Backdated option gamma: Meaning, Criticisms & Real-World Uses

What Is Backdated Option Gamma?

The term "Backdated Option Gamma" is not a recognized or standard financial concept. It appears to be a conflation of two distinct and unrelated financial terms: Option Backdating and Option Gamma. This article will first clarify why "Backdated Option Gamma" is not a valid term and then provide a comprehensive overview of "Option Backdating," which falls under the broader categories of Corporate Governance and Financial Misconduct. A brief explanation of Option Gamma will also be included to highlight its separate nature.

Option Backdating Explained

Option backdating refers to the unethical and often illegal practice of retroactively changing the effective grant date of stock options to a date in the past when the underlying stock's market price was lower than the actual grant date. This manipulation allows the recipient, typically an executive, to acquire "in-the-money" options, meaning their strike price is below the current market price, thereby increasing their potential profit upon exercise without proper disclosure or accounting for the compensation expense. This practice was a significant issue in executive compensation in the early 2000s, leading to numerous investigations and enforcement actions by regulatory bodies.

Option Gamma Explained

Option Gamma, on the other hand, is one of the "Greeks" in options trading, representing the rate of change of an option's delta with respect to a change in the underlying asset's price. In simpler terms, it measures how sensitive an option's delta is to movements in the underlying asset. Gamma is a crucial concept in option pricing models and risk management for options traders, indicating the convexity of an option's price curve. It has no direct relationship with the practice of backdating option grant dates.

History and Origin of Option Backdating

The practice of option backdating gained prominence during the dot-com boom of the late 1990s and early 2000s, exploiting ambiguities and loopholes in accounting rules and reporting requirements. Prior to 2002, companies were not required to immediately disclose stock option grants, often reporting them months or even years later. This delayed reporting created an opportunity for executives to look back at historical stock prices and assign a grant date when the price was at a low, making the options immediately profitable.

The widespread nature of option backdating came to light primarily through academic research. A study by Erik Lie, a finance professor at the University of Iowa, published in 2005, systematically identified patterns of unusually well-timed option grants that coincided with stock price lows, strongly suggesting backdating.⁸ This academic work, combined with investigative journalism, particularly by the Wall Street Journal, initiated significant public and regulatory scrutiny around 2006.⁷ The resulting scandal led to a wave of investigations by the U.S. Securities and Exchange Commission (SEC) and the Department of Justice, prompting numerous restatements of financial statements, executive resignations, and legal penalties across various industries.,⁶,⁵

Key Takeaways

"Backdated Option Gamma" is not a recognized financial term; it combines the distinct concepts of option backdating and option gamma.
Option backdating is the illegal practice of retroactively altering the grant date of stock options to a date with a lower stock price to increase their value without proper accounting.
The practice came to prominence in the early 2000s and led to major corporate scandals, restatements, and legal consequences.
Option Gamma is a measure of an option's delta's sensitivity to changes in the underlying asset's price, unrelated to backdating.
The Sarbanes-Oxley Act of 2002 significantly curbed backdating by requiring timely disclosure of option grants.

Formula and Calculation

Option backdating itself does not involve a specific formula or calculation in the traditional sense of financial modeling. Instead, it is an administrative manipulation of dates to achieve a specific outcome. The "gain" from backdating would simply be the difference between the stock's market price on the true grant date and the lower, chosen backdated grant date, multiplied by the number of options granted.

For instance, if a company's stock was trading at $50 on the actual grant date, but executives backdated the grant to a date when the stock was trading at $30, the immediate "in-the-money" value per option would be $20, which should have been recognized as a compensation expense. However, companies engaging in backdating often failed to properly account for this intrinsic value at the time of grant.

Option Gamma, however, does have a mathematical formula. Gamma is the second derivative of the option price with respect to the underlying asset's price, or the first derivative of delta with respect to the underlying price. In the Black-Scholes model, for a European call option, Gamma ((\Gamma)) is calculated as:

\Gamma = \frac{N'(d_1)}{S \sigma \sqrt{T-t}}

Where:

(N'(d_1)) is the probability density function of the standard normal distribution evaluated at (d_1).
(S) is the current market price of the underlying asset.
(\sigma) is the implied volatility of the underlying asset.
(T-t) is the time remaining until expiration (in years).
(d_1) is a component of the Black-Scholes formula, involving the underlying price, strike price, time to expiration, risk-free rate, and volatility.

This formula is entirely separate from the concept of option backdating.

Interpreting Option Backdating

Interpreting the act of option backdating centers on its implications for corporate governance, transparency, and the integrity of financial statements. When options are backdated, it suggests a deliberate attempt to enrich executives at the expense of shareholders and to mislead regulators and the public about the true cost of executive compensation.

The primary interpretation of backdated options is that they represent undisclosed or improperly accounted-for compensation. By choosing a grant date when the stock price was lower, the options instantly hold intrinsic value, yet companies often failed to expense this value on their books, thereby inflating reported earnings. This practice undermines fair financial reporting and can lead to a misrepresentation of a company's financial health. It also raises questions about the oversight role of a company's board of directors and its audit committee.

Hypothetical Example of Option Backdating

Consider a hypothetical company, Innovate Corp., that decides to grant stock options to its CEO on March 15, 2005. On this date, Innovate Corp. stock is trading at $45 per share. If the company were to grant options at this price, they would be "at-the-money."

However, suppose the CEO, in collusion with certain board members, decides to backdate the grant. They look back at the historical stock prices and find that on January 10, 2005, Innovate Corp.'s stock price hit a low of $28. They then create documentation falsely stating that the options were granted on January 10, 2005, with a strike price of $28.

On March 15, 2005, when the options are effectively granted, they are already "in-the-money" by $17 per share ($45 - $28). This $17 per share should be recognized as a compensation expense on the company's financial statements. If the company grants 1 million options, this amounts to $17 million in hidden or understated executive compensation and an overstatement of net income. This manipulation provides an immediate, undisclosed benefit to the executive and misleads shareholders and regulators about the company's true financial performance and compensation practices.

Practical Applications

The practical implications of option backdating are primarily evident in the realms of corporate law, corporate governance, and regulatory compliance. The widespread scandals of the mid-2000s underscored the critical need for stricter controls and greater transparency in executive compensation practices.

Regulatory Scrutiny: Regulatory bodies like the Securities and Exchange Commission (SEC) have actively pursued companies and executives involved in backdating. For example, the SEC filed a civil injunctive action against UnitedHealth Group Inc. and its former General Counsel in 2008 for concealing over $1 billion in stock option compensation through backdating.,⁴
Legislative Reform: The Sarbanes-Oxley Act (SOX) of 2002 was a pivotal piece of legislation enacted to address corporate accounting scandals. While not directly aimed at backdating, Section 403 of SOX required executives to report stock option grants within two business days of the grant date. This dramatically reduced the ability to retrospectively choose a favorable date, significantly curbing the practice of option backdating.
Enhanced Audit and Internal Controls: Companies now face much greater pressure to implement robust internal controls and undergo thorough audit processes to ensure that stock option grants are properly dated, valued, and accounted for in their financial statements.

Limitations and Criticisms

While option backdating offers immediate financial benefits to recipients, it carries significant limitations and severe criticisms, largely due to its deceptive nature and the negative impact on corporate governance and shareholder trust.

Legality and Ethics: The primary criticism is that undisclosed option backdating is unethical and often illegal, constituting accounting fraud and securities fraud. It involves falsifying documents and misleading shareholders about the true cost of executive compensation.
Shareholder Value Destruction: Companies implicated in backdating scandals often suffered significant reputational damage, stock price declines, and substantial legal costs, including fines and settlements. Research indicates that shareholders of firms accused of backdating experienced large negative abnormal returns.³ The practice can lead to a massive loss of investor confidence, as seen in various high-profile cases.²
Misleading Financial Reporting: Backdating distorts a company's financial statements by understating compensation expenses, leading to inflated earnings. This provides a false picture of profitability and can mislead investors and analysts. Restating earnings due to backdating can be a complex and costly process.¹
Impact on Internal Controls: The existence of widespread backdating implied a breakdown in internal financial controls and often indicated a lack of effective oversight by boards of directors and audit committees, compromising overall corporate governance.

The enhanced scrutiny and regulatory changes, particularly the Sarbanes-Oxley Act, have largely eliminated the ability for companies to engage in the most egregious forms of undisclosed option backdating.

Option Backdating vs. Spring-Loading

Option backdating and spring-loading are both practices related to the timing of stock option grants for executive compensation, but they differ significantly in their legality and method.

Option Backdating: This involves retroactively changing the grant date of an option to a past date when the company's stock price was lower. The intent is to make the options "in-the-money" immediately, providing an instant paper gain to the executive. This practice is generally illegal if not fully disclosed and properly accounted for, as it involves falsifying records and misleading shareholders and regulators. The backdating scandals of the early 2000s highlighted the fraudulent nature of this practice.

Spring-Loading: This occurs when a company grants stock options just before the announcement of positive, market-moving news that is expected to increase the stock price. The grant date is the actual date the options are approved, and the strike price is set at the current market price. While not illegal if disclosed, it raises ethical concerns regarding the use of material non-public information to benefit executives. The key difference is that with spring-loading, the grant date is the actual date, not a falsified retroactive one, and the options are initially "at-the-money," becoming profitable after the news is released.

Both practices leverage timing to benefit option recipients, but option backdating involves a deceptive alteration of historical facts, making it a form of fraud, whereas spring-loading is more of an ethical dilemma concerning insider information.

FAQs

Q: Why is "Backdated Option Gamma" not a real term?

A: The term "Backdated Option Gamma" does not exist in finance because "backdating" refers to the fraudulent manipulation of stock option grant dates, while "gamma" is a mathematical measure of an option's sensitivity to price changes of the underlying asset. They are two entirely separate concepts from different areas of finance—corporate governance and options pricing theory.

Q: What was the main problem with option backdating?

A: The main problem with option backdating was that it allowed companies to grant "in-the-money" stock options to executives without properly accounting for the intrinsic value as a compensation expense. This practice misled shareholders by overstating company earnings and understating the true cost of executive compensation. It often involved falsifying documents and constituted a form of fraud.

Q: Did anyone go to jail for option backdating?

A: Yes, several executives faced criminal charges and served prison time for their involvement in option backdating scandals. Beyond fines and civil penalties from the Securities and Exchange Commission (SEC), some cases led to convictions for securities fraud and other related offenses, highlighting the severe legal consequences of the practice.

Q: How did the Sarbanes-Oxley Act impact option backdating?

A: The Sarbanes-Oxley Act (SOX) of 2002 significantly curbed option backdating by mandating accelerated disclosure requirements for stock option grants. Specifically, Section 403 of SOX requires company insiders to report changes in ownership, including option grants, within two business days of the transaction. This swift reporting requirement eliminated the ability to retroactively select a favorable grant date.