grant date where the company's stock had traded at its lowest point. By assigning this historically low price as the strike price, the options immediately held value, benefiting the recipient without direct correlation to future performance from the actual grant date. Regulators, including the Securities and Exchange Commission (SEC), began thorough investigations into this practice around 2006, leading to a wave of criminal charges and executive resignations.5 For instance, in August 2006, the SEC filed civil charges against former senior executives of Comverse Technology, Inc., alleging a decade-long fraudulent scheme involving undisclosed, in-the-money options granted by backdating stock option grants to coincide with historically low stock prices.4
Key Takeaways
- A backdated issue premium is the immediate, unearned gain from stock options granted with a retroactive date when the underlying stock price was lower.
- This practice makes options "in-the-money" at the time of their actual issuance, boosting the recipient's potential profit.
- It often involves misrepresentation in financial reporting, failing to accurately reflect the true compensation expense.
- The illegality of a backdated issue premium hinges on whether it was disclosed to shareholders and properly accounted for in financial statements and tax calculations.
- Regulatory reforms, such as the Sarbanes-Oxley Act (SOX), significantly reduced the ability to engage in fraudulent backdating by requiring timely disclosure of option grants.
Formula and Calculation
The backdated issue premium, when calculated, represents the difference between the stock's market price on the actual date the option grant was decided upon and the artificially lower strike price chosen through backdating.
Premium per share = ( \text{Actual Market Price on Grant Decision Date} - \text{Backdated Strike Price} )
For example, if the actual decision to grant options was made on June 15, when the stock price was $50, but the grant was backdated to May 1, when the stock price was $30, the backdated issue premium per share would be:
If 10,000 options were granted, the total backdated issue premium would be ( $20 \times 10,000 = $200,000 ). This amount represents the immediate, built-in profit for the option holder that would not have existed had the options been granted at the actual decision date's market price.
Interpreting the Backdated Issue Premium
A backdated issue premium is a clear indicator of a benefit improperly conferred to option recipients. When this premium exists, it means the individuals received options that already had intrinsic value from day one, rather than options whose value would only materialize if the stock price increased after the grant. From a corporate governance perspective, a significant backdated issue premium suggests a severe breach of fiduciary duty, as it disadvantages shareholders by reducing reported earnings and potentially misrepresenting the company's financial health. It signals that executive incentives were not purely aligned with future stock performance but rather retroactively enhanced.
Hypothetical Example
Consider "Tech Innovations Inc." On March 10, executives decide to grant 100,000 stock options to its CEO. On this date, the company's stock trades at $75 per share. However, the board retroactively dates the grant to January 5, when the stock price was $50 per share.
By backdating the grant date, the strike price for the options is set at $50, instead of $75. The backdated issue premium per share is calculated as:
The total backdated issue premium for this grant is ( $25 \times 100,000 \text{ options} = $2,500,000 ). This $2.5 million represents an immediate, unearned gain for the CEO, based on the manipulation of the grant date, rather than actual stock price appreciation after the grant was made.
Practical Applications
The concept of a backdated issue premium is primarily applied in investigations of financial misconduct and in the realm of corporate governance. It comes to light during audits or regulatory reviews aimed at uncovering improper executive compensation practices. When evidence of a backdated issue premium is found, it can trigger legal action by regulators like the Securities and Exchange Commission (SEC) or shareholder lawsuits. For example, former Brocade Communications Systems Inc. CEO Gregory Reyes was convicted in the first criminal trial related to stock options backdating, accused of defrauding investors and doctoring company records.3 This underscores how the existence of such a premium can lead to severe consequences for individuals and companies involved. Companies that were found to have engaged in backdating were often forced to restate their financial statements to properly account for the compensation expense associated with the in-the-money options.
Limitations and Criticisms
While the existence of a backdated issue premium clearly indicates a benefit conferred, the legal and ethical implications primarily arise when such a premium is concealed or improperly accounted for. Critics argue that regardless of legality at the time, the practice inherently undermines the principle of pay-for-performance that stock options are intended to embody. It transforms a future incentive into an immediate, often undisclosed, bonus. The widespread nature of backdating in the late 1990s and early 2000s highlighted significant weaknesses in corporate internal controls and oversight by boards of directors.
Academic research and regulatory scrutiny have demonstrated how backdating permeated many firms, sometimes facilitated by a lack of clarity in accounting rules or even by the tacit acceptance of some auditors.2 Even though changes brought by the Sarbanes-Oxley Act have made fraudulent backdating much harder by requiring rapid disclosure of option grants, the historical prevalence of the backdated issue premium serves as a case study in how executive incentives can become misaligned with shareholder interests, prompting questions about ethical conduct in finance.1
Backdated Issue Premium vs. Stock Option Backdating
The term "Backdated Issue Premium" refers specifically to the financial gain or inherent value created when stock options are granted with a retroactive effective date set to a time when the underlying stock price was lower. It quantifies the immediate, in-the-money advantage received by the option holder.
In contrast, "Stock Option Backdating" is the broader practice or act of setting such a retroactive grant date. The confusion often arises because the practice of backdating directly results in a backdated issue premium. One is the action (backdating), and the other is the quantifiable financial outcome of that action (the premium). While not all instances of backdating were deemed illegal, particularly before stricter regulations, the lack of proper disclosure and accounting for the resulting premium is what constituted fraud in many high-profile cases.
FAQs
1. Is a backdated issue premium always illegal?
No, not inherently. The act of backdating itself was not always illegal, especially before stricter regulations. However, it became illegal if the resulting backdated issue premium was not properly disclosed to shareholders and accounted for in the company's financial statements as a compensation expense. The issue primarily stemmed from companies misrepresenting the true value of these grants and their impact on earnings per share.
2. How did regulators detect backdated issue premiums?
Regulators and academic researchers often detected suspicious backdating patterns by observing unusual stock price movements around option grant dates. If a company consistently granted options just before a significant stock price increase, it raised red flags. Forensic accounting and thorough reviews of company records, board minutes, and internal communications were also crucial in uncovering such practices.
3. What was the purpose of creating a backdated issue premium?
The primary purpose was to provide executives and employees with an immediate, guaranteed profit on their stock options at the time of grant. By choosing a historical low market price as the strike price, the options were immediately valuable, effectively acting as an undisclosed bonus or additional compensation without appearing as a direct expense on the income statement under older accounting rules.